Suppose someone approached you and said, “If you buy the investment I have in mind for you, you can get good returns — but you won’t be able to access your money for 10 years without a substantial penalty.”
And then what if someone else said to you, “I can get you the same returns on your investment, and you can access your money, cashing it in at any time without a penalty; you’ll get the returns earned to date.”
Suppose you found out the returns from the investment that ties up your money for a decade aren’t likely to be as good as those from the second proposition.
You’d forget about the first proposition, right? Why tie up your money just to suffer lower returns? If anything, you need higher returns to justify the lack of access.
Investments that you have ready access to — without penalty — are known as liquid investments, and those that tie up your money for a quarter, a year or even a decade and impose significant penalties for cashing them in are illiquid investments.
Most standard investments are liquid: stocks, bonds, savings accounts, money market accounts and shares of mutual funds and exchange-traded funds for any of various forms of underlying investments (stocks, various types of bonds and commodities).
Illiquid investments include many less familiar types, such as forms of annuities, venture capital and private equity funds, hedge funds and private real estate investment trusts.
Regardless of how good an illiquid investment may seem, you must weigh that against the opportunity costs of having your money tied up. Key questions: Can I get better returns? Does this investment create diversification so that when the market zigs, this investment zags? Suppose you tie up a large chunk of your accumulated assets, then the house you want as your vacation/retirement home becomes available at a foreclosure sale for a fraction of its actual value.
To be compensated for damage from lost opportunity, you need a reasonable assurance of stellar returns from your illiquid investment. But the prospects of such returns from these investments sometimes aren’t good and, in many cases, are unknowable.
With an annuity, at least, you know what you’re getting. Various studies have shown you can do better long-term by putting this money in liquid investments. But many investors like the certainty of a guaranteed income stream. Many annuity investors like the illiquidity because it bars their access to money they might otherwise spend.
By contrast, with venture capital, private equity and hedge funds, there are no guaranteed returns. These investments can have long lockup periods with surrender charges for anyone who wants to get at their capital earlier.
Lockup periods for hedge funds aren’t as long, but net returns are challenged by high fees charged by fund managers. Some of these funds may be a good idea, depending on investors’ risk tolerance and goals, and on the fund’s capacity to increase when the stock market declines — but the lockup is a certainty.
Another illiquid investment is a private real estate investment trust — a pooled investment for commercial or multi-family residential property.
When you buy shares in private REITs, your money could be tied up for long periods. Yet the same type of investment is available in publicly traded form. You can track values daily and get out anytime you like.
Many illiquid investments are marketed primarily to people of considerable means, and this is perhaps as it should be. You need substantial assets to closet a big chunk of money away for years. This way, you retain flexibility to take advantage of opportunities.
Marketing of illiquid investments can be intense. As the salesman touts supposed advantages, interrupt and ask an important question: What do you get out of this? If they don’t want to talk about it, you may want to end the conversation. Full disclosure should include the motivation to sell.
If you decide to buy illiquid, you might want to have a going-away party for your money; you may not see it again for a long time.
And when your money comes home, you want it to bring along enough friends to justify the wait.
Jamie Cornehlsen and Ted Schwartz are advisors with Capstone Investment Financial Group. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village. Reach them at email@example.com or firstname.lastname@example.org.