- November 1, 2019: Vol. 6, Number 10

A time for illiquidity: Putting assets temporarily out of reach can prove a stronghold in a volatile market

by Kali Persall

With the next recession knocking at the door, a myriad of conversations are taking place about when this will happen, what it will look like and how it will affect the real estate investment market.

The United States is still in the midst of one of its longest economic expansions in the country’s history — a decade as of June — but investors still cannot seem to shake the fear that the cycle is getting long in the tooth. Registered investment advisers reported in a recent sentiment survey that the No. 1 concern among their clients was a recession (33 percent), replacing volatility as the top spot (up 7 percent from the previous quarter), and their worries are well-founded. In August, the bond yield curve inverted, meaning the interest rates on short-term bonds were higher than interest rates paid by long-term bonds. It is a sign the market believes short-term investing is riskier than long-term, a pattern that has occurred before every U.S. recession since 1955. While no one knows for certain when the next recession will hit, it is likely we could see it within the next 18 months, according to an Economic Policy Institute report.

As a result, many investors are starting to look harder at how accessible their assets will be when the starting pistol fires. According to Aegon Asset Management, spurred by low interest rates, investors have increased their exposure to illiquid assets in recent years in search of alternative ways to generate returns. Illiquidity functions like a storm cellar during times of economic volatility, allowing investors to save their assets for a sunny day all while generating yield in the interim. For that reason, illiquidity is being increasingly regarded as a strategic stronghold during a recession.

While liquid assets are notoriously attractive for their ability to move through markets quickly, an ace in the hole when the eleventh-hour strikes, they also carry alarm-sounding potential that could contribute to a liquidity crisis (evidenced by the previous economic downturn). Recessions have been known to push the panic button on the market, causing investors to make snap, emotional decisions. Suddenly, the “buy low, sell high” investment formula is turned on its head as investors fall prey to loss aversion instincts. Take the Fidelity Magellan Fund, for example, the largest — and arguably most successful — mutual fund in history. While the fund itself returned a staggering 29 percent annually for a period of 13 years, the average investor actually lost money. This could be owed to the fact there were three recessions during the Magellan Fund’s prime (1977-1990). “Buy high, sell low” is counterintuitive, but has proven to be a common trap investors fall into whenever a bear market threatens to reemerge. However, studies show that strategic investments can help manage volatility. According to research published by Bloomberg in August, the average duration of a bear market is nine months (with an average loss of 28 percent), while the duration of an average bull market is 54 months (with an average gain of 129 percent). That means all investors have to do is wait it out.

Illiquidity can pump the brakes on impulsive divestments, and that is why industry experts such as Patrick Wathen, managing partner at Equity Velocity Funds, are making room for it in their portfolios. “For me, a large part of that is you can’t knee-jerk sell this stuff,” says Wathen. “Even if you do want to move something quickly, quickly in commercial real estate is 45 to 60 days. It’s an insulation from emotional-based decision making, which I think is a recessionary plague.”

Illiquidity offers investors stability in the form of less day-to-day fluctuation and more long-term yield. It is yield that makes real estate so valuable, Wathen notes, likening it to locking away gold in a safe. But unlike gold or timber — other illiquid assets — real estate, and its fluctuating market valuations, is income-producing. That is what makes it an especially attractive illiquid asset.

“Depending on taxable versus nontaxable accounts, real estate is the only asset that depreciates from a tax basis while appreciating over time if you’re investing properly,” says Matt Lasky, managing partner at Equity Velocity Funds. “The embedded tax benefits, coupled with positive leverage and the ability to fund cash streams, makes it pretty unique relative to other illiquid assets.”

Michael Ezzell, CEO of Inland Securities, also noted that real estate is attractive on an absolute basis because it exhibits a return profile that is attractive to investors: potential for income, potential for capital appreciation, depreciation that can shelter income and a potential hedge against inflation.

“On a relative basis, a real estate property or portfolio that is not subjected to the whims of the broader equity markets can help reduce portfolio volatility when compared to the equity and fixed-income markets,” says Ezzell. He added that this applies to REITs that invest in both real estate equity, real estate debt and commercial mortgages.

In Wathen’s case, the majority of his portfolio is illiquid, in part because it gives him “skin in the game” with investors. Still, he says many of the conversations among RIAs, high-net-worth individuals and family offices he has observed are still skewed toward liquidity, fueled by good buying opportunities.

There is no one-size-fits-all standard for what percentage of a portfolio should be illiquid and liquid, considering the different needs of individual investors, Ezzell points out. He posits that assets are not necessarily being converted from liquid to illiquid for the sake of being illiquid, but instead financial advisers and investors are converting assets based on where they fit within the client’s overall financial goals. This process takes into account the variable of time, or more specifically, when a client will need to use their savings to support those goals, says Ezzell. He adds that in this context, investments that feature less liquidity than a typical stock can be used to bring a different risk/return profile into the client’s asset allocation, with the goal of growing or protecting portfolio returns, while maintaining or lowering overall portfolio volatility. In the end, the exact allocation must be determined by the client and their financial adviser, to ensure the client’s needs and risk profile are ultimately addressed.

“What we have seen in practice is shorter time horizons and smaller overall investable assets together may mean a lower overall risk profile that may not be conducive to the inclusion of less liquid assets,” says Ezzell. “To be meaningful from a performance perspective, we often see clients utilize a 5 to 10 percent allocation to less liquid assets and sometimes higher depending on client needs and risk profiles.”

While there is no such thing as a “recession-proof” real estate investment, illiquid assets do offer a cushion from volatility if incorporated into an investor’s portfolio strategically.

“When included in a broader diversified portfolio, this muting of equity volatility in a portion of the client’s portfolio lowers overall portfolio volatility, potentially generating lower relative losses,” says Ezzell.

The Chartered Alternative Investment Analyst (CAIA) Association recommends that funds that do decide to invest in illiquid assets set a maximum allocation based on a stress test. All in all, whatever illiquidity may look like in a portfolio, the bottom line is this: thinking outside the box just may be the secret to investor resilience if and when the next recession finally does cross the threshold.


Kali Persall is a reporter at Institutional Real Estate, Inc. and editor of iREOC Connect.




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