What is the Difference Between Liquid and Illiquid Assets?
You may not think too much about selling an investment asset when you first buy it. After all, you need it to accumulate value. But when you’re trying to get rid of an asset to capitalize on a moment or minimize a loss, liquidity should be the most important factor on your mind.
And for alternative investors, liquidity is one of the major challenges you have to face.
Here’s a look at the difference between liquid and illiquid alternative investments—and whether liquid alternative investments are worth adding to your portfolio.
What are Alternative Investments?
First, a quick review of the basics.
Alternative investments are any investment asset that doesn’t fall into one of the three conventional categories:
In other words, any investment that isn’t stocks, bonds, or cash technically qualifies as an alternative investment, a huge category ranging from blue-chip art to hedge funds to distressed securities to real estate.
However, as alternative investors know, all alternative investments have a few key features in common. They’re more complex, less regulated, and less liquid than conventional assets. Alternative investments tend to be illiquid because of their complexity, uniqueness, and the overall difficulty of valuing them. For example, how do you value a Matisse? It’s an important question, because if you can’t value an investment easily, it’s that much harder to sell it.
What are Liquid and Illiquid Assets?
This is where the concept of liquidity versus illiquidity comes into play.
A liquid asset is any asset that can be easily converted into cash in a short period of time. Cash is the most liquid of all assets, but stocks also qualify as a highly liquid investment asset. The benefit of liquid assets is that you can sell them quite easily, which makes it easy to collect your gains.
An illiquid asset, by comparison, cannot be easily sold and converted into cash without a substantial loss in value. This can happen for any number of reasons—maybe there isn’t much investor interest, maybe investor interest has cooled off, maybe there isn’t a wide investor pool to begin with, or maybe, in the case of alternative assets, the asset itself is difficult to value.
As previously stated, one of the major challenges with alternative investments is their relative illiquidity. This results from a few factors: the asset itself is difficult to value, the asset is highly complex, the investor market is niche, or any combination thereof.
Because of this, alternative investments tend to be harder to sell quickly. For example, you can almost always find a buyer for Apple stock, but you’d have a much smaller market to sell Magritte’s Son of Man.
What are Liquid Alternative Investments?
Within alternative investments (which can broadly be classified by asset liquidity) there’s a specific subset of assets called liquid alternative investments, which are not to be confused with the rest of the alternative investment pool.
Liquid alternative investments are a type of mutual fund or exchange-traded fund offering investors diversification and downside protection through exposure to alternative investments. As the name implies, their major selling point is that they can be bought and sold daily like stocks (and may even be bought and sold on the stock market) in stark contrast to most other alternative assets (which tend to offer monthly liquidity at best, usually quarterly or annual liquidity).
Differences Liquid and Illiquid Alternative Investments
With that in mind, let’s talk about the difference between liquid and illiquid alternative investments.
The Liquidity Spectrum
The most obvious difference is the liquidity spectrum. The key feature differentiating these assets is how quickly and easily they can be converted to cash.
At the highly liquid end of the spectrum are things like ETFs or liquid alternative investments, while the highly illiquid end of the spectrum includes things like hedge funds and private equity. That isn’t to say that illiquid assets aren’t worth the investment, just that you have to know what you’re signing up for.
Liquid and illiquid alternative investments both have different cost structures. These are often shaped by the specific investment asset in question, but the relative liquidity of an asset can also influence costs attached to it.
For example, the art market tends to be illiquid except for the blue-chip art market. Even at the blue-chip level, you have to navigate significant costs attached to a sale, from attorneys to art appraisers to auction fees to insurance. As a general rule, the harder it is to sell an asset, the more money you’ll have to spend on expert intermediaries to smooth out the liquidation (except in the case of illiquid assets that you can source directly).
Last but not least are investment requirements.
Liquid and illiquid assets both face government regulation to protect investors from fraud. As a whole, alternative investments, which tend towards illiquidity, are less regulated than their conventional, liquid counterparts. For this reason, illiquid alternatives tend to be offered only to accredited investors (registered, financially sophisticated investors who are allowed to invest in assets that may not be registered with financial authorities).
Compare that to a highly liquid asset like an ETF, which does not require investor accreditation. After all, ETFs are relatively straightforward and low-cost compared to something like a hedge fund.
The Accessible Approach to Alternative Investing
We know that alternative investing can be challenging—well beyond the choice between liquid and illiquid alternative investments. That’s why we’re here to democratize the world of blue-chip art investing by allowing our members to purchase shares in authenticated multi-million-dollar artworks from high-growth artist markets with the highest potential risk-adjusted returns. Ready to make the most of your alternative investment portfolio? Fill out your membership application today to learn more.