How Much Should I Invest in Non-Liquid Investments?
Investment liquidity is doubtlessly a good thing. Yet, that doesn't mean that illiquidity is doubtlessly a bad thing. In fact, liquidity can sometimes be a curse and illiquidity can sometimes be a blessing. This is the realization felt by traders after they've participated in a panic (incidentally, it's easy to label a panic in hindsight, but very difficult to see a situation as temporary, emotional selling while it's happening and when your net worth is falling!).
Within a holistic perspective, illiquidity can be viewed as a shelter from behavioral biases. Having the ability to sell at any given moment during trading hours can too often translate into the compulsion to sell at an inopportune time with that compulsion being fed by biases that are woven through the human psyche; even trained, professional psyches.
Both liquid and illiquid investments have a place in most portfolios. How should an allocation to illiquid investments be determined? Many advisors employ a mean-variance optimization to set asset allocations. However, as one of the assumptions of a mean-variance analysis is that investors need only know the expected returns, variances, and co-variances of returns to determine optimal portfolios, it will not capture client constraints related to liquidity and time horizon. This being the case, below is a logical and simple framework that can be used to augment a mean-variance analysis or potentially be built upon and used as a stand-alone method for determining portfolio allocations to illiquid assets.
Firstly, consider client specific constraints for liquidity and time horizon. If a withdrawal(s) from their comprehensive liquid holdings (in other words, all holdings including those that might be managed elsewhere) seems probable, determine how much the client might need from their liquid portfolio under a reasonably stressed scenario over a time period matching that of the anticipated illiquid investment. There may well be known and planned liquidity requirements during this time period. Those are easy. The "stressed" part of this has to do with the unplanned and the definition of "reasonably" will be client-specific taking into account items that may include an interruption of income such as a job loss and the temporary lack of income during a transition, an increase in capital required to be contributed into a family business, etc.
Secondly, reasonably stress the liquid portfolio values over this time period. There are various approaches here (macro return expectations for the liquid assets classes or a more portfolio specific tool such as Value at Risk can be used, for example).
The timing of withdrawals and the returns on the liquid portfolio would most easily be performed annually, but any frequency within the overall time period that is most appropriate to a specific client can be used to more accurately account for time value.
Under the chosen stress scenario that simulate both liquidity needs and portfolio returns, the portion of excess liquid assets remaining is eligible for illiquid investments (i.e. stressed liquid portfolio value minus stressed liquidity needs equals amount available for illiquid allocation).
Having this dollar amount in hand it can now be used as a limit on the results of a mean-variance optimization. If the advisor is developing asset allocations using a mean-variance optimizer and the allocation suggested by that optimization exceeds that of the process above, the allocation to the illiquid assets should be reduced. If the optimization produces a result below that suggested as eligible, no revision to the mean-variance result is needed.
This methodology results in higher allocations to illiquid investments when there are lower liquidity needs, shorter lock up periods, and greater relative risk adjusted returns - which is as exactly as it should be.
Before running a mean-variance analysis, a quick rule can be applied to determine if the addition of an asset will enhance the portfolio:
Where:
E(Rnew)= the expected return on the new investment
Rf = the risk free rate of return
σnew= standard deviation of the new investment
E(Rp)= the expected return of the existing portfolio
σp= the standard deviation of the existing portfolio
ρnew,p= the correlation between the returns of the new investment and the existing portfolio
This rule says that if the Sharpe Ratio of the new investment is greater than the product of the pre-existing portfolio's Sharpe Ratio and the correlation between that portfolio and the proposed asset, the addition will improve the portfolio's risk adjusted return. There are shortcomings when applying a measure like the Sharpe Ratio to illiquid investments, however, this is still a useful tool for your toolbox.
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