Who would you rather lend $100 to: A trustworthy friend who promises to pay you back $150 whenever you ask, or a trustworthy friend who promises to pay you back $200 in five years?
Turns out most people would say they’d prefer to lend money to the friend who’ll pay them back when asked, even if the other friend is offering a better return. That’s because people value liquidity—they want to be able to get their hands on their money when they need it.
When it comes to investing, liquidity is a measure of how quickly you can sell something without impacting the price.1 A U.S. Treasury Bill is a liquid asset—T-bills can be sold almost instantly, and that sale probably won’t affect the Treasury market or lower the price you get. Your home, on the other hand, is an illiquid asset. It would take a few months to sell, and when you put it on the market, the price you get may be different from what you expect.
We know investors value liquidity. In fact, they’ll usually pay more for more-liquid assets and less for less-liquid assets.2 For example, if an investment manager purchased a building and put it into a traded fund, you’d pay more for a stake in that building than you would for a stake in the same building housed in a non-traded fund. The rental income would be the same in either case, but you’d pay more if you purchased your stake through a traded fund. In other words, you’d pay less for a given cash flow from an illiquid asset than you would for a liquid one. This difference in return is known as the “illiquidity premium.”
[Related: Watch portfolio manager John Snowden’s video on finding the right balance]
Investors want an illiquidity premium because they worry about liquidity risk, which is the risk that they might not be able to get their money when they need it or sell an illiquid asset when markets turn bad.2 The illiquidity premium can be very attractive. One study found that private equity funds outperformed the S&P 500 by more than 3 percent annually, which adds up over time.3 This means that including illiquid assets in a portfolio may help drive higher returns, and who doesn’t like that?
Illiquid assets may also help you in other ways. For example, when markets are falling, closed-end funds, which have limited liquidity, may perform better than open-end funds.4 When markets fall, investors in open-end funds may panic and sell their positions, forcing the fund to sell its liquid assets to pay them out. The remaining investors are left with a smaller portfolio.
In a closed-end fund, investors can’t easily sell in a panic during a market fall. This allows the fund to stay the course strategically and hold on to its whole portfolio. When the market recovers, closed-end funds may bounce back faster and more strongly than open-end funds.4