LIQUID & ILLIQUID ASSETS:
Must-haves For A Diversified Portfolio
WHAT if you were confronted with a financial emergency that you needed to pay in a hurry? Something major like, say, an unforeseen medical expense that could create serious financial strain if you don’t have health coverage or, if you have insurance but still needed to find money to cover a significant amount of deductibles. Could you readily settle the bill without tapping out your credit card reserves? That is to say, would you be able to dip into a savings account, pawn a valuable piece of jewellery or family heirloom, or cash in a bond share or two if needs be? If you were in a position to do any of these, then you are what can be described as being in a state of liquidity.
WHAT ARE LIQUID ASSETS?
Liquidity refers to the ability of an individual or a company to find sufficient liquid assets to pay bills on time. Liquid assets comprise possessions that can be converted to cash without losing substantial value. The factors determining liquidity include how established the market is, how easily ownership can be transferred, and how long it will take for the asset to be sold or liquidated.
High-quality liquid assets (HQLAS) are those assets that are the most easily converted to cash. This would make cash in hand and funds withdrawn from a bank, or credit union account the most liquid of assets, repurchase agreements (repo) are also near to cash and therefore this is an important asset class for an investor to have in her portfolio because they are necessary for covering living expenses and, as noted before, potential emergencies. Liquid assets are therefore built through the creation of an emergency fund.
Other non-cash liquid assets may not be so readily convertible into cash. They are valuable possessions, mind you, but are just not able to be sold for cash right away or without losing some value with the sale. They include: Stocks, bonds, exchange traded funds (ETFS), mutual funds, money market funds, CDS, and precious metals.
The ease of conversion in these non-cash assets depends on their security type. Stocks, for example, can usually be sold in a few days but, if the market is down, you could have to sell below value. CDS, and even 401Ks, similarly, will usually have penalties and withdrawal restrictions attached to them if removed before their maturity dates.
WHY LIQUIDITY MATTERS
Maintaining liquidity above the bare minimum, it can’t be said nearly enough, is wise not only for individuals but also companies for the provision of cushion in the event of the unexpected. A stark example of the importance of this occurred in the banking sector.
Think back to the financial crisis of 2008, when American banks found themselves embroiled in the so-called subprime mortgage fiasco. What happened then was these banks, as a result of the recession, found themselves holding billions of dollars in unpaid loans when depositors panicked and withdrew their funds. The banks did not possess sufficient cushion in terms of liquid assets to weather the storm, and so many became insolvent, necessitating the federal Government to stave off catastrophic economic collapse.
After this, a liquidity coverage ratio (LCR) rule was created to ensure that debacle is never repeated. In Jamaica this standard has also been enforced, which states that all banks and financial institutions must have an adequate amount of HQLAS, consisting of cash and assets, to meet its liquidity needs for a 30-day period, thus supporting and enhancing their short-term resilience. Your portfolio should be balanced enough to include liquid assets as a part of your investment strategy.
WHAT ARE ILLIQUID ASSETS?
Illiquid assets, on the other hand, are possessions that are not easily sold or converted to cash. Some prime examples of illiquid assets, also known as fixed assets, include real estate, collectibles, stock options, private equity, and estates. These fixed assets are good investments to have particularly for investors with risk appetites and patience to wait for them to come to maturity, when the compensation, known as liquidity premium, is often very attractive, even more so than that of liquid assets. Remember, higher risks often earn higher rewards. These are the assets that will provide the returns you seek via the illiquidity discount, this is where capital gains are made.
Like liquid assets, illiquid assets are vital to an investor’s diversified portfolio. However, depending on the kind of investor that you are, you should figure out what the right ratio of liquid to illiquid is for you. Last week we spoke about Stratus funds- powered by NCB and how alternatives can play a role in your portfolio.
A key component of longterm financial planning is having some of your total net worth in both liquid and illiquid assets. Sometimes, investors focus too much on illiquid assets out of fear, which is often misplaced due to not really understanding how illiquid assets operate. So they are constantly working for their money instead of having their money work for them. On the flip side, there are those who throw all their money in a high amount of illiquid assets which, while good for the long term because of the high rate of return, can tie up too much of their money in the short term when they may need it in the event of sudden financial hardships. Assess your investments to ensure that you are not too heavily weighted in either liquid or illiquid assets, everyone’s circumstances are different but all should optimally meet your short- and long-term objectives. If your portfolio is too heavy on illiquid assets, perhaps aim at liquidating some of them and using the yield to grow your emergency fund. If your portfolio is low on illiquid assets consider starting with a smaller portion in illiquid assets until you are comfortable with investing. If you have forayed into stocks and bonds already, consider alternatives.
Asset allocation, as the saying goes, is critical for investment. Be sure to enhance your portfolio’s performance with a good mix of liquid and illiquid assets in order to cushion the effects of volatility in the market and maximise on achieving your financial goals.