Alternative investments are those that fall outside of the traditional ideas of investing and include private equity, venture capital, commodities, real estate, and more. Many investments fall on a spectrum that refers to the investments’ liquidity, or how quickly the investment position can be exited, and the asset exchanged for spendable money.
What is Liquidity?
Liquidity refers to how easily an asset can be exchanged for cash without affecting the value or incurring hefty fees. The US dollar and other world currencies can be considered liquid assets, as they can be spent immediately on goods and services in their respective countries. Cash, checking accounts, and savings accounts are generally considered liquid assets. Marketable securities in the public markets are generally considered liquid, as they can easily be sold in exchange for cash. On the other hand, illiquid assets cannot be as easily exchanged for cash, and may include private equity, real estate, cars, antiques, and some types of debt instruments. Liquidity typically falls on a scale, as some assets may be more liquid or illiquid than other assets.
Liquidity in Alternative Investments
Alternative investments generally fall under the same liquidity scale as other investments. Most alternative investments have low liquidity compared to traditional investments. Private equity, commodities, and collectibles can be illiquid, especially private equity where the average holding period in 2020 was 5.4 years. These alternative assets cannot be easily traded for cash and in general, investors hold these assets for longer timelines. Commodities and collectibles potentially could be more liquid than private equity, as they can be sold once an appropriate buyer has been identified. The secondary market may offer opportunities for illiquid private equity investments to increase their liquidity, as these shares can be sold to other private market investors.
Cryptocurrencies and NFTs can fall more on the liquid side of alternative investments, as some cryptocurrency exchanges may provide opportunities to buy and sell crypto for cash. While cryptocurrency is not as liquid as physical currencies, it can be more liquid than other alternative investments like private equity and shares in a startup.
Benefits and Risks
Liquid alternative investments hold benefits such as the ability to be easily exchanged for cash. The ability to buy and sell cryptocurrency daily can make it attractive to some investors. However, liquid alternative assets that are priced daily are typically heavily correlated to the stock market and their value can rapidly fluctuate. The benefit of exiting a position comes with the risk of losing value of the investment.
Another benefit of liquid alternative investments is the accessibility of opportunities. Many liquid alternative investments have fewer barriers to entry than illiquid alternative investments. Some illiquid alternative investments may be limited to accredited investors, which have limitations based on annual income, net worth, and educational certifications. In general, liquid alternative investments may not have these same limitations.
Illiquid alternative assets have the potential to increase over time . These illiquid assets could also provide greater diversification potential than liquid alternative investments. However, illiquid alternative investments typically come with greater risk, as there is no guarantee any investment will provide a return. Additionally, if the illiquid asset does provide a return, it may require holding for a long period of time. These benefits and risks should be kept in mind when considering which investment opportunities are right for an individual investor’s portfolio.
All investments, whether alternative investments or not, fall on the spectrum of liquidity. Some assets can be easily exchanged for cash without affecting the value of the investment, which represents high liquidity. Other assets may take longer to find a suitable buyer, come with specific requirements, and require payment of fees to exit the position, meaning it is more difficult to convert the investment to cash, representing low liquidity. The value of liquid assets can be correlated to the stock market and can be subject to greater price fluctuations than illiquid assets. When choosing investment opportunities, it is important for investors to consider the liquidity of the investment, the benefits and risks of liquid and illiquid alternative investments, and their own specific needs for liquidity.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.