Are You Paying for Liquidity You Don't Need?

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Advisors tout the obvious advantages of liquid portfolios and investments. But they are slower to mention that this liquidity comes at a cost. A vast literature in finance supports the idea that less liquid assets offer higher expected returns. This is the so called “liquidity premium.”

Given these premiums, advisors should look more closely at their clients’ investments as well as portfolio design from a liquidity perspective. Investors, particularly those with long-term goals, may be paying for daily liquidity they don’t need. By ignoring liquidity premiums, advisors are not maximizing the funds of their clients.

What is liquidity – and what is the liquidity premium?

Liquidity is a slippery topic. There is no universal definition, except for maybe that of economist Maureen O’Hara, who said, “liquidity is hard to define but you know it when you see it.” Part of the problem is that liquidity is phase dependent. It varies through time and by market condition.

In general, liquidity refers to how easy it is to buy or sell assets. This turns out to be a multi-dimensional concept. It involves speed (how long it takes to sell something), cost (the bid-ask spread), and the price impact of a trade. Volume, used by some analysts as a measure of liquidity, is a very poor proxy for liquidity. More telling is the price impact induced by volume, that is, how much can you trade without moving the price?

More interesting for investors is what this means for returns. Investors need to be compensated for the cost of trading less liquid securities, as well as the risk that assets could turn illiquid in a crisis. The result is that these securities should offer investors higher expected returns, the “liquidity premium.”