Should Retail Investors Fear Illiquidity?

In the investment world, illiquidity often carries a stigma. But what if the very feature that seems restrictive is, in fact, a safeguard? Illiquidity could be the buffer that helps avoid impulsive decisions and the dangers of trying to time the market. In this newsletter, we explore why stepping back from day trading in favor of longer term allocations to more illiquid products might just be the smart move.

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Retail access to alternative investments, which encompass a wide variety of financial asset classes, is currently the object of a spirited debate among financial professionals and regulators alike. At the center of it, illiquidity is often used by regulators as a reason to restrict access to certain asset classes.

This, we believe, penalizes “mass affluent” retail investors, which end up being cut off from potentially attractive investment opportunities while being free to access others that, despite their higher liquidity, may come with

Liquidity is front and center when it comes to the regulatory treatment of alts. Some well-known alternative assets are typically more liquid and are traded globally by retail investors on large, easily accessible platforms, with rapid execution and effective price discovery. However, for assets such as private credit, private equity, venture capital, real estate, and hedge funds illiquidity can be a major roadblock, and is often cited as a reason by the regulator to ring fence these opportunities, restricting access to an elite subset of institutional investors and ultra wealthy individuals. 

Furthermore, if access to various forms of “speculative” investments - such as binary options trading or crypto platforms - is offered to even to the most illiterate investor, regulators across the globe should seriously consider why such discrepancy exists - why liquidity risk tramps other sources of risk that can be likely more detrimental to investment performance.

Against this backdrop, we’re already witnessing a growth in the number of innovative companies broadening private market assets’ access to a wider mass market. This is usually achieved via loopholes in existing regulations.

Behavioral Finance Insights: The Illusion of control 

Traditional finance states that the more illiquid the investment, the higher premium an investor should require. It also advocates that the smaller the portfolio size and income availability, the larger the allocation to liquid assets should be. Reality is vastly more complex.

Indeed, investors with adequate income levels are still investing overwhelmingly in public markets. Additionally, most investors - especially the less financially educated - believe they can time financial markets, and trade public equities on a daily basis, thinking they can somehow “buy low and sell high.” They end up losing money with almost absolute certainty. 

Market timing is an illusion. Nobody can do it consistently and over a long time period.  Yet investors - sophisticated or not - are free to day-trade in liquid markets, despite evidence that they’d be better off with passive exposure. In 2021, Richard Thaler attributed the surge in day trading to “boredom” and to a general decrease in fees: 

“People like free, so the combination of free commissions and boredom got a lot of them interested in investing, especially at the individual stock level. After all, just buying mutual funds, or even worse, index funds is so boring. There is no entertainment value in buying a global index fund.”

The entertainment value Thaler is talking about is an element in common with sports betting, as are the adrenaline rush and the addictive potential. Incidentally, Thaler also argues that each one day trader suffers from the delusion that they are the only ones capable of beating institutional investors who have access to sophisticated infrastructure and information.

So while an argument could be successfully made that lower income and unsophisticated investors should - typically - stay away from illiquid products (but also from day trading), investors with adequate levels of wealth should reconsider their approach and give alternative investments a second look. 

Private market alternative investments traditionally offer long-term opportunities that cannot be exited from on a whim. The prevailing argument is that the lack of liquidity is per se an issue for investors. But what if, in line with behavioral finance findings, liquidity constraints could actually insulate investors from making subpar decisions?

Illiquidity Premium: Friend or Foe?

Let’s assume that liquidity constitutes a material additional risk driver for investments in the private markets space. If this was the case, then there would be evidence that additional illiquidity risk is adequately compensated. 

According to many studies, that is the case. 

A review published by AQR in 2020, which investigated the illiquidity premium of private equity versus public equity from 1993 till 2018, concluded that, based on a net-of-fee returns, private equity does not offer an attractive premium over public equities. In a more recent study published by Barclays in 2022, the authors suggest there is an average liquidity premium ranging - on average - between 2% to 4% for buyout funds and 3% to 5% for riskier early-stage VC funds. Lastly, a 2024 CAIA study on private equity illiquidity premium between 2000 and 2023 found a 4.8% premium over public markets. 

So far, all these studies seem to suggest investors are indeed rewarded for their illiquidity risk. But if, as evidence suggests, such a liquidity premium exists, should there not be a free market for any investor to access these opportunities and benefit from this premium? Not so fast. 

Notable performance numbers do not per se support the case for extending access to EVERY investor. But they at least push us - the financial community - to ask the question, especially in light of the obligations we have from fiduciary duty. 

The answer is, again, not so simple. If we assume the highest illiquidity premium - let’s say 5% - then does liquidity argumentatively pose a threat so big to investor risk-return profiles that access to a wider market should be limited? 

Additionally, would these “attractive” returns erode if the floodgates were opened to the mass market?

Firstly, Not all alts are created equal. They carry various risk-reward profiles and do not follow a one-size-fits-all approach. This alone would require more attention from and fine tuning by the regulator. Second, even mass market investors have different investment objectives, beyond just absolute performance - diversification and value-alignment being just two examples - regardless of whether they’re investing in traditional assets or alternatives. 

Ultimately, we believe including private market assets should be a free choice wherever possible, more tied to the single investor’s self-assessed risk-return profile than to the regulator’s choice. 

Liquidity Constraints and Accreditation 

To be clear, investor screening systems that protect weaker individuals are a good thing. But it is worth asking why the regulator believes liquidity to be a major discriminant when it comes to what products can unaccredited (unsophisticated, less wealthy) investors access. The SEC, the EU and the FCA use different systems, all of them however are based on a combination of wealth and education when it comes to allowing access to less liquid products. 

It seems especially inconsistent that the regulator would allow access to products such as crypto or binary options trading exchanges to “non accredited” investors - simply because these products are liquid. Does the regulator believe that because it is easy - relatively speaking - to find a buyer, then an (unsophisticated) investor is automatically protected?  

As many financial professionals reading this surely know, options can extremely complex instruments, and are traditionally used to reach specific portfolio goals, in the context of wider portfolio strategy. On the other hand, platforms selling “binary options” or contract for differences (CFDs) are shaped like casinos, where payout is “all or nothing,” which automatically creates an affinity with gambling or sports betting. That, in turn, attracts uneducated investors with the promise of a hefty, instant payout, which is virtually the same as guessing a soccer match result. 

How do these investments not require “accreditation,” contrary to what happens with allocations to professionally-sourced (but less liquid) opportunities in other alternative asset classes?

A Positive Example of Regulation Lifting Barriers for Access to Alternatives: ELTIF 2.0

An example of “good” regulatory approach is - in our view - the EU regulation on alts. 

Uncharacteristically, the European Union took an innovative approach in regulating private market (more illiquid) investments in 2015, when it introduced Regulation 2015/760 on alternative investments. The Regulation introduced the European Long Term Investment Fund or ELTIF. Although innovative at first, given the complexities and constraints, this new framework had a tough time delivering on its exciting prospects of “democratizing” private market investments.

In 2024, the EU modified that regulation, with flexibility at the core of a revamped framework (Regulation 2023/606). The most relevant changes revolve around liquidity and lifting restrictions. Notably, under ELTIF 2.0 (as the new vehicle has been labeled), the minimum investment amount for individual investors (previously set at 10,000 EUR, was removed). Secondly, the maximum investment in a single asset was increased from 10% to 20%, while the minimum investment in eligible assets was lowered to 55% from 70%. Ultimately, in order to promote ease of access to private markets, the eligibility assessment was aligned with the MiFID tests, which harmonizes the educational assessment criteria to ensure investors meet a threshold of understanding these investments prior to making financial decisions.

The final regulatory technical standards are yet to be finalized, with policies around redemptions, minimum holding periods, disclosures, notification obligations, and valuation frequency still being debated between ESMA and the EU Commission.

With a finalized legal framework on ELTIF 2.0 expected in 2024Q4, the odds for the mass affluent market accessing private markets are likely - in our view - to improve exponentially in Europe. This should also benefit investors across the HNWI spectrum.  

(Image taken from CAIA Association Mapping a Journey Towards Alternative Investments in Wealth Management “Crossing The Threshold”)

Bain reported in 2023 that between $8 trillion to $12 trillion in household funds are available to be deployed into private alternative assets; “Individual investors hold roughly 50% of the estimated $275 trillion to $295 trillion of global AUM, but account just 16% of AUM held by alternative investment funds.” Yet the main barriers are admin costs, illiquidity, difficult collateral process for lending and high minimum investment size. With ELTIF 2.0 providing a roadmap to alleviating many of these barriers, the alternative assets market is expected to grow significantly as a portion of individual’s portfolios.

Conclusion

In conclusion, the debate on illiquidity in alternative investments reveals a nuanced reality. While higher liquidity is often seen as a safeguard for investors, particularly those with lower incomes, it can also lead to poor investment decisions driven by behavioral biases.

The assumption that more liquid assets are inherently safer is misguided, as the ease of trading can tempt investors to make impulsive, suboptimal choices. This is evident in the losses accumulated by - mostly unaccredited, unsophisticated - investors who attempt day trading in equities as well as in binary options and cryptocurrencies.

On the other hand, less liquid alternative investments, such as private equity, venture capital, and real estate, offer long-term opportunities that can shield investors from the pitfalls of market timing attempts and impulsive trading. It remains to be seen if the development of more liquid secondaries markets could convince the regulator to widen access.

For now, the inconsistency in regulatory treatment between highly speculative, liquid investments and professionally-managed, illiquid alternatives raises important questions. If the goal is to protect investors, the focus should be on the overall risk profile and - namely - on the investor's understanding of financial products, and in who and when does the due diligence, rather than solely on liquidity. 

An important consideration is  "skin in the game," which - for instance - only a little more than half of private credit managers have. These managers, who invest their own capital alongside their clients', align their interests with those of their investors. This alignment can enhance trust among retail investors, potentially justifying regulatory reforms to increase access to such alternative investments. When investors see that managers are equally exposed to the risks and rewards of their investments, it can instill greater confidence and mitigate concerns about illiquidity.