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Four Reasons Investors Shouldn’t Shy Away from Illiquid Alternatives

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Four Reasons Investors Shouldn’t Shy Away from Illiquid Alternatives

Written by: Brian Resnick

Many investors are somewhat skittish about illiquid alternatives because they’re worried about tying up their money for a long time in an investment that they can’t trade or exchange easily. However, illiquidity may actually work to investors’ advantage.

Some alternatives hold on to investors’ capital for as long as a decade. Many “lock-up” periods are shorter, but illiquid alternatives are a far cry from the seemingly nonstop transactional world of public stock and bond markets. That nature gives some investors pause, but it shouldn’t.

Here are four reasons why investors shouldn’t turn away from opportunities in illiquid alternatives.

Reason One: Diversification Versus Public Markets

Alternatives, including real assets, private equity and private debt, offer diversification from traditional stocks and bonds. For one thing, their return patterns are different. Private credit returns, for example, have had a low correlation to those of public credit. Over time, this may help smooth out the ups and downs of portfolio swings.

“Vintage” diversification can also help. Many types of alternatives invest their money over the course of several years—the year a fund makes its first investment is the vintage year. Each vintage is subject to market conditions that can vary from those of other vintages: interest rates, market valuations and inflation rates are examples. So, investing over different vintages acts as a form of built-in diversification.

Reason Two: An Illiquidity Premium for Investing Longer

Because investors in illiquid alternatives face longer lockup periods, they have to be enticed with higher return potential. Take middle market lending, for example. Middle market companies are a big part of America’s economy, and middle market lenders provide them with critical funding.

But investors face longer time horizons to realize their returns, and that patience only makes sense if the returns from this private credit investment outweigh a public market investment. In other words, investors warrant an illiquidity premium in the form of higher yield because of their willingness to tie up their investment dollars for longer periods.

Reason Three: Avoiding the Daily Swings of Public Markets

The long-term nature of illiquid alternatives such as private credit tends to insulate investors from the daily swings taking place in public markets. That’s because many illiquid alternative investments are valued or marked to market only at specific points in time—usually quarterly—but their exact return is only known when the investment is disposed.

Another reason for the lower volatility: investors can’t buy or sell illiquid alternatives easily, so they’re less prone to indiscriminate market sell-offs. In fact, private-market investments could be feeling similar stresses as public investments, but private investors are typically focused only on the exit price, not constant fluctuations.

Reason Four: The Patience to Look for Better Opportunities

Illiquid alternatives don’t need to rush into making their investments. In fact, many funds have multiyear terms to make new investments with investors’ capital. So, when markets get rocky or overly expensive, private funds can pause and wait for better investing conditions.

This scenario can leave illiquid alternative funds with “dry powder” waiting to make investments. It’s hard for alternative funds to invest when the market dips—it takes a while to analyze and close a deal, making it hard and risky to react quickly to a correction. But a longer downturn creates opportunities to put dry powder to work when fear strikes the market, which could provide investors in illiquid alternatives with a more attractive starting point.

Despite some investors’ misgivings about illiquid alternatives, these investments have the potential to complement public-market investments, reducing volatility and enhancing returns. But it’s important to consider them through a holistic asset-allocation framework that considers their unique needs, including the desire to maintain enough cash flow to cover spending needs.

Brian Resnick, CFA, is a Director and Senior Investment Strategist for Alternatives and Multi-Asset at AB

Related: Earnings Growth Is King in a Post-Cycle World

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