Take into consideration the liquidity advantages

Investors and their advisers tend to pay scant attention to liquidity, what it costs and whether they need it. Just like more widely recognised factors such as market risk, diversification and investment time frames, liquidity should be carefully considered when a financial strategy is developed.

We define liquidity as the ability to buy or sell an asset quickly, with minimal impact on the price, and with low transaction costs.

By "cost of liquidity", we mean the premium charged for (and hence the tendency to accept a lower return from) investments that can be sold quickly and cost effectively. The degree and pricing of liquidity can vary enormously.

Shares

A "liquidity premium" is usually included in the pricing structure of those assets that cannot be traded on daily markets. For instance, large capitalisation stocks such as Telstra, BHP, the major banks are actively traded on stockmarkets every business day. An individual's decision to sell a holding of such stocks won't usually impact on the selling price, so the liquidity premium is negligible.

By contrast, there is less demand and perhaps no daily market for some small companies. It may be a week or more before a buyer appears. Investors in small cap stocks therefore expect to earn a higher return to compensate so that, if they must sell on a given day, there is less certainty about the price they will receive than if they were trading shares for which there is normally a daily market. The liquidity premium arises because the stock may have to be sold at a price below their expectations, if they require an immediate buyer.

Property

Property is an asset class for which liquidity is a major issue. Most investors are familiar with the idea that direct residential property is best sold in spring and autumn whereas listed property trusts can be efficiently sold all year round.

The current state of the market is the main consideration for listed property. For direct property investors, liquidity is seasonal. When buying or selling, they need to consider factors like public or school holidays, or if the house or flat will present badly because it is mid summer or mid winter. Furthermore, if you own bricks and mortar, you can't simply sell half the property because you need cash.

Private Equity

We recommend investors and their financial advisers look particularly at asset liquidity and ask themselves if it is worth foregoing potential returns in exchange for liquidity. At Macquarie, we believe investors should be made aware of the part played by liquidity in terms of risk and return. The recent success of an unlisted equity offering to the retail market, the Macquarie Private Equity Trust (MPET), showed that more sophisticated investors and their advisers may be ready to explore the potential of investing in assets with limited liquidity.

MPET, a classic "illiquid" investment, closed in May, having raised about $90 million from retail investors. Only $30 to $50 million had been expected. Units in MPET are not redeemable on demand and clients were told they should be prepared to wait at least 5-8 years before expecting to take their profits.

However, Macquarie's investors accepted this lack of liquidity because the potential returns were estimated at about 5 per cent above the 10 year projected returns for the Australian share market.

The fact that more than half the subscribers were self-managed super funds tied in neatly with the liquidity constraints. If you are going to tie money up in super, it is less important to be able to cash out of an investment and, in any case, time frames are likely to be longer term.

Superannuation

The tax effective returns offered by super compared with non-super investments are another example of the cost of liquidity. In fact, the government offers a discounted tax rate to help investors make voluntary contributions to an asset class that would otherwise be unattractive because investors' contributions are effectively tied up until retirement and can't be used for anything else.

The table below (table 1) shows how different products within the same general asset categories may be priced differently at least partly because of their relative liquidity.

For the major asset classes, we find that the typical estimated transaction costs, as a percentage of the value of the asset, are lower for more liquid asset classes and higher for less liquid asset classes (see table 2). In other words, some of the increased returns that one can expect from illiquid assets are offset by the higher cost of buying and selling. Making a profit from liquidity

Very few investors need all of their investments in highly liquid assets. Investors should consider what proportion of their portfolios can comfortably sit in less liquid (and less costly) assets. Depending upon an investor's circumstances, the proportion of their portfolio that should be tied up in less liquid assets will vary from 20 to 50 per cent.

Having decided how much to invest in these assets, it then becomes a matter of choosing which illiquid asset to invest in. Investing in private equity is probably the biggest boost that an illiquid asset can give to returns. But because of the risks as well as illiquidity, Macquarie recommends that no more than 5 to 15 per cent of a portfolio should be invested in this asset class.

In working with clients, financial planners should clearly raise the issue of liquidity along with the other key financial considerations. Just as planners take steps to produce a formal or informal risk profile for each client, by working with the client to determine their need for long and short term cash it is possible to produce a liquidity profile.

Tim Farrelly is head of adviser marketing and Dr Phillip Dolan is head of research at Macquarie Investment Management.