Breaking Down the Liquidity Silos

December 3, 2023

4 minute read

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Multi Asset Strategies – EMEA, Neuberger Berman

Breaking down the boundaries between liquid and illiquid assets could broaden our outlook and better align portfolios to our objectives and time horizon.

Over the years, many of these posts have emphasized the virtues of balance, diversification and humility—a few years ago, one was titled “On the Joy of Being Wrong.”

This year has retaught the lesson, with its unexpectedly resilient growth, strong equity markets and soaring bond yields, and it was top of our minds as we put together our Solving for 2024 outlook themes. We found ourselves thinking hard about what we could say with a certain degree of conviction.

But we also noticed something else: Many of the topics under discussion stretched across public and private markets.

Degrees of Liquidity

Integrating public and private markets in our investment thinking moves us away from the idea that we should hold “traditional” liquid assets and “alternative” illiquid assets in separate buckets.

Instead, it focuses our attention back onto balancing fundamental economic exposures—interest-rate risk, credit risk, equity risk, inflation risk. Each of these exposures can be taken with varying degrees of liquidity, which means investors can take all the economic exposures they need while also matching their portfolio liquidity profile with their unique objectives and time horizons.

This idea was in fact on our longlist of potential Solving themes. Why didn’t it make the cut? Because, at a time of such uncertainty, it seemed to be too structural and certain a trend to warrant singling out.

But we do think it is a point worth emphasizing.

This trend is arguably part of a general return to first principles in investing. In our view, it reflects a desire to back away from the uncertainty of markets to refocus on the certainties of our own investment objectives, including our own investment time horizon—and potentially gain an edge over short-term-focused market participants who get pulled back and forth by volatility.

De-Siloed Thinking

This is not the only advantage of de-siloing our liquid-versus-illiquid thinking. It can also help to make our outlook more comprehensive.

Companies owned by private equity investors far outnumber those listed on stock exchanges. The gap continues to widen, and the size and influence of many privately owned firms continues to grow. Ignore those companies, and you may ignore an important engine of the global economy.

A view that encompasses the liquid, semiliquid and illiquid parts of the market may also make us more aware of relative value within credit and equity markets. Perhaps bank loans are currently more attractive than high yield bonds, and private debt more attractive than both? Sometimes that relative value can materialize between the very same issuer’s bonds and loans.

A more comprehensive view also helps uncover the complex interactions between public and private markets, which can be yet another source of opportunity. This is a point that comes through in some of our Solving themes.

For example, our fixed income theme on the default cycle recognizes that, to form a comprehensive credit outlook, it is more and more important to have a view on the stresses and strains and behind-the-scenes debt workouts between private lenders and borrowers.

Then there is our private markets theme, “Where Capital Is Constrained, Capital Providers Can Be Rewarded.” This rests on an awareness that public stock exchanges are not providing the normal exit routes for private assets, and public bond and loan markets are not providing the normal flow of debt capital for private companies.

Siloed thinking—liquid-versus-illiquid, public-versus-private—can leave some investors unaware of these opportunities.

Matching Liquidity With Time Horizon

As genuine as these advantages of de-siloing are, however, we think the most profound is that it frees investors to exploit perhaps the most powerful and neglected edge they have: certainty about their own investment objectives, and particularly their own investment time horizon and tolerance for short-term illiquidity.

Think of this as bringing a three-dimensional view of relative value into our market analysis: As well as taking account of the relative value of different assets with similar economic exposures but varying liquidity, we can also account for the value of liquidity relative to our own investment and drawdown time horizons. Because those horizons typically lie beyond that of the usual market cycle, thinking this way can meaningfully enhance the attractiveness of illiquid, private or buy-and-hold investments.

If our needs are met by the risk-free future cash flows of a government bond held to maturity, why subject ourselves to the vagaries of market volatility? By the same token, if we need an equity-like return but we do not need liquidity for a decade, why not seek at least a portion of our equity exposure in private-market buyouts, if that is where the most attractive opportunity lies?

We are not surprised to see more and more investors breaking down their public-versus-private-market silos so they can start thinking and acting in this way—taking a bespoke view of liquidity in the service of their unique objectives and time horizons.

In an environment of rising economic and market uncertainty, we believe it is a way for investors to focus their strategy where they have greater clarity, and thereby allocate with more conviction.

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What to Watch For

- Monday, December 4:
  - Japan Consumer Price Index
- Tuesday, December 5:
  - U.S. ISM Services
  - JOLTS Job Openings
- Thursday, December 7:
  - Eurozone 3Q GDP (Final)
  - Japan 3Q GDP (Final)
- Friday, December 8:
  - U.S. Employment Report
  - University of Michigan Consumer Sentiment (Preliminary)