It’s been fascinating to watch how differently asset classes have performed over the past few years.
Share markets have generally delivered strong double-digit returns, while others, such as unlisted commercial property trusts and residential property in Melbourne and to a lesser extent, Sydney have really struggled.
This is nothing new, of course. All investment markets move in cycles, and a long-term investor should expect periods of underperformance. Few assets deliver perfectly consistent returns year after year. But investment performance is only one part of the picture. There are several other important factors to be aware of, which is the reason for writing this blog.
Why Melbourne and Sydney property has lagged
Residential property in Melbourne and Sydney has underperformed other major capital cities. This has a lot to do with affordability and borrowing capacity. Borrowing capacity started to compress in 2017, when the regulator and banks began tightening credit policy. The COVID effect and the shift to working from home also had an impact. Thesetwo factors stimulated demand for relatively cheaper property markets. Melbourne, in particular, has endured a lot of negative sentiment, and the recent taxation changes only compound this.
The commercial office market has also been under pressure, again, particularly in Melbourne. Some of our clients hold investments in unlisted commercial property trusts, and performance there has been weak, and in some cases,a stronger word suggested.. terrible. Commercial property has been affected by changing tenant demand, the work-from-home trend, the high capital required for refurbishment, almost doubling in fit out costs, and higher interest rates.
The upshot is that investors in these unlisted, illiquid assets have little choice but to hold through the cycle. That may well be the wisest approach. But the lack of flexibility needs to be understood and interrogated.
To be clear, this is not a comparison of long-term returns, or which asset class performs better. It is about understanding the role liquidity plays in portfolio management.
What liquidity actually buys
Before comparing liquid and illiquid assets, it is important to define liquidity. Simply put, liquidity is how quickly and cost-effectively you can convert an asset into cash without significant disruption. The main considerations are:
- How long it takes to sell the asset
- What it costs to sell, in terms of transaction fees and tax
- How simple the process is
- How much of your time it takes
Liquidity is not about whether you expect to need cash. It is about whether you can access it if circumstances change, your view changes, or the underlying risks of the investment change.
This has a significant bearing on the flexibility of an investment strategy, and your capacity to respond to the inevitable changes in life and circumstances over time. This optionality works both ways. There will be times when you want to reduce risk, and other times when you want the flexibility to pursue an attractive opportunity to build more wealth.
Assuming you consistently make smart, long-term financial decisions, maintaining as much flexibility as possible is likely to serve you best.
The case for liquid, listed assets
Here’s the case for liquid assets:
Gradual investment and divestment
You can increase or decrease an investment by 1% or 100%, typically at very low transaction cost. This means investing in liquid assets is never an all-or-nothing decision. It gives you flexibility both during accumulation and later, in the decumulation stage.
Using new capital to rebalance
If you become uncomfortable with a particular exposure, you can direct new capital elsewhere to dilute that risk rather than selling down. For example, if you are concerned about the valuation of large-cap US stocks, you can direct new capital into other geographic markets, a value-factor global index, or an equal-weight US index. Liquidity gives you many ways to manage portfolio risk without being forced to sell.
Proactively managing concentration risk
Liquidity gives you a high degree of portfolio management control. For example, some clients hold concentrated positions in stocks such as CBA and BHP. Over the past 12 months, we have been strategically divesting these positions when we consider the price to be attractive (sell at above intrinsic value). Liquidity is what makes that possible. Without it, there would be no way to reduce concentration when the price is right.
Control over tax liability
Because we control the exact timing of sales, we have far more control over managing tax liabilities. We can choose which financial year to sell in, which parcels to sell and when, and whether to crystallise capital losses to offset gains elsewhere. This is exactly what we have been doing proactively for clients holding BHP and CBA.
Liquidity as a secondary buffer
Because liquid assets can be converted to cash quickly, holding a liquid portfolio allows clients to stay invested for longer. In practice, this means we can hold a higher allocation to growth assets than we would if the portfolio were dominated by illiquid holdings, since we don’t need to hold as much idle cash as a buffer.
Transparency
One of the underrated advantages of liquid assets is price discovery. Widely traded assets are priced daily by a deep, informed market, which gives some confidence that known risks and opportunities are already reflected in the price. This doesn’t mean markets are perfectly efficient at all times, and prices can still diverge from fundamentals.
The hidden catch with listed assets: it is too easy to act
There are always two sides to every coin, so here are some disadvantages of liquid assets.
Emotion-driven decisions
Easily the biggest disadvantage is that liquidity makes it easy to buy and sell on emotion or shifting sentiment. This behavioural trap should not be underestimated. It can lead to a knee-jerk decision to sell at exactly the wrong time, or, just as often, FOMO-driven buying at exactly the wrong time.
This is where illiquid assets have an advantage. The time buffer between deciding to sell and actually being able to sell can insulate an investor from their own worst instincts.
There are ways to counter this. A financial adviser’s core job is to stop clients making poor-quality decisions. But without an adviser, a simple rule, such as sitting with a decision for at least a week before acting on it, can help.
The anxiety of daily pricing
Another disadvantage of liquid assets is transparent, daily pricing. This is a psychological consideration rather than a fundamental one. An asset being repriced every day, or every hour, doesn’t mean you need to look at it. But many investors cite the visible volatility as a genuine source of anxiety, even when nothing about the underlying asset has changed.
The hidden cost of investing gradually
This might seem like an odd point, but the ability to invest incrementally can be a disadvantage in certain circumstances. Unlisted assets like property force you to commit a large amount of capital in one tranche. Assuming that capital is invested in a quality asset at an attractive price and held for decades, being forced to invest more, sooner, is likely to work in your favour. By contrast, an investor who invests gradually, as is common in share markets, will mathematically end up worse off than one who commits a lump sum upfront, assuming the same rate of return for both.
The case for unlisted, illiquid assets
Now for the case for unlisted assets. It’s important to state upfront that, as a business, we are completely asset-class agnostic. This means we always take a balanced assessment of both major growth asset classes (property and shares), without any bias toward either.
Illiquidity stops you from making mistakes
As discussed above, illiquidity can be an advantage if it stops you from making a mistake. For instance, investors who purchased investment-grade apartments in Melbourne 10-13 years ago would, in most cases, have generated poor returns. While it might be tempting to sell, doing so is time-consuming and costly. The property may need minor improvements before it’s ready for sale. The tenant must be vacated. Staging (furniture) is often worthwhile, and agent fees will apply. These costs compound an already ordinary situation. Instead, most investors hold for the long term, on the basis that the asset itself is fundamentally sound and should perform over time. This typically is not an asset-selection mistake. It’s a market-cycle issue, and illiquidity forces investors to ride it out rather than crystallise a loss at the worst possible time.
No daily pricing means less noise
Another advantage of unlisted assets is that they are not priced every day. Their intrinsic value still fluctuates, but this is not visible to investors through daily price movements. This can create a false sense of stability, in that investors perceive the asset as less volatile than it truly is. But the behavioural benefit is real. Some investors are more likely to stick to a long-term buy-and-hold strategy when they are not confronted with daily price swings.
Control over the asset itself
Direct property gives investors a level of control that listed assets don’t. You can improve the asset, add value, and directly shape the investment outcome. Compare direct property with listed REITs. A REIT gives you no say over which properties it holds. Direct property lets you apply an evidence-based, rules-based approach to select assets in locations you believe have strong fundamentals.
The hidden catch with unlisted assets: what you don’t know can hurt you
Here are some hidden disadvantages of unlisted assets that every investor needs to reconcile.
You don’t really know what it’s worth until you sell it
Valuations of unlisted assets don’t always reflect true underlying market value. There’s often a time lag between unlisted property trust valuations and their listed equivalents. With residential property specifically, the eventual sale price is heavily influenced by market sentiment at the time of sale and how well the sales campaign is run. This makes it genuinely difficult to know your actual return until you sell.
Can unlisted assets really be liquid?
Some unlisted managed funds have liquidity provisions and hold high levels of cash, which can give investors a degree of confidence about their ability to redeem. But if the asset class hits real trouble, funds can freeze redemptions altogether. This happened repeatedly during the GFC. Investors who believed they had liquidity discovered, at the point it mattered most, that they didn’t.
Liquidity needs change with age
We have discussed many times that assets providing compounding capital growth are the most effective vehicles for building wealth, largely because they limit the annual tax drag on returns. Unlisted assets like residential property can be a powerful and efficient tool for leveraging and growing wealth on this basis (subject to tax changes). But for the reasons above, illiquidity can become a disadvantage later, particularly in retirement. The real mistake is not owning illiquid assets. It’s failing to recognise when illiquidity is working in your favour, and when it starts working against you.
How to actually weigh up the trade-off
The most important point I want to make in this blog is that we don’t want to make decisions that are “return-chasing” in disguise. It’s true that liquid assets have performed strongly over the past 5 years, and in some sectors, the past 10. Investors holding most of their wealth in property in Melbourne and, to a lesser extent, Sydney, may feel they have missed out. But in the long run, fundamentals drive returns, and all markets move in cycles. At some point, we are probably going to see the reverse: Australian property producing attractive returns while share markets struggle. So let me be frank. This is not an argument for dumping illiquid assets simply because liquid assets have outperformed recently.
When choosing between liquid and illiquid assets, the first consideration is your own experience and temperament. Liquid assets offer real portfolio management advantages, but used poorly, they can become a disadvantage. If you are prone to overreacting during periods of volatility, illiquid assets are likely to suit you better.
The second observation is that the right level of liquidity changes over your lifetime. Investors starting out might reasonably hold most of their wealth in illiquid assets. But as wealth builds and retirement approaches, illiquid assets become less attractive.
The key takeaway is that every investor needs a plan to introduce more liquidity as they progress through their investment journey. This is why purchasing additional illiquid assets in your 50’s and 60’s is, for most clients (not all), is rarely appropriate.
Close
This blog was never meant to compare property against shares, or to be about investment returns at all. It’s about liquidity itself: what it offers, and when those advantages suit an investor.
Typically, there are two key factors that determine how much liquidity you should hold: your behavioural characteristics, and the stage of your investment journey.
Have a think about what proportion of your portfolio is held in liquid assets, and how you might want to change that over the coming years and decades, as your circumstances and temperament evolve.
