What Does Liquidity Mean for Investors?

How Quickly Can You Move Your Money?

Picture of by Dr David Phelps

by Dr David Phelps

When it comes to liquidity, most people think of cash on hand. Cash on hand is highly liquid but there are other ways (alternative investments) to keep your capital, wherever it is, liquid, granting you more options, control, and security.

For investors, liquidity is a huge aspect to consider, especially in a changing market cycle where new opportunities or dangers can present themselves.

Being able to move your money quickly becomes attractive in this environment.

How Quick Can You Access Your Capital?

Fungibility is the way I’d define liquidity. It means how quickly you can access that capital and move it somewhere else. How quickly you can interchange money for something else – including cash on hand, into a bank account, or in another investment.

We generally ask “How liquid is that money?”

Typically, we think about deposits in the bank as being very liquid. They're called on-demand accounts because we can ask for that money and the bank is supposed to give it to us immediately.

However, this has recently become a concern for a few banks that had many clients pulling out large amounts of money at the same time (Silicon Valley Bank and Signature Bank to name a few). This has called into question how liquid one’s money truly is in a bank. If not for the backstopping of the FDIC (in reality it’s the backstop of taxpayers but that’s another topic) more banks would have defaulted.

This is one of many reasons why we must think of other ways to stay liquid without having hard cash on hand or keeping it all in a bank.

How to Stay Liquid and Diversified

US Treasuries are considered less risky than money in the bank today. Unless the US government defaults, those treasuries will always get paid. 

We had a debt maturity conflict but they extended the debt ceiling again (no surprise) because defaulting on US obligations for even a day would be a travesty. It would cause ripple effects throughout the globe. It is highly unlikely that this will happen.

Say you put your money into US treasuries for a very short time. If you do it via a brokerage account you can even get it back out the next day. It can be highly liquid depending upon how long you decide to leave it in there. You can ladder treasuries to mature from a few weeks to 30 years if you want to. So, varying degrees of liquidity with a lot of certainty.

That brings up another aspect to consider regarding liquidity. How certain are you that your capital is truly liquid? That as fast as you put it somewhere, you can get it right back out?

Another option is precious metals. Junk silver is an example in this category. It’s highly liquid especially if you hold that junk silver in a physical location close to you (under your mattress, in a safety deposit box, a hidden safe at home, etc.)

Other precious metals like gold certainly hold the same liquidity. As does gun ammo. Ammo is fungible, at least in my neck of the woods in Texas. I could take my ammo holdings and probably within my radius – where I walk my dog Button – I could parlay that ammo off and barter for anything, including whatever currency I wanted.

It would probably take a lot of ammo to stack up any significant amount of currency, but this is an example of exchangeability: how easily you can exchange something you hold for something you want.

Typically, currencies are how we make those exchanges but if you can keep an open mind on what has value in your marketplace, then you can probably think of your own barter examples.

How Liquid is Real Estate and Alternative Investments?

But what if you own assets that take a long time to get your capital out? Like a business. Our businesses are generally not liquid because it takes a longer amount of time to trade that business for currency or move that equity into another asset.

The quickest way to do so is to refinance it, but that is not always guaranteed since banks have tightened credit much more than previous years. The other option is to sell the business but that takes time unless you fire sale it (not ideal for an owner).

Equity ownership in real estate is also not very liquid. Whether it's my home or rental property or equity syndications, it is similar to a business. You have to sell or refinance to get cash back.

Debt lending – debt as an asset – is typically more liquid than equity because debt is a contract with a borrower. That contract can state specific terms and returns on the principal loan and maturity date. However, there is still the possibility that the borrower defaults which means having to work harder to get back your capital via the collateral attached to the loan. 

But in most cases, you can sell a well-constructed note receivable with a reliable borrower to somebody else, maybe even a bank. Or, better yet, within private markets (private capital).

Access to private capital, a network of people who would be interested in taking over a note, a loan, or even an equity asset can make that asset more liquid than usual.

In a private marketplace such as Freedom Founders, somebody would be interested in purchasing a note receivable via their IRA account because interest is great in IRAs. If the interest rate was good enough on it, like 12% or more, you might be able to sell it at par or at the balance that currently is on it. You might have to discount it a little bit to sell it more quickly but my point is: I can get my capital out.

That would be harder to do with a piece of real estate. If I was selling a rental property in North Dallas, it’d have less appeal because the buyer would then have to manage it.

A note receivable, on the other hand, wouldn’t have to be managed much. That’s the difference in liquidity between debt and equity.

How Liquid is Investing in a Fund?

There are some lending funds (funds that lend money to others) that allow for more flexibility and liquidity. Funds generally have lock-up terms which means you can’t pull out your capital for a certain amount of time. The maximum lock-up period for debt lending funds is three years. Others have two years and there are others still set at 12 months, 6 months, and even 90 days.

In the last six months, outside of Freedom Founders, we've seen Blackstone, BlackRock, Starwood, and other bigger public funds put a limit on the number of redemptions that investors could ask for even if they had advertised a redemption feature of 30-90 days. Now they say they can't do it. What point does this make?

A fund can only be as liquid as the assets in that fund. Debt income streams can be sold, redeemed, and turned into cash in the marketplace a lot more easily than equities.

For example, if a sponsor has an equity fund such as a single-family portfolio yet offers a 90-day redemption feature, you have to ask yourself: How can that sponsor do that? Are those assets easily liquidated? No, they are not. Selling equity, like rental properties, takes time.

Even if you fire sale them at discount prices, it still takes time to go through buyers, do due diligence, get their funding in place, etc. It can still take 30-90 days just to get started. That's not highly fungible and if a number of people wanted to get their capital out, they would have to sell a lot of their portfolio. It’s not going to happen in the amount of time they promised. Even though 90 days was promised to get all your money back, it's not feasible. 

Now a debt lending fund offering a 90-day redemption is more feasible. However, being flooded with a marketplace of redemptions on the paper/notes being held would be hard even for a debt fund.

An example of this was Silicon Valley Bank. That was the issue that caused them to default. They had a lot of depositors demanding their deposits – the beginnings of a “run on the bank”. What were the primary assets they held? It was not cash in the vault. No banks keep cash in the vault. They have to keep it out there earning something. Most of their assets were in long-term ten-year maturity treasuries and mortgage-backed securities.

But wait. Treasuries and mortgage-backed securities are sellable. Why didn’t they sell them? Because they were long-dated. The maturity dates were at least 10 years and they were typically with coupon values. The interest rate on those securities was under 3% because they invested in them two or three years ago before rates went up.

To sell those treasuries now, you’d have to offer at least 12 percent. They would need to be purchased at a severe discount and that is what happened.

When it came time for Silicon Valley Bank to call in their assets to try to pay the depositors they couldn't do it. They couldn't sell enough assets at discounts required in the marketplace to redeem the demand deposits for their investors.  

So when investing in funds that offer liquidity, you need to keep in mind the kind of assets they hold and how long-dated they are.

Some funds that are offering liquidity have both note receivables (debt) and some equities. It makes for a more diversified fund. But again, how can that fund guarantee or promise redemptions in six months or less?

Are they just hoping not many people will ask to get their money out? In many cases, they are relying on more capital coming in. They don’t keep your money in its own special bucket. It’s pooled all together.

Just like the banks don't hold your 100k from your checking account in a vault for you. They have some reserves, but it's very low based on the amount of demand deposits they have. 

The same thing is true with fund managers. They cannot have a restricted account to keep all the capital they promised for ninety days ready to go in a snap. They can't do it. It wouldn't be viable. They could not offer that to you unless they reduce your rate of return on that money from 10% to 2% like a bank.

These are the risks we take. That's why we need a balance between cash, treasuries, precious metals, and any other liquid asset.

How to Know How Liquid an Investment is

Liquidity comes down to the assets that are in that investment, not what the sponsor tells you. How liquid are those assets?

For years going forward there will be a lot of volatility. To best understand how to allocate your capital you need to be aware of the ups and downs.

It is not a steady run up like the previous 14 years, and then we have a recession correction that will allow us to go up again. 

It is going to be up and down, up and down. We just need to be in tune with that pattern and set our expectations as investors for this.

To your freedom!

– David


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