Once you give it away, you can’t get it back, especially during a crisis.
The views expressed here are those of the author and do not necessarily reflect the views of Morningstar.
When you invest, there are only a couple of important things to think about. Let us assume that you have accomplished your goal of saving $5,000 to buy a mutual fund. The first important question is return. If you are going to become the next Warren Buffett, you must make a high return on your $5,000, because even with a high return, it will take a lot of years to get to $1 billion. Perhaps you should find the best performing star in the Morningstar universe and buy that one.
About 30 seconds later, you will realize that there is a second important factor: risk. Even though the market has been rising a lot for the past nine years, there is no reason to think that is going to continue for the next nine years, and it would be terrible to lose the $5,000 you worked so hard to put away.
Diversification is a partial answer to risk, so buying several funds of different types will reduce risk, although risk never really goes away. After additional planning and worrying, you’ll realize that there is another problem that you are facing. At some point in the next few years, your car will need replacing, or your daughter will decide to get married, or you will really want to buy a vacation house. These will require cash. It would be a good idea if you could easily sell your investment to pay for one of these important life events. Mutual funds are designed to have excellent liquidity daily, a valuable feature.
I invented a thought experiment about liquidity. Let us assume that you are out with a buddy, had a few drinks, and invented a game: Any time that you ran into your friend, he had the right to ask you to give him $1,000 in cash. After that, it you would be your turn, and you could ask him for the $1,000. If one of you could not make the payment, there would be a fine of an additional $1,000, and the game would be over. Would this be a fun game? It is a fair game, because neither of you would have an advantage over the other, but I don’t think it would be enjoyable. Suddenly, you would have to adapt your habits to carry $1,000 on your person all the time. You would have to worry about having it stolen, would have to wear a money belt, and if you were short of cash, you would have to start avoiding places where your friend might show up. This game would be very disagreeable because of all the distortions it would make on your conduct. If you could put a money value on your disagreeableness, that would be the value of your liquidity.
If someone asks you to give them your liquidity, make sure you get paid for it. Hedge funds have been very popular with wealthy investors over the past 20 years, but people are not as eager to invest in them as they used to be. One reason, certainly, is that returns for most hedge funds have not been very high, in large part because their fees are excessive. Another reason is that you must give up liquidity. You may be allowed to withdraw money once a year after giving three months’ notice—a far cry from the liquidity of a mutual fund. The hedge fund operator was very glad to get the convenience of the liquidity you gave up, and it’s not obvious you got anything in return.
Private equity, venture capital, and real estate funds go one step worse. The hedge fund offers negative liquidity. The hedge fund manager has the right to call on you whenever he feels like the buddy in our game. If an investor or an institution agrees to be a limited partner in a fund, with a notional investment of $1 million, the fund may not ask for any money the first six months, and then demand that you put up $500,000 in the seventh month.
At the end of the year, the fund will send you a report. Let us assume that the $500,000 went up to $550,000. The fund will say that your internal rate of return was 10%. However, you may feel that you had committed $1 million, and your return was only 5%. The fund manager will smile and say, “Well, you don’t know how we do things around here.” But the cost of having to reserve the second $500,000 for future use is, in fact, a cost to you, and because the fund can call for your money any time they feel like it, you don’t have zero liquidity; you have negative liquidity.