An ode to illiquid stocks for the retail investor

Today's go-to advice for the small retail investor is to invest in passive ETFs and index funds. These low cost alternatives are better than investing in high-cost active funds that will probably not beat the market anyway. There's a lot of good sense in the passive strategy.

Here's another idea. If you're a small investor who has a chunk of money that needs to be invested for the long haul, consider investing in illiquid stocks rather than liquid stocks, ETFs, or mutual funds. Pound for pound, illiquid stocks should provide you with a better return than liquid stocks (and ETFs and mutual funds, which hold mostly liquid stocks). Because you're a small fish, you won't really suffer from their relative illiquidity, as long as you're in for the long term. Here's my reasoning.

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Take two companies that are identical. They begin their lives with the same plant & equipment and produce the exact same product. Say the risks of the business in which they operate are minimal. They will both be wound up in ten years and distribute all the cash they've earned to shareholders, plus whatever cash they get from selling their plant & equipment. The price of both shares will advance each year at a rate that is competitive with the overall market return until year 10 when the shares are canceled and cash paid out.

The one difference between the two is that for whatever reason, shares in the first company, call it LiquidCo, are far more liquid than shares in the second, DryCo. LiquidCo's bid-ask spread is narrower, it trades far more often, and when it does trade the volumes are much higher.

Given a choice between investing in two identical companies with differing liquidities, investors will always prefer the more liquid one. This is because liquidity provides its own return. Owning a stock with high volumes and low spreads provides the investor with the comfort of knowing that should some unforeseen event arise, they can easily sell their holdings in order to mobilize resources to deal with that event. The liquidity of a stock is, in a sense, consumed over its lifetime, much like a fire extinguisher or a backup generator is consumed, though never actually used. The problem with illiquid stocks, therefore, is that they provide their holders with little to consume.

As a result, the share prices of our two identical firms will diverge from each other at the outset. Since shares of LiquidCo provide an extra stream of consumption over their lifetime, they will trade at a premium to the DryCo shares. However, both shares still promise to pay out the exact same cash value upon termination. This means that as time passes, the illiquid shares need to advance at a more rapid rate than the liquid shares in order to arrive at the same terminal price. See the chart below for an illustration.

The logic behind this, in brief, is that illiquid shares need to provide a higher pecuniary return than liquid shares because they must compensate investors for their lack of a consumption return. This higher pecuniary return is illustrated by DryCo's steeper slope.

Here's where small retail investors come into the picture. Because the capital you're going to be deploying is so small, you can flit in and out of illiquid stocks far easier than behemoths like pensions funds, mutual funds, and hedge funds can. From your perspective, it makes little difference if you invest in LiquidCo or DryCo since your tiny size should allow you to sell either of them with ease. Your choice, therefore, is an easy one. Buy Dryco, the shares will appreciate faster! Thanks to your minuscule size, the market is, in a way, giving you a free ride. You get a higher return without having to sacrifice anything. In short, you get to enjoy a consumer surplus. [1]

Put differently, the consumption return provided by LiquidCo is simply not a valuable good to you as a small and nimble investor. By holding LiquidCo, you're throwing money away by paying for those services. Rather than enjoying a consumer surplus, you're bearing a consumer deficit by holding liquid shares, perhaps without even realizing it. [2]

This advice is of little use to large fish like mutual funds and hedge funds. These players never know when they will face client redemptions necessitating the liquidation of large amounts of stock. Investing in illiquid shares poses a very real inconvenience for them since they are likely to be punished if they try to sell their illiquid portfolio to raise cash to meet redemption requests. Paying the premium to own liquid shares may be the best alternative for a large player.

Because they dominate the market, large players are largely responsible for determining the premium of liquid shares over illiquid ones. Retail investors who directly invest in stocks have become a rare breed, typically opting for mutual funds or ETFs. As such, the premium doesn't reflect retail preferences at all, but the preferences of larger players. Liquid stocks are well-priced for institutional investors but mispriced for the retail investor.

Look over your portfolio. Are you mostly invested in liquid stocks? If so, you may be paying for a flow of liquidity-linked consumption that you simply don't need. Do you hold a lot of mutual funds and ETFs? Both will be biased towards liquid stocks. Mutual fund managers need the flexibility of liquid shares to meet redemptions, and ETFs are usually constructed using popular indexes comprised of primarily liquid stocks. If your liquidity position is overdetermined, it may be time to shift towards the illiquid side of the spectrum. The tough part, of course, is finding what illiquid stocks to buy. But that's a different story.

[1] For this strategy to work in the real world, you really do need to be holding for the long term. My chart shows a steady upward progression. But in the real world, there will be hiccups along the way, and when these happen, illiquid stocks will tend to have larger drawdowns than liquid stocks, even though the underlying earnings of each firm will be precisely similar. As long as you don't put yourself in a position that you're forced to sell during temporary downturns, then you should earn superior returns over the long term.

[2] This is why I like the idea of liquidity options, or "moneyness markets". It makes sense for retail investor to buy LiquidCo if they can resell a portion of the unwanted non-pecuniary liquidity return to some other investor. That way the retail investor owns the slowly appreciating shares of LiquidCo and also earns a stream of revenue for having rented out the non-pecuniary liquidity return. This combination of capital gains and rental revenues should replicate the return they would otherwise earn on DryCo. See this post, which makes the case for "moneyness markets" for the value investor (and helpful comment from John Hawkins).