The Trouble in Conflating Illiquidity and Stability

Notwithstanding November’s rally in stocks and bonds, publicly traded assets have had a rough ride this year. For many investors, it isn’t just the broader declines that sting, but the wild back-and-forth that adds to the emotional havoc. It is one thing to know that all of these swings tend to even out in the long run, rewarding those with the patience to stick it out. It is another to conjure the necessary discipline when stocks are up one week and down bigger the next—with pundits warning more pain is in store. Enter what seems to many like the holy grail: assets that aren’t publicly traded—seemingly insulated from near-term ups and downs yet still have long-term return potential. Think non-traded REITs, property, private equity funds, venture capital investments, hedge funds and the like. If you are a longtime MarketMinder reader, you might be familiar with our hatred of non-traded REITs, which generally reward brokers more than investors and have no identifiable edge over their listed counterparts, in our view. This article isn’t about that. Rather, we think it is important to understand unlisted assets’ lack of volatility is illusory.

Any asset, regardless of whether it is listed publicly, is worth only what others are willing to pay for it. That, always and everywhere, is the price. Publicly traded assets like stocks—or securities traded often over-the-counter, like US Treasurys and many corporate bonds—have near-countless price reference points. Anything that trades constantly has near-instant price quotes, making price volatility apparent to all who look.

Unlisted assets, on the surface, may seem different. Many unlisted funds—non-traded REITs, private equity funds, hedge funds, venture capital funds—report valuations at set intervals, perhaps quarterly or annually. Start-ups get valuations whenever they complete a round of fundraising, as in, venture capital firm X takes a Y% stake that values the company at $Z billion, with much of the calculation based on models, hype and guesswork. Property values are similarly fuzzy: Unless your house is on the market and receiving bids, estimates of its value probably rest on assumptions based on what similar neighbors have sold for. That may or may not match what you can actually receive, especially if you have to sell in a hurry or if the market has shifted.

This raises the key problem: Unlisted doesn’t mean stable. The inability to see prices changing moment by moment doesn’t mean prices aren’t shifting. It just means the asset is illiquid, making the price exceedingly difficult to discover at any one time. Consider a private fund that reports its net asset valuation quarterly. You will get four price reference points per year, creating the illusion of smoothness. But if you have to redeem or sell your holding in the interim (presuming there is a provision enabling you to do so, which isn’t a given), you may find the price diverging markedly from the most recent quote. If times are good you might—might—find it is higher. But if they aren’t, you may have to take a steep haircut, and the discounted price may not match reality.

A recent (and excellent) Sydney Morning Herald op-ed illustrates the problem well with an anecdote about an Australian start-up called Canva, whose investors wrote down its value this year as Tech stocks fell globally. But they broadly disagreed on what it was worth. “Various Canva investors wrote down their valuations by between 36 per cent and 60 per cent. Some were quicker to change their valuations than others. That matters in terms of the performance numbers the funds have reported but also the treatment of individual fund members. A member withdrawing their funds before the valuations changed would benefit, potentially (given how sizeable some funds exposures were to Canva) to the detriment of continuing or new members.”^[i] Meaning, those unfortunate enough to need (or choose) to redeem their holdings after that valuation would have taken a big and perhaps arbitrary hit, all because of the timing and methodology a fund manager chose to use. If you are dealing instead with listed assets, you take this arbitrariness out of the equation. You have price transparency.

Similar stories abound in the start-up world today, as a piece in the UK’s Telegraph documents. One famous, privately held Swedish buy-now-pay-later firm saw its valuation cut from £38 billion to £6 billion in a year. Another was valued at £28 billion in July 2021 and is now trading for half that over the counter.^[ii] And don’t even get us started on FTX, BlockFi and the litany of troubled crypto firms. All of these feed into private equity and venture capital fund valuations. Investors who stay in these funds for the very long term might still do ok if the good investments outweigh the bad, but presuming there is minimal volatility on the way there is far out of step with reality.

We aren’t inherently against any of these investments (well, aside from non-traded REITs). But we think it is paramount for investors to understand what they are buying and whether that matches their presumptions and motivations. If you have an unlisted fund that reports its valuation quarterly, you get four points on a chart of annual performance. Any lines you draw from A to B to C to D will look smooth. What you don’t see are all the changes in the fund’s net asset value from day to day. Those still exist! Consider a stereotypical hedge fund, where the manager might make dozens of short-term trades per month. Some win big, some lose big, gaining or losing millions for the fund in an instant. But you don’t see that—all you see is the sum total of this activity every 90 days (or however often), which is sometimes the result of one really big, really awesome trade that offset a bunch of busts. That big trade is usually the stuff of legends. But it doesn’t erase the negativity—and fund value volatility—that preceded it. Just because you can’t see it, doesn’t mean it wasn’t there.

Always remember this simple truth: Return and risk go hand in hand, and risk often means volatility. No high-returning asset moves in a straight line, and that includes unlisted assets—you just can’t see the wiggles. Illiquid doesn’t mean non-volatile. It means hard to value and hard to sell. If you are considering unlisted or private assets, we think keeping those thoughts front of mind is critical.