When we think of markets, we often imagine a fast-paced Wall Street floor, where prices flash like strobe lights and everything is one click away from being bought or sold. But in reality, most asset classes are more like a sleepy auction house than a stock ticker. Welcome to the world of illiquid markets — where patience is a virtue and pricing is more art than science.
Let’s explore how illiquidity arises, why it persists, and how it sneakily biases reported returns — sometimes making investments look shinier than they are.
đź’Ľ Characteristics of Illiquid Markets
1. Most Assets Are Illiquid $($Yes, Even Yours$)$
Let’s face it: liquidity is overrated. Even large public markets aren’t perfectly liquid — it just seems that way because of high-frequency trading. Illiquid assets, on the other hand, include things like:
- Real estate $($Try selling your house tomorrow… or next week.$)$
- Art $($Some paintings get sold once every 50 years — talk about patient capital!$)$
- Infrastructure investments $($Think roads and bridges, not something you can flip on eBay.$)$
- Private equity and OTC securities
Public equities might have a turnover rate of over 100%, but try moving an office building in downtown New York — you’ll be lucky to find a buyer in a year.
If assets are this illiquid, how big is the market for them?
2. Markets for Illiquid Assets Are Huge
Don’t let their slow movement fool you — these assets are financial heavyweights. For instance:
- $($U.S.$)$ residential mortgage market $($2012$)$: \$16 trillion
- Institutional real estate: \$9 trillion
- NYSE + Nasdaq combined: \$17 trillion
In short, the total wealth held in illiquid assets is bigger than what’s in liquid stock and bond markets.
If these assets are so large, do people really hold that much of them?
3. Investors Hold Lots of Illiquid Assets
You know what the average person’s biggest investment is? Their house. Illiquid. And for wealthy folks? A solid 10–20% is in fine art, jewelry, or other “treasure assets.”
Institutional investors are no different:
- University endowments: From 5% in the ’90s to 25% in illiquid assets today.
- Pension funds: From 5% to 20% over the same time.
Illiquid assets are everywhere — they just don’t flash on CNBC.
So if everyone holds illiquid assets, what happens when the market panics?
4. Liquidity Can Disappear… Just Like That
Remember 2008? The money market froze. Mortgage-backed securities became unsellable. Even auction rate securities turned into financial zombies — still frozen years later.
Liquidity isn’t a permanent feature; it’s a fragile guest that leaves early when the music stops.
Why is this fragility a thing? Can’t markets just be perfect?
🔧 Market Imperfections = Illiquidity
Let’s kill the myth: markets are not perfect. The economics textbook told you markets were frictionless — but real-world markets are more like a rusty bicycle.
Key Market Imperfections:
🧩 Market Participation Costs
To enter an illiquid market, you need time, capital, and expertise. This clientele effect limits who can play. If only a few can buy, don’t expect quick sales.
đź’¸ Transaction Costs
In illiquid assets, you don’t just pay brokerage fees. You hire lawyers, accountants, and even private investigators $($okay, maybe not always$)$. These hidden costs block frequent trading.
🧠Search Frictions
Can’t sell that 70-story office tower? Blame search frictions — it takes time to find a buyer with deep pockets $($and a taste for skyscrapers$)$.
🕵️‍♂️ Asymmetric Information
When one party knows more than the other, the market screams “lemon risk”. If I think you’re selling me junk, I won’t buy — and poof, the market freezes.
🧨 Price Impacts
A big sale in a thin market moves prices — a lot. Large trades can cause liquidity blackouts.
đźš« Funding Constraints
No credit = no transaction. Many illiquid assets are debt-funded, and in tight markets, deals don’t happen.
So even if we can sell, do the prices reflect reality?
🤹 Illiquid Asset Return Biases & Unsmoothing
🤔 Why You Should Be Skeptical of Illiquid Return Data
Let’s be blunt: reported returns of illiquid assets are often biased. The main culprits?
1. Survivorship Bias
Only the survivors report their performance. Failed funds quietly exit stage left. As a result, databases overrepresent successful funds. Studies show:
- Mutual fund returns are 1–2% lower than reported.
- Private asset returns can be 4% lower.
It’s like reviewing a movie after only watching Oscar winners.
What if we do have data, but only for when prices are high?
2. Sample Selection Bias
Sales usually happen when prices are high, not when they’re down. That’s like calculating your fitness from the one day you hit 10,000 steps — after a week on the couch.
In private equity:
- IPOs happen in bull markets.
- Distressed firms may never liquidate — they become zombies.
This bias causes:
- Overstated alpha $($returns above benchmark$)$
- Understated beta $($systematic risk$)$
- Understated volatility
3. Infrequent Trading and Smoothed Returns
You can’t mark to market what doesn’t trade. Quarterly reports of private funds can show smoothed, low-volatility returns. But in reality? The ride was bumpier.
Correlations with public markets also seem artificially low. Why? The smoothing masks true volatility and co-movement.
So how do we get the real picture?
🔧 The Magic of Unsmoothing
Unsmoothing (also known as de-smoothing) is the process of reversing that smoothing effect. We use filtering algorithms to add noise back and get a more accurate view.
Real-World Example:
In 2008:
- Reported real estate loss: \$-$8.3%
- Unsmoothened loss: \$-\$36.3%
- Reported standard deviation: 2.25%
- True volatility: 6.26%
Even correlations with $S&P 500$ jumped from 9.2% to 15.8% when unsmoothed.
Think of unsmoothing as removing the Instagram filter from your financial portfolio — suddenly, the real blemishes show.
🧠Final Thoughts: Embrace the Messy Truth
Illiquid markets are not broken — they’re just different. They’re like classic cars: beautiful, valuable, but don’t expect them to corner like a Tesla.
If you’re investing in real estate, art, private equity, or infrastructure:
- Understand the liquidity risk
- Question reported returns
- Apply unsmoothing if needed
- Be aware of biases
Above all, know that illiquid investments often come with a “fog of valuation” — but with the right tools, that fog can be lifted.