The Shallow Benefit of Deep Liquidity

From Collaborative Fund, October 4:

At some point in the last few years high-frequency traders began using picoseconds to measure the time needed to execute their trades. That’s a trillionth of a second. Big numbers require context: There are as many picoseconds in one second as there are seconds in 31,709 years.

Few things can be done faster than the time it takes to buy or sell hundreds of companies’ stock. It can be done in huge amounts, too. Bill Gates has sold $200 million or more worth of Microsoft shares almost every month for a decade.

The term for this is liquidity. Most individual investors can turn their stock portfolio into cash at reasonable prices in seconds. Institutions can usually do it in days or weeks.

It is a massive benefit to investing in public stocks. But it doesn’t come free. You pay a lot for the service. And it’s a service many public investors overpay for, unaware of its downside.
Here’s the problem. The more liquid an investment is, the lower return it will earn compared to similar investments that are less liquid. The upside is that you can sell a liquid investment in the next few picoseconds. But most financial advisors praise liquid investments while (rightly) preaching long-term investing where you don’t touch your investments for years or decades. It’s hard to square the two.

Ask yourself: If Vanguard offered an S&P 500 index fund with a five-year lockup that guaranteed an extra percentage point of annual returns above the fully liquid fund, would you take it? I would. Many of you would.

These aren’t small numbers. The liquidity premium – the amount of return you surrender for the benefit of being able to sell quickly – can be bigger than most of the edges public market investors fight over. UBS found that each month a hedge fund bars its investors from redemption translates into an extra 20 basis points of return, on average. Another study of illiquid private equity funds showed roughly the same premium over comparable S&P 500 stocks. Two percentage points a year is astronomical in a world where investors bicker over basis points. It is several times larger than the beaten-into-our-brains impact mutual fund fees have on returns....MORE

HT: this also came to us via Alpha Ideas but we're not sure which post