LO 65.1: Evaluate the characteristics of illiquid markets. * 1

LO 65.1: Evaluate the characteristics of illiquid markets. * 1
There are several characteristics that describe illiquid asset markets, including: 1. Most asset classes are illiquid, at least to some degree.
2. Markets for illiquid assets are large.
3.
Illiquid assets comprise the bulk of most investors portfolios.
4. Liquidity dries up even in liquid asset markets.
M o s t As s e t C l a s s e s Ar e Il l iq u id
All markets, even large-cap equity markets, are somewhat illiquid. It is clear, however, that some assets (e.g., real estate) are less liquid than others (e.g., public equities). Illiquid assets trade infrequently, in small amounts, and generally exhibit low turnover. For example, there are mere seconds between transactions in public equity markets with an annualized turnover rate greater than 100%. In contrast, over-the-counter (OTC) equities typically trade within a day, but sometimes a week or more may pass between trades, with annualized turnover of 25% to 35%. Corporate bonds trade daily, and municipal bonds typically trade semiannually. At the far end of the liquidity spectrum is institutional infrastructure with an average investment commitment of 50 to 60 years (up to 99 years), and art, with 40 to 70 years between transactions. There is negligible turnover in infrastructure. Turnover in residential real estate is about 5% per year, while turnover in institutional real estate is approximately 7%. Time between real estate transactions can range from months to decades.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
M a r k e t s f o r Il l iq u id As s e t s Ar e La r g e
The size of the U.S. residential mortgage market was $16 trillion in 2012. The institutional real estate market was measured at $9 trillion. In contrast, the market capitalization of the NYSE and Nasdaq combined was approximately $17 trillion. The total wealth held in illiquid assets exceeds the total wealth in traditional, liquid stock, and bond markets.
In v e s t o r H o l d in g s o f Il l iq u id As s e t s
The home is often an individuals most valuable asset. As a result, illiquid assets represent approximately 90% of total wealth, not counting human capital, the largest and least liquid asset for many individual investors. High net worth individuals in the United States even typically allocate 10% of portfolios to fine art and jewelry, known as treasure assets. High net worth individuals in foreign countries hold an average of 20% in treasure assets. Institutional investors have also increased allocations to illiquid assets over the last 20 years. University endowments have increased allocations of illiquid assets to approximately 25%, up from 5% in the early 1990s. Pension funds have increased allocations to approximately 20%, up from 5% in 1995. In general, investors hold sizeable amounts of illiquid assets.
Liq u id it y Ca n D r y U p
In stressed economic periods, such as during the 20072009 financial crisis, liquidity can dry up. For example, money markets froze (i.e., repurchase agreement and commercial paper markets) during the crisis as investors were unwilling to trade at any price. Residential and commercial mortgage-backed securities markets, structured credit markets, and the auction rate securities market, a market for floating rate municipal bonds, also became illiquid during the crisis. The auction rate securities market is still frozen, more than six years later. Major liquidity crises have occurred at least once every 10 years across the globe, in conjunction with downturns and financial distress.
M a r k e t Im p e r f e c t io n s

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