Illiquid Investment

Wilhelmina Voss tells her representative that her single greatest worry about any investment is being unable to convert it into cash promptly at a price close to its appraised value. Which holding exposes her most directly to that concern?

1. A.A recently issued 10-year Treasury note.On-the-run Treasuries trade in the deepest, most liquid market in the world.
2. B.Shares of a large-capitalization NYSE-listed common stock.Listed large-cap shares carry price risk but are readily salable at or near the quoted market.
3. C.Units of a non-traded real estate limited partnership.Correct. There is no ready secondary market, transfers are restricted, and sales typically occur at steep discounts if at all.
4. D.Shares of a retail money market mutual fund.A money market fund is redeemable and among the most liquid holdings an investor can own.

Why: Liquidity, or marketability, risk is the risk that an investor cannot sell quickly without accepting a meaningful price concession. A non-traded partnership interest has no exchange listing, no continuous quotation, and typically only a thin secondary market at deep discounts, plus transfer restrictions and general partner consent requirements. Treasuries, large-cap listed equities and money market funds all offer same-day or next-day liquidity at or near quoted value.

A representative at Corbin Securities recommends that Yusuf Adeyinka invest 90,000 dollars, roughly half of his investable assets, in a non-traded REIT with a seven-year expected holding period and a share repurchase program limited to 5 percent of shares outstanding per year. Yusuf's profile on file states that he expects to need these funds for a house down payment in about two years. The illiquidity and the repurchase limits were disclosed in writing and Yusuf signed the acknowledgment. Under Regulation Best Interest, what is the principal problem?

1. A.The recommendation fails the Care Obligation, because a product whose liquidity profile cannot meet a stated two-year cash need is not in this customer's best interest no matter what was disclosed.Correct. The Care Obligation is judged against the customer's profile, and disclosure does not cure a recommendation that fails it.
2. B.There is no Reg BI problem, because the illiquidity and repurchase limits were disclosed in writing and acknowledged.Wrong. Reg BI expressly provides that disclosure does not satisfy the Care Obligation.
3. C.The problem is the Disclosure Obligation, because the repurchase cap should have been described in the relationship summary rather than in the offering materials.Wrong. Disclosure was in fact made; the defect is in the substance of the recommendation, not its disclosure.
4. D.The problem is the Conflict of Interest Obligation, because non-traded REITs typically pay higher selling compensation than listed REITs.Compensation conflicts are real, but on these facts the decisive failure is the mismatch between the product's liquidity and the customer's two-year need.

Why: The Care Obligation requires the representative to have a reasonable basis to believe the recommendation is in the retail customer's best interest in light of that customer's investment profile. A product with a seven-year expected hold and a hard cap on redemptions cannot meet a stated two-year cash need, so the mismatch is fatal on the merits. Disclosure and a signed acknowledgment do not repair a recommendation that fails the Care Obligation; Reg BI expressly rejects disclosure as a cure for an unsuitable recommendation.

Trustee Gabriel Onwuachi reviews a $40,000 position in a micro-cap stock that trades roughly 8,000 shares a day, quoted $11.80 bid and $12.40 asked. He asks his adviser what risk this position adds beyond ordinary price volatility. The best explanation is:

1. A.Credit risk, since a micro-cap issuer is more likely to default on its obligations.Incorrect. Credit risk concerns an issuer's ability to pay what it owes on a debt obligation. The concern described here is the cost and difficulty of exiting an equity position.
2. B.Systematic risk, which affects the whole market and cannot be diversified away.Incorrect. Thin trading in one small company is specific to that security. Systematic risk is the market-wide component that diversification cannot remove.
3. C.Liquidity risk: the roughly 5% quoted spread and thin daily volume mean the position cannot be converted to cash quickly at anything near the quoted price, and an urgent sale would require an additional price concession.Correct. The spread is an immediate round-trip cost, and a $40,000 order against 8,000 shares of daily volume would move the price against the seller as well.
4. D.Reinvestment risk, because proceeds from any sale may have to be redeployed at a lower rate of return.Incorrect. Reinvestment risk concerns the rate available on future cash flows, such as coupons or maturing principal. It has nothing to do with the cost of exiting a thinly traded stock.

Why: This is liquidity (marketability) risk. The quoted spread of $0.60 on a roughly $12.10 midpoint is about 5% of the position's value, meaning the holder gives up roughly 5% simply to round-trip the trade. Worse, with only 8,000 shares changing hands a day, a $40,000 sale represents a large share of daily volume, so executing it quickly would push the price down further - a market impact cost on top of the spread. Liquidity risk is therefore the risk that the position cannot be converted to cash promptly at anything close to its quoted value.

A suitability review asks for the customer LIQUID net worth. Which asset is EXCLUDED from that figure?

1. A.Money market fund holdingsMoney market funds are among the most liquid assets a customer can hold.
2. B.Listed common stockMarketable securities convert to cash in days and count as liquid.
3. C.Equity in the customer primary residenceCorrect - home equity is the classic exclusion from liquid net worth.
4. D.A bank savings accountBank deposits are immediately accessible cash - fully liquid.

Why: Liquid net worth counts assets readily convertible to cash - bank deposits, money market funds, marketable securities. Equity in a primary residence is excluded: it is illiquid and inaccessible without selling or borrowing against the home. Review: customer financial profile terms.