Investors are hurting their long-term returns by focusing too much on assets that can be cashed in at virtually any moment, according to a new outlook published by Citi Private Bank.
The $290 billion Citi unit, which serves clients with at least $25 million in assets, believes that individuals with years of investing ahead shouldn't be afraid to lock their money up for months or years in real estate, hedge and private equity funds, and other so-called illiquid asset classes.
"Have investors raised their risk tolerance too much while reducing their liquidity preference too little? The value of select less-liquid investments may be underestimated," said the report, which was co-written by Global Chief Investment Strategist Steven Wieting and others.
"With higher potential returns, greater control, and the ability to participate in strategies unavailable in public markets, illiquid investments can potentially offer a premium to liquid investments and add material value to a balanced portfolio, especially when consistently implemented," it added.
Just how much of a premium do illiquids offer? Citi estimates, for example, that private equity and real estate plays will generate an annualized return for investors of 11.9 percent over the next 10 years.
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That's down from 2009 estimates but still compares favorably to a 3.4 percent estimated return for developed market corporate credit and 6.7 percent for developed market large-cap stocks over the same period.
Private equity firms often lock up investor money for 10 years, making it the most illiquid of investments. But the returns can be phenomenal if the right manager is used.
As of June 2013, the top 25 percent of buyout-focused private equity funds had produced a 10-year total annual return of 26.3 percent, the report said, and the top 25 percent of real estate-focused PE funds returned 29 percent. That compares to an total return of 7.2 percent.
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Hedge funds are less liquid—usually locking up capital for the first year and then offering quarterly redemption opportunities—but can still produce strong returns, according to Citi.
Citi is recommending equity-focused hedge funds in 2014, especially those that have expertise in specific industries or that practice "event-driven" strategies to take advantage of corporate deals.
The bank said credit hedge funds are less attractive but that European bond traders still had opportunities.
"Overall, we continue to see our clients underexposed to hedge funds relative to our 16 percent recommended allocation—a trend that we strongly feel needs to be addressed," it said. "The current low-yield environment, with equity market rallies over the past few years, argues strongly for adding a source of uncorrelated returns to a diversified portfolio. Simply put, the easy money in the traditional markets is likely over."
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Bonds are another way to exchange liquidity for higher potential returns.
"No balanced portfolio should have a zero fixed-income weighting," the report stated. "For those investors who are also willing to hold individual bonds until maturity ... we note the potential for yield enhancement in high-quality bonds that are infrequently traded and in some alternative bond structures."
Citi noted opportunities in less liquid residential and commercial mortgage-backed securities and collateralized loan obligations, for example.
—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.