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What price should we pay for Liquidity?

What is liquidity?

One question to ask when you are investing is ‘Can I get my money back easily?’ The answer we want to hear is yes, but the reality is that not all investment assets are traded every minute of every day.

Last year we saw diversified property funds, an asset class that had seen some stellar performance for the past 7 years, suffer a dramatic withdrawal of liquidity. 

In the wake of Brexit, some investors wanted their money back and managers had to react. Some suspended redemptions, preventing realisation of cash until funds could be raised from the sale of property.  Others put a “fair value adjustment” to the fund value until the market stabilised. 

This is a classic example of how liquidity can dramatically change. In the case of the fair value adjustments, the ability to realise liquidity cost as much as 15% of asset value.

Where does liquidity impact our returns?

Every cost attributed to getting in and out of an investment can be seen as a function of liquidity.

In practice, we consider the breadth (bid-ask spread), and depth (number of investors willing to transact in a market), and the movement in price caused by an absence of participants willing to transact, as costs on returns.

What controls liquidity?

Why do bid-ask spreads and the depth of markets vary? This can be traced back to the balance of buyers and sellers. A lack of either one or both will widen spreads increasing the price to buy, and reducing the sales proceeds.

Liquidity is supplemented by market makers who ‘offer liquidity’, taking on a position temporarily until they can sell themselves. They are traders not investors. Factors such as market volatility, asymmetric information of investors and regulatory capital requirements will determine the level of market maker activity and thus liquidity. 

Which assets classes are impacted?

Looking across asset classes, the greatest liquidity can be found in FX markets where there are huge transactions across many market participants, meaning the cost of reversing an FX deal is almost insignificant (despite what you may observe at the airport). 

Government Bond Markets, in particular US TSY’s are similarly very liquid. 

At the other end of the spectrum Property is not – estate agency commission, structural surveys and solicitor fees add layers of costs, but notably the time it takes to sell a property, or the capital cost lost for a ‘quick’ sale highlight how relatively illiquid the asset class is. 

Where asset classes have less investor coverage, liquidity will cluster around the most popular investments. Within the corporate bonds market that may mean liquidity is seen on the most recent issues or largest names. In the oil market you see liquidity on the front month futures contracts and less action in the longer dated ones.

A large cap stock such as BP provides investors a high degree of liquidity, while a smaller company such as 21st Century Tech (listed on Aim), will cost you far more to trade in and out assuming there is enough depth that you can even buy and sell at the bid and ask:

Source: Barclays, 1st March 2017

Markets under stress

Liquidity becomes significantly more relevant when markets become stressed. 

The costs of trading and even ability to get your investment back become stretched when either buyers or sellers retreat from a market place.

During the financial crisis of 2008/09 liquidity became stretched and the bid ask spread on most assets, even large cap stocks widened significantly.

Average liquidity for an asset class can also vary over time for structural reasons – and under the law of unintended consequences.  Regulators have looked to reduce the risk of market stress on the financial system by requiring banks to hold higher asset levels as a backstop for open positions. Quite simply this has increased the cost to trade and reduced the level of inventory market markers hold.

Subsequently, fund managers have to take far longer to execute large institutional deals even in previously liquid names and while in normal conditions this is acceptable, time will tell how market stress impacts performance.

How much should we pay for liquidity?

There are a number of factors that can determine our need for liquidity and thus how valuable it is to us.

Most important is our time horizon. With an extended time horizon many of the costs associated with liquidity reduce or disappear.  In particular, the market stress impact on liquidity becomes negligible as a long term investor can hold their investments through a period of volatility.  Further, market depth is less important if the investor has time to complete a deal in smaller chunks over time.

Capacity for risk is another important factor. Those with little capacity for risk have less ability to absorb the costs associated with illiquidity, meaning its importance to them is magnified. Equally, a loss of composure will lead an investor to value liquidity more highly as market stress and price volatility pressurise them to unwind positions. 

So what price should be pay for liquidity?

Investment time horizon, capacity for risk and composure are required for an investor to value the relative importance of liquidity in their selection of investments. To put a simple cash price onto liquidity is meaningless, even for a specific product, because the value of liquidity varies from one investor to another. 

As with property investments last summer, liquidity for some was valued at over 15% of asset value, but many valued it far lower. Illiquidity is a transient beast and the ability to retain composure and time horizon allowed for liquidity to return to that market within 4 months. Not only did asset prices recover but daily dealing has returned and discounts disappeared. 

Property remains an important asset class within diversified portfolios, providing strong risk adjusted returns for investors who can look through temporary illiquidity events.

Investing requires due consideration to many moving parts and while liquidity’s contribution is hard to quantify it can be a crucial part to both risk and return.

 Along with sentiment and valuation, we see it as crucial to shaping the direction of prices in all markets.

By investing in a diversified portfolio where liquidity risk of both asset class and manager is embedded in the due diligence and investment process of the discretionary manager, it is possible to mitigate the impact of liquidity to a reasonable level 

Ultimately individual investment constraints will determine the value of liquidity, but a spread of investments across a wide selection of different markets avoids being stranded in one asset class when all its liquidity has drained away.



Parmenion

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