"How good" is liquidity
14 August 2019
By Kerry Gill
Liquidity is a subject unlikely to be part of many BBQ conversations, let alone feature in a sentence with the current prime minister’s trademark phraseology.
However, we think liquidity is as essential to investment management as portfolio construction.
The importance of liquidity brings to mind Warren Buffett’s line: It’s only when the tide goes out do you discover who's been swimming naked.
The past decade of strong risk asset returns may have lulled some investors into thinking that current conditions will continue into the future. However, investment markets are cyclical and as past events have shown, also vulnerable to shocks.
Few could have imagined, pre-GFC, that crisis in the US sub-prime mortgage market would morph into global trauma making entire markets — such as the corporate bond and mortgage-backed securities markets, for instance — dysfunctional.
Liquidity ceased in these and other markets, leaving investors unable to access their funds.
In 2010, one year on from the GFC’s darkest days, there was $20 billion in Australian frozen funds’across the mortgage, high yield, property and hedge fund spectrums.1
Any number of triggers — perhaps a Persian Gulf conflict, intensification of the US-China trade war — could set off a market shock and potentially trigger liquidity issues.
These are just two possible scenarios. Beyond these are “unknown unknowns” that can upend confidence.
To be clear, liquidity events are not just in the past, albeit fairly recent past.
There is, at the time of writing, a live liquidity crisis in the UK involving Woodford Investment Management, founded by one of Britain’s best known investment managers.2
After many consecutive months in which withdrawals from one of Woodford’s funds became greater than the new money coming in, the company found they couldn’t realise cash quickly enough to meet the withdrawal requests. Their response: withdrawals were gated, leaving legions of investors angry and in limbo.3
Woodford held unusually big stakes in smaller and early stage unlisted companies, which are hard to sell quickly.
Unlisted assets, such as infrastructure, real estate, and private equity, as well as alternative investments, including hedge funds, have become larger parts of many Australian portfolios post-GFC.
There are sound diversification arguments for investing in them.
However, sizeable unlisted asset (and hedge fund) exposures — unless carefully managed — does create potential for liquidity mismatches if markets become agitated.
Moreover, in stressed environments, unlisted assets may inadvertently become proportionately larger parts of portfolios, at the same time as listed markets fall in value, creating asset allocation issues coupled with liquidity complications.
A risk management lens
Consistent with our view that liquidity is as essential to investment management as portfolio construction, we think that a risk management lens is an appropriate way of dynamically addressing the issue.
Liquidity management cannot be treated as set-and-forget. It needs to be inbuilt within investment strategy.
Putting this into practice can include doing such things as testing portfolios’ capacity to meet redemption requests in stressed conditions versus ‘normal’ times.
Stress scenarios developed by the many investment managers operating in Australia may differ, but a guiding principle broadly applicable across the industry would be the requirement that funds have the ability to sell assets without incurring large transaction costs or quickly enough to prevent or minimise a loss.
Despite the GFC’s severity, none of our funds were frozen during that period. It wasn’t luck that made this possible, rather the result of being prepared for the worst.
The current positive risk asset cycle is now a decade long. How much further it may run is the subject of a lot of investment industry debate.
Nobody knows with certainty when the cycle will end, but endings tend to be messy.
Responsible investment managers need to be prepared whatever happens.
1 It's time for investors to face the truth about frozen funds,opens in new window. Dominic McCormick. Money Management, 15 March 2010. Accessed 30 August 2010.
2 Bright star to black hole,opens in new window: the rise and fall of fund manager Neil Woodford. Rupert Neate. The Guardian 9 June 2009. Accessed 7 August 2019.
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