Liquidity and You (Part 3 of 3)
This is the final installment of the 3 part series on liquidity and how it relates to your financial investments. The first two installments can be accessed here PART 1, PART 2. Through these articles we intend to demystify the term “liquidity”, define “liquidity risks”, and help you “identify investments that pose high liquidity risks.”
Part 3: How to identify investments that pose high liquidity risks?
The first two articles in this series established a framework for understanding market liquidity:
“There are two elements that impact a market’s ability to be liquid or not:
- Crowd size – or the number of active market participants
- Availability of the asset (or thing) being traded
A contraction in either one of these elements can diminish market liquidity.”
And defined liquidity risk:
“The risk that the asset being traded will be susceptible to large, unpredictable changes in price that are unrelated to the fundamental value of the asset.”
Many people are only made aware of their portfolio’s exposure to liquidity risk after they have incurred significant losses. Therefore, identifying which types of investments are more susceptible to liquidity risks, can help you avoid some negative consequences.
The first step is to understanding which investments can carry the highest liquidity risk is to know which characteristics create higher risk factors.
Liquidity Risk Factors
- Funds with large assets under management
Bigger is not always better when it comes to trading in the secondary market. In fact, it is possible that a fund can become too big for the market. When a fund becomes too large, the simple act of buying and selling can be very difficult without significantly moving the market against their position. The end result is a loss of performance due to lack of agility when the market become volatile.
As an individual investor in a large fund, you can be negatively impacted by the size of a fund even though your personal holdings are modest.
Here is a wonderful piece by Jon Beckett that uses a supertanker analogy to articulate the size issue with large funds.
- Funds that offer same day redemption features
“Same day” redemption is the ability for individual investors to liquidate their position in a fund (mutual, equity or bond) within a day. Though this sounds like a wonderful feature, there are some unintended consequences that may impact you as an individual investor. The same day redemption process forces the fund to sell positions even if the prices for those assets are well below their fundamental value. Forced liquidation impacts all holders of the fund (even those who are not liquidating) because the activity depresses the prices of the assets being held by the fund.
Regulators are well aware of this potential problem and the largest asset managers are looking at ways that they can meet mass redemptions without impacting the market.
- Investments that only offer “end of day valuations”
Funds invested in products that trade in opaque markets rely on an “end of day” valuation process to help investors understand the present value (as well as the changes in value) of the fund. Unfortunately, this valuation process is unreliable and may be misleading to individual investors. A lot can happen during a 24 hour period and without intra-day valuations, an individual investor is left waiting for the results of a test each day instead of knowing the value as the market moves.
- Funds that are invested in products that trade in opaque/unstructured markets
Opaque/unstructured markets lack basic architecture like an exchange, post trade information and/or pre-trade information. Without this architecture, asset price formation is informal (there is NO consensus on what something is worth) and liquidity is unreliable. Outside of the most actively traded government bonds, most bond markets fit this description.
Using these risk factors as a guide, the investment products that carry the highest liquidity risks today are large bond funds.
What types of investments have lower liquidity risk factors?
For individual investors, investments that carry lower liquidity risk are usually in smaller size in products that trade in structured markets, like FX, stocks, futures and options. That is not to say that these products don’t carry investment risk, because they certainly do. But, the value of your investments in these markets are more likely to be determined by fundamental factors and not technical distortions due to liquidity risks.
Recently, there has been a lot of focus on a newer type of investment product for individual investors, exchange traded funds or ETFs (How do ETFs work?).
In theory, ETFs provide retail investors the diversification and size benefits of a fund, but are structured in such a way that they offer the trading, valuation and protection of trading in an individual stock. As ETFs expand from equities to other, less structured markets like corporate bonds, some believe that they pose the same types of liquidity risks as traditional funds.
As the impact of financial market liquidity plays a more prominent role in the value of investor’s portfolios, it is our hope that this series has provided you with a deeper understanding of the definition of liquidity, liquidity risk and how to identify investments that carry a high degree of liquidity risk.