The queues stretched all the way down the high street. In typical British fashion, they waited patiently and mainly in good humour. However, the anxiety could not be hidden. In these dramatic scenes from 2007, an abstract investment principle was translated vividly onto the faces of those customers of Northern Rock. They were worried, and they wanted their money back.
Some investments (like those in private companies, which need a long time to be turned around) can be ‘locked up’ for up to 12 years!
This abstract yet defining investment principle is liquidity: the ability to sell for cash an asset within a certain time period. Cash in a bank account can normally be accessed the day you need it and is therefore liquid. In contrast, even if you can agree a sale of your house immediately the proceeds will probably take at least eight weeks. Thus a house as an investment is illiquid. Some investments (like those in private companies, which need a long time to be turned around) can be ‘locked up’ for up to 12 years!
This is relevant in the world of investment because in theory, all other things being equal, investors should earn a higher return on investment the more illiquid they are. This is logical because, all other things being equal, people should prefer to be able to liquidate their assets more quickly, rather than less quickly. Furthermore, more liquid assets usually cost less to buy and sell because their higher liquidity reflects more buyers and sellers, which lowers the cost of trading. Exiting a bank account should cost nothing whereas selling a house can be very expensive. Thus, investors in illiquid assets need to be incentivised to tie their money up for longer with a higher expected return on their investment.
Investment professionals need to consider whether the higher potential returns from a less liquid investment justify the additional risk of a slow or costly sale of that investment.
Individual investors need to consider how comfortable they are with tying up their money for periods lasting from a couple of days to several years (with many variants in between), even if they will not need it. Investment professionals need to consider whether the higher potential returns from a less liquid investment justify the additional risk of a slow or costly sale of that investment. In the event that another better opportunity presents itself, the illiquid investment goes wrong or it needs to be sold to fund a redemption from the fund.
IW&I’s approach to the liquidity of collective investment vehicles (open-ended funds, which are subject to redemptions, and closed ended investment companies, which are not) reflects this. In a low return world, additional sources of return are worth considering, where appropriate. All the funds we invest in can be bought and sold every day to reflect our clients’ preference: that not only they can liquidate any holding at short notice but also that we can do so, should it be in their best interests.
It is unlikely, however, that all the assets owned by daily traded funds can be bought and sold every day without incurring a heavy cost. Fund managers therefore need to be skilful in managing the potentially conflicting need to maximise their returns (which could include owning less liquid assets), with having a portfolio liquid enough to ensure investors can get their funds back immediately.
Funds that own big country government bonds, and equities and bonds of large publicly traded companies can sell assets quickly for any reason at minimal cost. In contrast, for the most illiquid of asset classes such as physical property, private equity and infrastructure assets, we nearly always invest via investment companies whose shares are traded every day but none of the underlying assets need to be bought or sold to fund redemptions. The value of these shares can be volatile and they can be relatively costly to trade, reflecting demand and the nature of the underlying assets. Nevertheless, the long-term appeal of these assets justifies the risks and costs, in particular compared with other structures that lock up investors’ money for years.
When told: “I cannot sell my house”, one should reply: “You mean you cannot sell at your asking price.”
Many funds own assets that are neither very liquid nor wholly illiquid. For example, they may own bonds of smaller countries or lower quality companies or the equities of smaller companies where there is less demand for (and supply of) their securities. In these instances the fund manager may find it hard to find buyers offering to pay a reasonable price for holdings it needs or wants to sell. (When told: “I cannot sell my house”, one should reply: “You mean you cannot sell at your asking price.”) Yet with fundamental analysis, these areas of the market can offer excellent returns relative to the risk of capital loss and are the areas where skilled fund managers can make the strongest returns. Here the judgement call IW&I has to make regarding the risk and return trade-off can be onerous.
For these funds, we consider each on a case-by-case basis and they are subject to on-going monitoring. We understand the investment strategy and determine the likely level of trading required (strategies that rely on high levels of trading cannot invest too heavily in assets that are not highly liquid). We know the types of securities and their liquidity, and the rules, limits and policies the fund manager has in place to manage liquidity risk and the strength of their enforcement. Indeed, we encourage taking liquidity risk that is carefully calibrated.
We assess and monitor the funds’ investor base to judge the risk that the fund might suffer if big redemptions need to be met. Funds with large, fickle investors are riskier to IW&I clients than those with a stable, diverse investor base. We calculate the risks and potential costs to IW&I of redeeming its holding all at once. If we had to sell our holding, how long might it take and at what cost?
Inappropriate liquidity risk to fund investors will typically manifest itself in poor performance and, occasionally, by the fund suspending redemptions. When funds suspend redemptions, they might do so to protect the fund investor from the cost of having to liquidate the fund’s assets too quickly. However a fund should never have to face that predicament.
Most open-ended funds carry liquidity risk. Some carry enough that a confluence of circumstances could lead to materially poor performance or suspended redemptions. This risk cannot be entirely eliminated without restricting investments to the largest and most liquid of underlying assets, which is unlikely to be in most clients’ interests. As always with investing, and like any other investment risk, liquidity is a risk to be embraced consciously, thoughtfully and appropriately.