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Friday, 24 October 2014

Sandy shows liquidity may be over-rated

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Trading in U.S.-traded stocks re-opened on Wednesday after a rare two-day midweek hiatus, as exchanges struggled to cope with the aftermath of Hurricane Sandy. Given the fact that everyone was prevented unexpectedly for two trading sessions from turning their stocks into cash, much less into other stocks, trading was amazingly tepid and calm.

James Saft, Reuters Columnist

Liquidity in an asset – one that trades often and can be bought or sold easily with minimal movement in price – is a characteristic which has always been prized in financial markets, and with good reason.

Wednesday’s calm trading highlights the very high premium on liquidity – the ability to turn investments easily into cash – investors have paid, especially since the financial crisis. The failure of Lehman Brothers in September of 2008 and the seizing up of markets in its aftermath taught investors a lesson. Many were caught out when highly technical and often bespoke instruments proved extremely hard to value and trade, just when investors most needed both liquidity and transparency.

To be sure, liquidity is a good, and like all goods, is not free. The ability to access easily and with minimal friction the value of an investment has true worth.

This drove a tidal wave of money into what was most liquid – with less liquid stocks suffering and, ultimately, very liquid government bonds the prime beneficiaries. That’s arguably still the case, despite central bank action which has the effect of subsidising risk taking, including the taking on of liquidity risk.

But are investors actually overpaying for liquidity?

Tough to say definitively, but we can say that investors sacrifice quite a bit in order to hold the most liquid assets. A 2009 review of the literature by analysts at risk management consultancy Barrie+Hibbert indicates that investors give up between 3.5% and 5.5% in extra return every year to hold more liquid equities compared to less liquid ones. Depending on their credit ratings, more liquid bonds generally return between 0.40 and 1.80 percent less than equivalent but less liquid issues.

Given that a mixed asset portfolio might only return 6 or 7 percent in total in a year, this is a huge hit, and one we ought to look at very closely before simply accepting blindly. In a low yield, low return world, accepting a premium for holding illiquid assets may become more and more attractive.

The joys of liquidity    

To be sure, liquidity is a good, and like all goods, is not free. The ability to access easily and with minimal friction the value of an investment has true worth. First, it allows the investor to potentially take advantage of better options elsewhere while paying a minimal penalty of face value. Secondly, as shown during the crisis, if everyone wants their money back at the same time, the value of that money, as distinct from the theoretical value of the investments it is funding, rises. There are many firms which would be around today if only they’d been more liquid, as opposed to more solvent.

This is as true of individuals as it is of firms. Lose your job and that investment in yield-less timberland maturing in 10 years may look a lot less attractive.

For large institutions and hedge funds, the more money you have to invest the more valuable liquidity can be, given that, as JP Morgan’s London Whale trader illustrated in an ill-fated and huge derivatives gambit, you may become the market, and hence trapped by it.

But many investors may simply be overpaying for liquidity, and very few have a firm handle on the true numbers.

“Pension funds or insurance companies, with liabilities that have an average duration of 10 or 20 years, do not need much liquidity,” HSBC strategist Garry Evans argued in a note to clients.

“Individual investors, particularly for their pension savings, should preferably have limited ability to sell their holdings, since this would tempt them to invest speculatively, or to use the savings for purposes other than post-retirement income.”

Pension funds or other very long-term investors should be able to absorb quite a bit of liquidity risk, and indeed many US university endowment funds were early to realise they could do well out of very long cycle investments like timber land.

Evans suggests private debt and infrastructure finance as areas where longer-term money willing to absorb liquidity risk might be put to work. You also might argue that carrying slightly larger amounts of cash could allow a portfolio to take on liquidity risk while retaining safety and agility.

Of course, the more illiquid an investment the more intermediaries tend to be able to extract for buying, selling and advising in their areas. Still, a portfolio of illiquid equities making 3 or 4% extra a year can pay out a lot in fees and still look good.

Sandy was a hurricane rather than a man-made financial catastrophe but perhaps it may end up illustrating that many investors could do quite well without across-the-board minute-to-minute access to their money.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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