Liquidity risk and why it surprises people

Liquidity — the ability to convert an asset into cash quickly at a reasonable price — is assumed by most investors and is a genuine variable that differs enormously between assets.

The spectrum

From most to least liquid.

Cash in an instant access account.

Major government bonds and large-company shares, tradable in size within seconds.

Broad index funds, dealt daily.

Smaller company shares and less liquid bonds, where selling in size moves the price.

Direct property funds, where the underlying assets take months to sell.

Direct property, private investments and collectibles, where sale takes months or longer and price discovery is poor.

And products with contractual lock-ups, where sale is not possible at all for a defined period.

The structural mismatch

Where the problems arise.

An open-ended fund promising daily dealing while holding assets that cannot be sold daily creates a mismatch.

In normal conditions this works, because redemptions and subscriptions roughly offset and cash buffers cover the difference.

Under stress, redemptions rise and the fund must sell assets — which is difficult precisely when everyone else is selling.

The result is suspension of dealing, which has occurred repeatedly in direct property funds and in some corporate bond and specialist equity funds.

Investors then cannot access their money for months, at exactly the point they wanted it.

What regulators have done

Responses to repeated incidents.

Reviews of open-ended funds holding illiquid assets.

Proposals and rules requiring notice periods for redemption from property funds in some jurisdictions.

Requirements for liquidity management tools including swing pricing and redemption gates.

And enhanced disclosure of liquidity risk.

Which means the structural issue is recognised and has not been eliminated.

Where liquidity disappears

The pattern.

Liquidity is procyclical: it is abundant when nobody needs it and scarce during stress.

Bid-offer spreads widen dramatically during volatile periods, which is a cost borne by anyone transacting then.

Market makers reduce the size they will trade.

And in extreme cases markets for particular instruments cease functioning temporarily.

Which means the liquidity observed in calm conditions is not the liquidity available when it matters.

The practical consequences

For a retail investor.

Money needed soon should be in cash, since cash is the only asset whose liquidity is not conditional.

Emergency funds should not be in investments, whatever their apparent liquidity.

Products with lock-ups or notice periods should be sized so that the inability to access them does not matter.

And the possibility of a fund suspension should be considered before investing in one holding illiquid assets.

The illiquidity premium

The theoretical compensation.

Investors should in principle be compensated for accepting illiquidity, through a higher expected return.

Whether that premium is actually earned in practice is debated, and in some retail products it clearly is not.

Which means the question to ask of any illiquid product is what specific additional return is being offered for the illiquidity, and whether it is quantified.

Where it is not quantified, the illiquidity is being accepted for nothing.

Valuation and smoothing

A related issue.

Illiquid assets are valued by appraisal rather than by market transactions, which produces smoothed reported returns.

Smoothed returns understate true volatility and overstate diversification benefits in any correlation analysis.

Which means illiquid assets frequently look better in risk statistics than they are, and the apparent stability is partly an artefact of how they are valued.

This applies to direct property, private equity and various private credit strategies.

Bank deposits

Worth including.

Instant access deposits are liquid within protection limits, and the protection has a limit per authorised institution.

Which applies per banking licence rather than per brand, meaning brands sharing a licence share one limit.

Fixed-term deposits are not liquid before maturity, or carry penalties.

And notice accounts require the notice period.

Which means even within cash, liquidity varies and should be matched to when the money is needed.

The checklist

Before buying anything.

How quickly can I sell this, and at what cost?

What happens in stressed conditions?

Are there notice periods, lock-ups or gates?

Has this type of product suspended dealing before?

Is the underlying asset as liquid as the wrapper implies?

And would it matter if I could not access this for a year?

If the last answer is yes, the holding is too large or the product is wrong.

General information only, not investment advice. Investments can fall in value and may be difficult to sell. Consult a regulated financial adviser.