In the past month, tales of unexpected illiquidity have hit the headlines, and investors are understandably concerned. With Mark Carney, Governor of the Bank of England, declaring investment funds have been “built on a lie”, and the media revealing that the FCA was aware of breaches at the now suspended Woodford fund for over a year, it feels like systemic failures are being exposed, and perhaps signposting another million dollar financial services scandal.
But let us pause for a moment. Before we add Liquidity to that list under Lehmanns and LIBOR, let’s consider what the term really represents.
What is liquidity?
In very simple terms, liquidity is how quickly we can turn something into cash. Some assets can be turned into cash very quickly (the ‘money-market’ funds in our managed liquidity asset class, or forthcoming Sterling Solution, for example). While others may take longer (such as property). Generally speaking you will get an additional return for holding less liquid assets, in exchange for the higher risk you are taking on in holding them.
Illiquiduty is normal
Take equities, for example. Liquidity is different for large cap, FTSE 100 shares than stocks listed on the AIM market. Royal Dutch Shell, the largest company on the UK stock market, has over 8 billion shares, with people buying and selling them every day, while for smaller companies there simply isn’t the same volume. As a result, they are harder to buy and sell, so they are less liquid. There is nothing inherently wrong in this – in fact, for an investor who understands and is comfortable with the risk and return profile of smaller cap shares, holding them can prove profitable over the long term.
What about property?
Property is another asset class where liquidity has historically been problematic. After the EU referendum in 2016, for example, many property funds were suspended just like Woodford’s fund has been. Fast forward 3 years, and investors hardly blink at the allocation within their portfolios, recognising the diversification benefits of bricks and mortar as an inflation hedge, uncorrelated to the bond and stock markets.
Not a dirty word
Illiquidity is not, in itself, a dirty word. It is a characteristic of all investments, and much of the time the impact of it can be predicted, monitored, and managed. Indeed, we consider the liquidity of all investments in substantial depth as part of our ongoing due diligence process. We review the underlying holdings as well as their relative size within the portfolio, so we understand our exposure. We also think about the bigger picture, looking at how large the fund is, how much influence other holders have, and what percentage of the fund we would ultimately own.
The bigger picture
This bigger picture matters, because ultimately you are at the mercy of supply and demand at the moment you wish to sell. Turning an asset into cash is a two player game – the seller, and the buyer. And if you want to sell when no one is looking to buy, you are either stuck with your unloved asset, or you will have to reduce your price until it becomes attractive enough to someone else to buy it, after all. It is actually in an effort to avoid this kind of “fire-sale” that funds suspend trading.
Without a doubt, there are lessons to be learned from the recent issues that have affected Woodford’s flagship fund, and from those who promoted and distributed it. I make no excuses where investors have been – or certainly, feel they have been – misled. But rather than panic, and hiding our money under the proverbial mattress, let us instead take from this a timely reminder of why we take a long term view when it comes to investing in risk assets, and of the true value of good financial advice.
The above article was previously published by Parmenion on 31st July 2019