David Thomson: The importance of liquidity

A key part of any investment process should be the consideration of liquidity. While volatility, and correlation are typically given due consideration we often find liquidity is ignored. Perhaps because it is harder to measure but it can prove the most important risk of all. Also, there is a truism in investment that liquidity is there except when you most need it. I first experienced this during 9/11 when markets were literally like rabbits frozen in the headlights. You couldn’t buy or sell; normal liquidity had simply evaporated.

Liquidity is important for a number of reasons, one being that it can disguise other types of risk by making volatility and correlations appear lower than they actually are in practice, a share whose price rarely changes or a fund which prices only monthly will inevitably measure as less volatile, or less correlated simply because it is illiquid. A good example is very small companies where the price can stay the same for months and then dramatically shoot up or down on a small piece of news.

Most importantly, liquidity can determine how bad things get in times of stress. It often seems unimportant when things are going well, but when things start to go badly it becomes a key determinant of the ultimate outcome. All fund managers, whether they admit it or not, will make mistakes from time to time and the liquidity of their portfolio will determine how easily they can address those mistakes and move on. You often hear the adage, ‘run your winners and cut your losers’ but without liquidity, you simply can’t do this.

At the same time, mismatches in the liquidity of the fund and its underlying holdings can cause problems. Over the years, it has become clear that in times of stress, liquidity is more important than any other factor. Examples abound, from Woodford through to the open-ended property funds that had to suspend dealings in the aftermath of the Brexit referendum. Investing in Investment Trusts may help to avoid these issues to a degree but prices can still fall dramatically.

Since the global financial crisis, despite recognising the importance of liquidity as either a mitigating factor to avoid disaster or lack of liquidity as a factor in compounding problems, the direction of regulation and changes in market structure have led to there being a continual erosion of liquidity across a range of asset classes. Regulations have discouraged investment banks from holding significant buffers in all securities, leading to greatly reduced liquidity in normally relatively safe corporate bonds, while equity trading has moved to so called ‘dark pools’ where liquidity is superficial and in very small sizes.

Since new regulations were introduced in 2018, liquidity in equities has further eroded, with investment banks’ incentive to provide research greatly reduced, as asset managers are now, in most cases, paying directly for that research.

Compounding this, the obligation to disclose transaction costs very much discourages dealing, especially in less liquid securities. It is undoubtedly the case that fund managers dealing strategies have changed in ways that reduce liquidity, in particular to reduce transaction costs by dealing in smaller incremental size.

Pragmatically, investors should have an increasing preference for larger and more liquid companies. Holdings constrained by illiquid investments such as property or smaller companies should form only a small part of your portfolio and then only in situations where you are seeking specialist niches that cannot otherwise be easily replicated. As an active investor, the ability to change your portfolio and respond to changing conditions should be a key part of your investment strategy. Liquidity is key.

David Thomson is chief investment officer at VWM Wealth.