David Jane examines liquidity and how it can disguise other types of risk.
We see risk in three key measurables: volatility, correlation and liquidity. Liquidity is often ignored, as it’s harder to measure, but it can often prove the most important risk.
Liquidity is important for a number of reasons, one being that it can disguise other types of risk by making volatility and correlations seem lower than they actually are. A share whose price rarely changes, or a fund that prices only monthly will inevitably measure as less volatile, or less correlated simply because it’s illiquid.
Most importantly, liquidity can determine how bad things get in times of stress. It often seems like an unimportant factor 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 able they are to address those mistakes in order to 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 a 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 long-term capital management through to the open-ended property funds.
Since the global financial crisis, despite recognising the importance of liquidity as either a mitigating factor to avoid disaster, or the lack of liquidity as a factor in compounding problems, the direction of regulation and changes in market structure have led to a continual erosion of liquidity across a range of asset classes.
Regulations have discouraged investment banks from holding significant trading books in all securities, leading to greatly reduced liquidity in corporate bonds, while equity trading has moved to “dark pools” where liquidity is superficial.
Since the Markets in Financial Instruments Directive, or MiFID II, 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 notional transaction costs very much discourages dealing, especially in less liquid securities. It’s undoubtedly the case that fund managers’ dealing strategies post-MiFID II have and will change in ways that reduce liquidity, in particular to reduce measured transaction costs by dealing in smaller incremental sizes.
The move towards indexation is also a factor here, although difficult to measure, and it has certainly had an impact on liquidity.
We have always preferred liquid stocks and bonds. As pragmatists, recent declines in liquidity have led us to having an increasing preference for larger and more liquid companies.
We have always constrained any relatively illiquid positions to a small part of the portfolio and only in situations where we are seeking specialist niches that can’t be otherwise replicated.
As genuinely active asset allocators, the ability to change our portfolios and to respond to changing conditions has and always will be a key part of our strategy.
David Jane is manager of Miton’s multi-asset fund range.