Liquidity has value because time has value, says Gareth Morgan. He explains why you should demand a liquidity premium and understand the risks of 'simulated liquidity'. Your view?

By Gareth Morgan*

This is the third of four articles on investment performance, and this one looks at liquidity.

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There are four pillars of portfolio performance: returns, volatility, liquidity and protection from catastrophic risk. In the previous two articles I have looked at returns, catastrophic risk and volatility.

In this article I focus on liquidity - an attribute of investment performance that slips below the radar for many investors. Once in a while they get a sharp reminder of its importance when they can't readily access their savings - their portfolio is "frozen" by their fund manager.

What does liquidity mean?

It is the ability to sell out of an investment without causing a significant movement in the price.

A liquid investment is easy to cash up; in contrast an illiquid investment is difficult to sell without taking a price hit.

There are two obvious questions here: first, why does liquidity matter, and secondly, how do you go about building and managing a liquid portfolio?

You may have two investments of equal value but different liquidity - say a cash deposit in the bank, and a property.

But if you needed to cash up your investments quickly these two investments are not actually "worth" the same. The liquid investment (the cash deposit) is more valuable to you than the illiquid property of the same "nominal" or apparent value. This gap in value is known as the "liquidity premium".

With listed securities the sharemarket applies a liquidity premium (most of the time). It's in the prevailing share price to the extent the latest price reflects the volume of the last trade. Price and volume are published, and reflect the price the marginal buyer is prepared to pay for that number of shares at that time.

But it's quite different when illiquid assets are bundled up into a fund.

These funds "simulate liquidity" and can give quite a false impression as to the actual liquidity of the underlying assets. A fund that simulates liquidity can be bought and sold every day, but the assets that sit inside the fund may not be anywhere near as liquid as the fund itself. We'll come back to simulated liquidity and why it is very important to investors.

Liquidity has value because time has value. When you invest your savings you are delaying spending to a later date. Eventually the time will come when you wish to (in some cases urgently need to) spend your savings.

When this day comes, investments that are highly liquid can be sold immediately, but those with low liquidity cannot. The time you spend waiting to sell has value in and of itself, especially if you really need the money; or even worse, especially if your bank really needs the money.

During credit contractions the premium put on liquidity is higher than usual. When asset prices fall and credit is hard to come by - when the heat goes on the banking system and the highly leveraged are forced to sell, there may not be demand for the assets in an investor's portfolio at the most recent traded price. Prices will fall until demand is stimulated. The value of liquidity, like time, can be high indeed depending on the conditions. If you have heard the saying "cash is king", this refers to the value of liquidity.

A savvy reader will by now see the connection between liquidity and risk. What is referred to as a "liquidity premium" is merely another name for a premium that investors demand for holding risky assets. Liquidity is a form of risk.

To the extent they can be, investors are risk-averse. They demand higher returns from investments that have liquidity risk.

When you hold an illiquid asset like an investment property, you should demand a higher return than for cash in the bank or shares that are traded every day in volumes way more than you own.

There are traps to look out for when it comes to liquidity. In KiwiSaver funds and other unlisted funds the biggest trap is "simulated liquidity".

Simulated liquidity is when illiquid, unlisted assets are bundled up in a fund.

If the units of a fund are traded more frequently than is possible for the underlying assets, a distortion is created. For listed funds this is not a major issue as the sharemarket will price the illiquidity in the underlying assets - this is often called the discount to asset backing.

But simulated liquidity becomes a problem when illiquid, off-market assets are bundled up in a fund that is not listed on a sharemarket. No discount is applied to unlisted funds that simulate liquidity and that can be totally misleading for investors.

Fund managers can effectively sell mutton as lamb, dressing up illiquid, non-listed assets as liquid assets.

There is no protection for investors from this deception.

They will often deploy pooling to achieve this, which means they'll carry a cash float to cover "normal" withdrawals from their fund. This means that to the extent there's sufficient cash investors can exit at a given price by simply drawing down on the cash, leaving the remaining investors with more and more of the illiquid assets as the asset backing to their claim.

In the extreme, the fund can be forced to the market to cash out these assets if it runs out of cash on hand. If this sale forces the price of the underlying asset down or worse, if they can't be sold as happened with the ANZ Diversified Yield Fund in 2008, then the investor experiences a sudden loss in value because of that illiquidity coming home to roost.

Funds that pool investors' monies and allow withdrawals to be made from the cash float without selling all the assets underlying the withdrawing member's investment expose remaining investors to heightened liquidity risk.

An important way to assess the liquidity of a fund or KiwiSaver scheme is to look at the assets the investment manager holds in the scheme and check the daily turnover of those assets relative to the size of the scheme's holdings. The question is, if the scheme were to try to sell a particular share or bond would the market be able to absorb the trade (how does it compare to daily trading volumes over the past month?) without influencing the price? There are few New Zealand stocks that are traded in sufficient volume for the biggest 10 KiwiSaver schemes to be able to exit quickly without affecting the price.

So, to assess the liquidity of your KiwiSaver investment you need transparency over your portfolio. You must be able to see where you are invested and a list of the top 10 holdings is not enough. As yet, there is no regulation to keep you safe from illiquidity; you must verify that your assets are listed and liquid, or you run the risk of becoming a statistic.

Summary

In summary, liquidity refers to how easy it is to sell an investment without causing a significant movement in the price. Liquid investments are more valuable if you need the money quickly.

This "liquidity premium" is another way of saying that illiquid assets are riskier and therefore require a higher return than liquid alternatives.

KiwiSaver funds that "simulate liquidity" can mislead investors into thinking their funds will always be liquid; investors may be exposed to more risk than they think.

Transparency is important - if individuals can see the complete make up of their portfolio they can assess its likely liquidity. The Government should require such transparency from KiwiSaver providers.

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Gareth Morgan is a director of Gareth Morgan Investments. Any opinions expressed in this column are personal views and are not made on behalf of Gareth Morgan Investments. This article was first published in the NZ Herald. It is used here with permission.

The first article in this series is here »
The second article is here »