The importance of staying liquid
The renowned, if somewhat acerbic, American poet and critic Dorothy Parker once commented that “Love is like quicksilver in the hand. Leave the fingers open and it stays. Clutch it and it darts away.”
While hard-nosed advisers and clients looking for portfolio returns are unlikely to be unduly moved, replace the word “love” with “liquidity” and we are looking at an aphorism that has potential relevance for us all.
This is because liquidity – defined here as the ability to buy and sell securities - tends to be taken for granted. And it is taken for granted because executing portfolio allocation decisions via a smartphone, tablet or desktop computer has never been easier.
Yet two comments from two entirely different regulatory authorities – let alone the lessons of history - suggest that advisers and clients cannot afford to assume that everything can always be done at the swipe of a thumb or click of a mouse.
- First, the Financial Conduct Authority earlier this month (8 Oct) revisited the issue of property and infrastructure funds. Chief executive Andrew Bailey has proposed that trading should halt if there is what the regulator terms “material uncertainty” as to the value of their underlying assets. This harks back to the summer 2016 panic that afflicted UK property funds, some of which temporarily gated clients’ cash and ceased to trade in the wake of the referendum vote on the UK’s membership of the EU. The FCA perhaps has an eye on next March, or whenever the proposed transition phase of Brexit comes to a conclusion. At a speech in New York (19 Oct), Bank of England Governor Mark Carney then joined the fray when he warned of the dangers that may be inherent in funds which offer the prospect of instant liquidity even if they hold what are inherently illiquid assets.
- Second, Malaysia’s central bank Governor, Nor Shamsiah Mohd Yunus, has issued a statement (16 October) arguing that capital controls should be considered as a tool when it comes to pre-empting a financial crisis. This flies in the face of current International Monetary Fund orthodoxy. It also brings back unhappy memories for experienced advisers and clients who have emerging market exposure.
As this column has already discussed this year, Malaysia went down the path of capital controls in 1998 with horrible results for financial markets. The Malaysian stock market plunged and those investors who found themselves with assets stranded in ringgit on the Kuala Lumpur exchanges looked to sell assets in other emerging markets, to avoid the risk of similar moves in other emerging markets and also to raise liquidity to protect themselves (and in the case of emerging market funds to meet redemptions from their own nervous investors). The contagion eventually reached developed markets, and global equities tumbled in the wake of a seemingly entirely unrelated Asian currency crisis.
Malaysia’s use of capital controls may have stabilised its economy but it hurt financial markets
Source: Refinitiv data
The 2018 Investment Company Factbook, a meaty 348-page tome published by the Investment Company Institute, reveals that regulated open-ended funds now manage $49 trillion, up from $22 trillion a decade ago. That represents just under one-quarter of the globe’s securities markets, with the surge in assets at least partly explained by the rise of exchange-traded funds.
Total global net assets of regulated open-ended funds ($ trillion)
Source: Investment Company Institute, 2018 Investment Company Fact Book
To manage clients’ assets funds rely on the sort of liquidity that the Malaysians would consider taking away, if push to ever came to shove. And if underlying markets do prove illiquid then the funds themselves could struggle to meet redemptions, if and when the flood in, whether the collectives invest in stocks or bonds, let alone property or infrastructure projects.
This is a reminder to advisers and clients that liquidity is not just being able to press a button and trade. True liquidity is dealing in the size, at the price and at the time that you want. Malaysia in 1998 and UK property funds in 2016 are examples of how this cannot be taken for granted.
None of this is to say a market accident or crash is imminent, even if cryptocurrencies and emerging market equities are already in bear market territory and the FAANG-plus index of leading technology stocks is suffering a correction after a 10%-plus tumble.
But rising volatility, rising interest rates and possible change in stock market leadership (all issues discussed of late by this column) at least raise the issue of whether advisers and clients should now be taking more or less risk at this stage of the cycle.
No-one is going to head into cash, as the returns there are so poor and the issue of timing market exit and entry points too fraught. But relying on liquidity – and the ability to redeem instantly to avoid trouble – may not be a good idea, either.
As such, it may be worth checking over portfolios to ensure that advisers and clients are happy with every element of asset allocation and fund selection for the (very) long term, because there is a chance any market downturn will make getting out of those positions at their preferred time, at their preferred price and in their chosen size harder than they think.
As John Kenneth Galbraith noted in his seminal tome from 1955, The Great Crash:
“Of all of the mysteries of the stock exchange there is none impenetrable as why there should be a buyer for everyone who seeks to sell. October 24 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid. Repeatedly and in many instances there was a plethora of selling and no buyers at all.”