Liquidity has become a popular tool for asset managers to boost performance. But investors should beware the risks that lurk for the ill-prepared, says Emma Cusworth.
“While liquidity in the past is a comfort, it is not a guarantee of its presence in the future. When everyone is rushing from a crowded room for the same exit doors, crushes ensue.”
Financial Conduct Authority
Liquidity is, by its very nature, fluid. Trying to gain an accurate measure of anything fluid is, of course, a tricky business. However, liquidity risk has become an increasingly important source of return for yield-hungry investors and, in today’s more constrained liquidity environment, there has never been a greater need for investors to measure and understand the ebb and flow of liquidity.
Despite its importance in determining the nature of how, when and at what price assets trade, there is still not a single, universally-accepted measure for liquidity, especially in credit markets, which predominantly trade over-the-counter.
Liquidity, or the lack of it, works to separate the expected price of a transaction from fair value – the less liquid the asset, the greater the gap. This simple relationship underlies the greater time and cost associated with trading today, but the range of factors affecting the relationship are complex.
