Getting to grips with liquidity

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25 Jul 2016

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.

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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.

Yet this interplay is largely unmeasured by commonly used models today. Adrian Hull, senior fixed income investment specialist at Kames Capital, says: “There’s no point putting together a framework that is good 95% of the time when it has the potential to mislead investors 5% of the time.”

And if liquidity risk cannot be appropriately measured, how can it be appropriately managed?

LIQUIDITY RISK AWAITS

If there is a sudden rush for the door, triggered by an event or market shock, then many funds will need to generate cash needed to meet redemptions. Funds and platforms offering daily liquidity, or operating with high mark-to-market leverage and daily margining requirements, could quickly find themselves forced to sell illiquid assets into a panicking market.

This is precisely where unmeasured liquidity risk can really bite. As one liquidity expert says: “Investors could lose a fortune in this kind of scenario, which would be the precise moment they start to really care about accurate measures of liquidity.”

Even a series of small events, which are more likely to happen and be more pronounced in today’s market, could be punishing unless investors take a more flexible approach to mark-to-market losses and short-term volatility. And those with cash in reserve would be well-placed to take advantage of opportunistic pricing. Furthermore, where liquidity risk is a source of return, the arguments in favour of longer redemption periods, or ‘patient capital’, as CQS’s James calls it, become more compelling.

Being in a position to do so means investors need to carefully consider their own position before buying into credit assets. “Investors need to adjust their approach to funding and the flexibility they afford their fund managers,” James says. “Patient capital within broader, flexible mandates will best be able to exploit opportunities in this new trading environment.”

IT’S AN ILLIQUID WIND

Taking a very close look at a manager’s approach to liquidity management should also become increasingly important. The FCA’s recent paper, Liquidity management for investment firms: good practice, is a useful starting point for those less experienced in this area of due diligence.

Given the highly fluid nature of liquidity and the lack of completely reliable measures, investors today need above all to be highly educated about asset liquidity so they can understand the likely effects of illiquidity on portfolio outcomes even if they can’t be measured.

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