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Illiquidity – The 3 Cardinal Rules

Liquidity in financial markets is an odd concept. 

Essentially it means you cannot do the trade you want because there are not enough investors to do the other side – if you are buying, there are just not enough sellers to sell you the stock you want.  This seems odd in financial markets that trade trillions of £’s of assets per day and we are told that hedge funds can place deals in five-milliseconds.

In the last few weeks there have been a number of stark reminders of how this odd concept can have real-world consequences. 

In the property market, for instance, you may have read in the headlines that many property unit trusts have had to sharply reduce their asset valuations or close trading in the trusts altogether, effectively locking in existing investors. 

Post the European Union (EU) referendum result, many investors – including Equilibrium – believe that the outcome of the vote will reduce the potential returns from real estate, especially in areas that have performed well in recent years such as central London.  Not only will the pace of hiring and investment fall in light of the uncertainty but there is the concern that many financial services and data processing companies will need to relocate to an EU country in order that they can continue trading within the EU on existing terms.  This could significantly reduce the demand for commercial property.

Understandably, investors wanted to sell.  Equilibrium sold on the Friday 24th, the day of the announcement of the outcome of the referendum.  Little did we know that there would follow a torrent of sales by other investors less fleet of foot.

For the property trusts this poses a massive liquidity issue. All those sellers of their trusts wanted their money within days, the funds did not have enough cash and so are now going to have to sell their assets.  Now, selling your house can take weeks if you are lucky but selling a skyscraper takes months – thus resulting the ‘liquidity crunch’ and halting of trading.

Over the years, we have experienced severe illiquidity a number of times and have 3 cardinal rules with regard to potential illiquidity situations:-

  1. Do not be in a position of being a forced buyer or forced seller in an illiquid market.  What this means is that at all costs, we do not want to be in a situation where we have to take a low price when we are selling – if indeed, we can sell - just because everybody else is selling at the same time (and vice versa in terms of buying).  For instance, by holding cash in the accounts, we can accommodate clients’ income requirements without having to go into markets and sell where illiquidity may restrict selling or reduce selling prices.
  2. Look to take advantage of herd-like behaviour by looking to do the opposite.  Illiquid markets often result in mispricing and this can present investment opportunities.  This is the basis of contrarian investing – by taking advantage of the mass selling or buying behaviour, we can get good prices, good liquidity and good returns.
  3. Have an investment process that can act fast and slow.  Fast reactions can ensure you beat the rush, as with the property trades in June.  However, equally the investment process needs to be flexible to cope with the inevitable illiquid situations.  The second recent example has been the rebalancing on the EQ AIM Portfolio.  The Portfolio deliberately invests in the larger AIM companies but even some of these stocks, in the £150-200m size range, have been pretty illiquid since the Brexit vote.

In this circumstance, we wanted to sell certain positions and buy others and the key in the illiquid markets was patience.  By not demanding the trades be done at our convenience but slowly trading in the market, we completed the trading at good prices without the trade-off between time and value.

Illiquidity is an odd concept but a very real one when it comes to wanting your money out or trying to get a decent buying price when the crowd are doing the same.  By accommodating the realities of illiquid markets into our investment process, we won’t leave clients high and dry.

 

The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The information provided through the Equilibrium website is based on our opinion and is for general information purposes only. It is not, and should not be construed as financial advice.