Sandy shows liquidity may be over-rated: James Saft

October 31, 2012

Oct 31 (Reuters) – Maybe liquidity isn’t all it’s cracked up
to be.

Trading in U.S.-traded stocks re-opened on Wednesday after a
rare two-day hiatus, as exchanges struggled to cope with the
aftermath of Hurricane Sandy.

Given the fact that everyone was prevented unexpectedly for
two trading sessions from turning their stocks into cash, much
less into other stocks, trading was amazingly tepid and calm.

Liquidity in an asset – one that trades often and can be
bought or sold easily with minimal movement in price – is a
characteristic which has always been prized in financial
markets, and with good reason.

Wednesday’s calm trading highlights the very high premium on
liquidity – the ability to turn investments easily into cash -
investors have paid, especially since the financial crisis. The
failure of Lehman Brothers in September of 2008 and the seizing
up of markets in its aftermath taught investors a lesson. Many
were caught out when highly technical and often bespoke
instruments proved extremely hard to value and trade, just when
investors most needed both liquidity and transparency.

This drove a tidal wave of money into what was most liquid -
with less liquid stocks suffering and, ultimately, very liquid
government bonds the prime beneficiaries. That’s arguably still
the case, despite central bank action which has the effect of
subsidizing risk taking, including the taking on of liquidity
risk.

But are investors actually overpaying for liquidity?

Tough to say definitively, but we can say that investors
sacrifice quite a bit in order to hold the most liquid assets. A
2009 review of the literature by analysts at risk management
consultancy Barrie+Hibbert indicates that investors give up
between 3.5 percent and 5.5 percent in extra return every year
to hold more liquid equities compared to less liquid ones. here
Depending on their credit ratings, more liquid bonds generally
return between 0.40 and 1.80 percent less than equivalent but
less liquid issues.

Given that a mixed asset portfolio might only return 6 or 7
percent in total in a year, this is a huge hit, and one we ought
to look at very closely before simply accepting blindly. In a
low yield, low return world, accepting a premium for holding
illiquid assets may become more and more attractive.

JOYS OF LIQUIDITY

To be sure, liquidity is a good, and like all goods, is not
free. The ability to access easily and with minimal friction the
value of an investment has true worth. First, it allows the
investor to potentially take advantage of better options
elsewhere while paying a minimal penalty of face value.
Secondly, as shown during the crisis, if everyone wants their
money back at the same time, the value of that money, as
distinct from the theoretical value of the investments it is
funding, rises. There are many firms which would be around today
if only they’d been more liquid, as opposed to more solvent.

This is as true of individuals as it is of firms. Lose your
job and that investment in yield-less timberland maturing in 10
years may look a lot less attractive.

For large institutions and hedge funds, the more money you
have to invest the more valuable liquidity can be, given that,
as JP Morgan’s London Whale trader illustrated in an ill-fated
and huge derivatives gambit, you may become the market, and
hence trapped by it.

But many investors may simply be overpaying for liquidity,
and very few have a firm handle on the true numbers.

“Pension funds or insurance companies, with liabilities that
have an average duration of 10 or 20 years, do not need much
liquidity,” HSBC strategist Garry Evans argued in a note to
clients.

“Individual investors, particularly for their pension
savings, should preferably have limited ability to sell their
holdings, since this would tempt them to invest speculatively,
or to use the savings for purposes other than post-retirement
income.”

Pension funds or other very long-term investors should be
able to absorb quite a bit of liquidity risk, and indeed many
U.S. university endowment funds were early to realize they could
do well out of very long cycle investments like timber land.

Evans suggests private debt and infrastructure finance as
areas where longer-term money willing to absorb liquidity risk
might be put to work. You also might argue that carrying
slightly larger amounts of cash could allow a portfolio to take
on liquidity risk while retaining safety and agility.

Of course, the more illiquid an investment the more
intermediaries tend to be able to extract for buying, selling
and advising in their areas. Still, a portfolio of illiquid
equities making 3 or 4 percent extra a year can pay out a lot in
fees and still look good.

Sandy was a hurricane rather than a man-made financial
catastrophe but perhaps it may end up illustrating that many
investors could do quite well without across-the-board
minute-to-minute access to their money.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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