Liquidity refers to how quickly and cheaply an investment can be sold. Liquidity planning is an incredibly important part of investing. Institutions like pension funds are very long-term investors, often expected to be around for decades. This gives them the opportunity to invest in illiquid assets to earn an illiquidity premium for extra returns and diversification.
Individual investors may also hold some illiquid investments for a higher return, such as fixed term savings accounts.
However, not having enough liquidity when you need it can cause big problems. It could mean being forced to sell an illiquid investment at a very large discount. Or it could mean selling other, more liquid investments, at a loss. In the worse case scenario, it could even mean not having enough cash available to make important payments.
In this post we will look at three reasons why investments can be illiquid and what this means for investors.
Why investments can be illiquid
An investment may be illiquid because of:
- The nature of the investment itself.
- There are not enough buyers.
- The buying and selling process for the investment is slow.
Let’s look at each of these in turn.
1. The nature of the investment itself
Firstly, the very nature of the investment may make it time consuming and expensive to sell.
An obvious example is real estate. Selling a commercial property is similar in many ways to selling a house. The property needs to be valued and physically prepared for selling. Documentation needs to be gathered and a selling agent needs to be appointed. The property needs to be marketed and when a buyer is found a lengthy legal process needs to be followed to transfer ownership. All this can take several months.
How quickly we can access money from an investment may also depend on the terms of the pooled fund1 it is held in. Some pooled funds will enable investors to request and receive back their investment within a day or less. However, other funds may take a few days, a week or longer to return cash to investors. These are the “dealing and settlement” terms of the fund.
2. There are not enough buyers
In practice, many investors will own less liquid assets like real estate in pooled funds. The units of the pooled fund can be bought and sold, a bit like the shares of a company. This means that investors can reduce their allocation to real estate without needing to go through the lengthy process described above.
However, this relies on there being other investors that are willing to buy the units of the fund. If not, then the fund manager will initially dip into cash held in reserve in the fund to pay the investor. However, if too many investors choose to sell at the same time, this cash will run out and the fund manager will need to sell properties, meaning that the fund becomes much less liquid.
Even investments that are not as intrinsically illiquid as real estate can become very illiquid if there are not enough buyers in the market for the asset. This is what happened in 2008 in the financial crisis and helps explains why even supposedly safe assets like gold suffered large losses.
Illiquidity and the 2008 financial crisis
Over 2007/2008, banks suffered huge losses when the US housing market collapsed. This dramatically reduced the ability of banks’ trading desks to buy and sell assets. This is because trading is often done using derivatives, which require the trader to hold sufficient cash (“collateral”) to back up positions2. Following their losses from the housing market collapse, banks started to run out of cash to use as collateral, so had to pull back from trading.
This resulted in a very large imbalance between buyers and sellers in the market. Investors that wanted to offload an investment quickly had to discount its price significantly to incentivise someone to come to the market to buy it. Banks often needing to sell assets quickly to meet losses on their existing trades, which also dragged prices lower.
Lower prices led to even worse losses for the banks, which impaired their ability to trade even more, resulting in even worse liquidity. This “liquidity spiral” is why even some supposedly safe assets like gold fell in value; investors we forced to sell these assets to release cash, driving down their price.
3. The buying and selling process for the investment is slow
Pension funds are very long-term investors and, as such, have very effective processes for making long-term investment decisions. However, these processes may not work so well when the pension fund needs to act very quickly, for example in response to fast moving financial markets.
Pension fund trustees are required by law to take investment advice before they invest. The trustees then need to review that advice and come to a decision. Once they have decided to act, a certain number of trustees needs to provide sign-off to the investment manager to buy or sell the investment.
The trustee body may include employees of the sponsoring company, as well as professional trustees. It may not be straightforward to convene this group to make a very quick decision and even gathering the required number of signatures to instruct a change can take time. All this means that it can take some time for a pension fund to sell an investment, even if the asset itself is liquid.
What this means for investors
An investor needs to consider all three of these factors when deciding what and how much illiquid assets to invest in.
Investors also need to establish what cash they will need and when. Sometimes their cash needs will be predictable, like the next month’s pension payments from a pension fund. However, pension funds may also need to find cash unexpectedly.
Members of DB pension funds who have not yet retired can opt to leave the pension fund altogether. If so, the member will be given a cash lump sum to transfer into another pension fund, in return for their current pension. These requests are unpredictable and could be a meaningful proportion of the pension fund’s assets, particularly if a senior executive with a large pension decides to transfer out of the fund.
The circumstances of an institution could also change, requiring a lot of cash sooner than expected. For example, a significant economic downturn may cause donations to a charity to fall significantly. This will make it harder to meet the immediate financial needs of the charity’s beneficiaries, without dipping into the charity’s reserves.
Some investments can also create unpredictable cash needs. Private equity funds and private debt funds will ask investors for cash as and when the fund needs cash to invest in an investment opportunity. Investors in these funds commit upfront to provide the cash when it’s needed; but they don’t know precisely when they will be called upon to provide it.
Derivatives, like those used in Liability Driven Investing, can also require the institution to make cash available at unpredictable times.
Pension funds and other investors use sophisticated strategies to manage these risks. We’ll explore one such approach – liquidity waterfalls – in the next post.
Image by Pexels.
Leave a Reply