Liquidity post the GFC
A marker of the post-GFC world has been the availability of money. The US Federal Reserve, and other central banks including Japan's and the ECB (European Central Bank), greatly increased the supply of money in the world. This was by measures such as purchasing bonds and holding them on their own balance sheets.
Our central bank (RBA) didn’t adopt the extreme monetary measures adopted by some other countries / jurisdictions. But money flow is a global thing, and even Australia’s interest rates were driven to record lows.
Many commentators have noted how this has likely contributed to higher-than-normal increases in the valuation of many assets; bonds, real estate, alternative assets, and share markets. And the fear now is the impact increasing interest rates could have on many asset prices.
But it is to where the money has flowed that is something your Investment Team is mindful of. And is the focus of Investment Matters this week.
What is notable in our minds is "liquidity risk" that may emerge in a market shakeup: in essence, the impact of the withdrawal of the money that has been pumped into a number of asset categories since the GFC.
What is liquidity?
Liquidity refers to the ability to quickly realise cash from selling an investment – without having any meaningful impact on its price. As an example, property is quite illiquid, cash is liquid.
The destination to which investment money has flowed since to the GFC has created liquidity risk.
The money tap was turned on in conjunction with extremely low cash interest rates, encouraging investors to take higher investment risk to obtain reasonable returns (e.g. the chase for yield). Many of these investments may not be that liquid when investors decide to exit – even just a moderate number of them.
Examples include REITs (real estate investment trusts, listed trusts with underlying office, retail or shopping centre, or industrial assets), smaller companies or companies with tighter share registers, larger companies paying dividends that now have very high valuations, and corporate bonds. This is by no means a comprehensive list – everything other than essentially cash has some form of risk. It is the degree of the risk that is important, and that in itself is sometimes hard to know in advance.
Also of note is the quite shocking increase in the number and size of Exchange Traded Funds (ETF's) over the last decade. Liquidity is perhaps the greatest, yet least considered, risk of investing in ETF's. And there is likely a big variance between individual ETFs, considering factors such as whether they are asset-backed, combined with the liquidity of the underlying investments.
Additionally, many managed funds have redemption availability that is not in line with the underlying asset liquidity. If too many redemption requests as received simultaneously, managed funds themselves become forced sellers of their underlying assets. We saw a few extreme instances of this during the GFC, where funds had to introduce restrictions or close redemptions altogether – occurrences of this kind may be worse in the future.
A problem of liquidity risk is the compounding effect that can occur. An investment falls in value as a few investors exit. Then this fall then contributes to more investors exiting, which further impacts the price thus feeding a downwards cycle. Price movements have the potential to greatly undershoot fundamental valuations, and volatility will likely increase.
Risk for your portfolio
We are conscious of liquidity risk of your investments.
What can we do to address this risk? The most significant and related measures are to:
- Hold cash (for your portfolios this is currently high, in fact in most cases higher than leading into the GFC, e.g. ~ 14.5% in your equity portfolio currently) – this not only provides opportunities to take advantage of difficult times, but it also means we ...
- Do not become a forced seller.
Additionally, the liquidity of the individual investments that make up your portfolio is a factor that we continue to consider. Most of your equity investments are quite liquid, especially the large cap ones. There are some quite illiquid investments that we expect will be realised sometime in the next six to 12 months e.g. the 360 Capital debenture. The proceeds will most likely be reinvested in more liquid investments. And in regard to small cap investments, there is a balancing act – if liquidity issues do step up more broadly, there is shorter term and perhaps medium term liquidity risk with these. However, they are predicted to be the growth engine of the portfolio over the coming three years.