Gone with the flow- Investors cannot hope to know the true liquidity of assets that rarely trade
For something so integral to investment, liquidity – the ease (or otherwise) with which an asset can be bought or sold – is extraordinarily hard to quantify. Assorted academics have attempted to create a suitable metric for it but have struggled to improve on the less than precise idea that liquidity is an intangible trade-off between the certainty of executing a deal and the price at which it is executed.
Say, for instance, I want to sell a holding of one million Tesco shares. I could feel pretty confident of finding a buyer for them if I were willing to take 20p a share – but that would mainly be because that is a significant discount to their market price. If I want to sell at the market price, however, then this will introduce uncertainties – for example, a fluctuating price or just how long it will take to sell the lot.
Price versus certainty is the trade-off and, while it is very hard to measure, some assets do allow you to make a more educated guess than others. Since, for example, FTSE 100 equities are traded every day, you could reasonably assume that, if your intended deal represented less than 5% of volumes traded in recent weeks, say, then your intervention in the market should not see the share price shift around too much
From there you would probably be justified in taking the view you could sell £Xm-worth of shares and stand a decent chance of seeing something close to £Xm in return. But none of this, as we have hopefully impressed on you, is an exact science and that is because share trading volumes go up and down for all sorts of reasons and there is a relationship between volumes and price.
Now the good news for contrarian investors – into which camp we on The Value Perspective of course firmly fall – is that this relationship often works in our favour. In other words, we tend to be buying shares when most of the rest of the market is worried and looking to sell and, conversely, if our ideas pay out, then a lot of people tend to be wanting to buy shares we are no longer interested in owning.
What that last point also helps to illustrate is that, while there are always two sides to any trade, liquidity tends to have one predominant direction or ‘flow’. Thus, when the weight of money is flowing out of shares that are falling in price, we are among the minority heading in the opposite direction and, when the majority of investors are flowing into rising shares, we will be there to take their money.
Interestingly, the International Monetary Fund has picked up on this idea of ‘flow’ liquidity in its latest Financial Stability Report, specifically in relation to high yield and emerging market debt. As you can see from the two charts below, emerging market companies have been issuing increasing amounts of debt – and with a higher degree of leverage than they have in the past.
Source: Bond Radar, June 2014
Furthermore, many of these companies have been issuing the debt in an external currency – usually US dollars – rather than their local one. In the eyes of The Value Perspective, this is the cardinal sin of the bond world because if, say, a Brazilian bond issuer’s revenues are in reals and its liabilities are in dollars and for whatever reason the real falls against the dollar, that business is in, well, real trouble.
So how are these companies getting away with this? It is because, to a large degree, the market is letting them and there are lots of buyers of their debt. As you can see from the next pair of charts, money has been flooding into corporate and overseas bonds – particularly from exchange-traded funds and mutual funds and particularly to the higher-risk areas of those markets.
Source: Federal Reserve and IMF staff calculations, 2014
When money is flowing into an asset class – usually because it has done well – people get away with things they never would in tougher times. On one side of this equation, financially weaker companies have found takers for their debt while, on the other side – as you can see from our next pair of charts – flow liquidity has improved and the cost of trading has fallen.
Source: Barclays and EPFR Global, 2014
So, however, have trading volumes and, the lower the trading volumes – not to mention the lower the trading size and trading frequency highlighted in our final pair of charts below – the harder it is gauge the true liquidity of a market. Most pertinently, if we start to see outflows as, say, interest rates start to rise, what would be the true price at which investors could exit the market?
Source: TRACE, 2014
The fact that any FTSE 100 stock we own trades every available trading day means we would fancy our chances of an educated guess at their true liquidity but how can the holder of emerging market debt have the faintest idea? As you can see (from the chart above), even in the good times these assets do not trade very often. We were amazed to discover, for example, a quarter of all emerging market debt in the main CEMBI index does not trade on a four-fifths of all possible trading days.
How do you even begin to gauge liquidity if an asset barely trades and so how can you hope to sketch out a price at which you might exit your position? And if, as so often happens, the majority of investors are likely to be running for the exit at the same time as each other, what are you prepared to do to ensure you emerge from the stampede relatively unscathed?
Fund Manager, Equity Value
I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth.
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