Illiquidity is a multi-headed beast, like the Hydra water serpent of Greek mythology. The mere scent of the Hydra was deadly, just as a whiff of illiquidity can be deadly for cash-flow projections and financial plans. And cutting off just one head is not enough to protect you from trouble.
There are multiple threats from illiquidity that must be considered:
- No market
- Freezes in redemptions and withdrawals
- Trapped in a zombie portfolio
A market with no buyers is the best-known face of illiquidity risk.
So far, global financial markets have not been frozen with the sheer panic that marked 2008, when many assets simply stopped trading, leaving investors no way out. But while the system appears robust the risk that it could collapse into a crisis remains real today, given how quickly developments occur.
Within the system, though, there are many sad examples of the ‘No market’ story playing out at individual and sector levels. Often it is in smaller assets, where market depth is thin in good times but evaporates in bad. If there is a buyer, their bid may be a huge discount on the last value. But even multi-billion dollar companies are being affected, as they suspend trade in their shares to reorganize debt or seek new capital.
At least listed assets on capital markets are relatively small value transactions, and buyers can usually eventually be found, even though the price might be unattractive. But even in good times buyers are much harder to find for large value, unlisted assets such as office buildings, airports, or toll roads. In bad times, the market might be so thin and reluctant to trade that there is effectively no market at all.
No market is the horror-story of illiquidity, and in the current market it’s a real possibility. However, the far more present danger for retail investors is that they are subjected to a freeze on redeeming or withdrawing their capital from a managed investment.
Freezes in redemptions and withdrawals
Investment and retirement funds freeze redemptions and withdrawals when there is a rush of money exiting the investment and liquid cash runs out, or the manager cannot accurately value assets to determine a meaningful exit price.
When nearly US$7.5 billion of property funds were frozen in the UK in March the managers said it was because of valuation difficulties, rather than a flood of redemptions. Property has many illiquidity blots on its global record, with some freezes taking years to resolve.
But the UK recently had a classic example of a run on a managed fund, when two funds operated by celebrity manager Neil Woodford were frozen leading to substantial losses of capital for investors.
The Woodford income fund was worth US$3.7 billion when it was frozen due to a rush of redemptions. Its cash reserves were exhausted, and it had to sell assets, which is when the truth was discovered — the assets it claimed to be listed equites with liquid markets were, in many cases, completely illiquid with no real market in existence. In order to maintain liquidity ratios the fund had arranged for some of its investments to be listed on minor, secondary exchanges that offered no true market in the shares.
Woodford was an extreme example, underpinned by deception. But even the most above-board, by-the-book manager can get caught in a freeze if they lack the cash to meet redemptions, which can often rise sharply and quickly during market volatility.
Australia’s government-mandated retirement savings system, called ‘Industry Super Funds’, are a good example.
These funds enjoy a guaranteed inflow of employer contributions each year and have grown to have hundreds of billions of dollars under management. They have excess contributions to meet predictable pension commitments. This has allowed them to invest in a range of unlisted assets, such as infrastructure, and maintain relatively low cash balances to meet reasonably predictable redemptions due to customer churn or hardship.
But suddenly, overnight, the Australian government changed the rules and threw many of these funds into crisis. As part of its coronavirus response the fund members will be allowed to withdraw A$20,000 of their retirement savings – a move that could see A$30 – A$50 billion unexpectedly leaving the system. Some of these giant funds are asking for government loans to carry them through, while others are considering mergers.
Once again, their assets are difficult to sell — even though they may be considered high quality. Because once again, it can be hard to find a buyer and determine a value for assets that are not freely priced by the market.
Fund freezes can creep up on you — a frozen fund which is part of a multi-fund portfolio can cause the portfolio to freeze.
Trapped in a zombie portfolio
Managers run out of choices when there is a run of redemptions on their fund. Like a snowball rolling down a hill the run it grows in size, speed and destructive potential.
The first redemptions are paid from cash reserves — sometimes the freeze will happen as those funds run low, but not always. Some will continue until the cash-on-hand runs out, when they sell the most liquid assets — often regardless of market conditions. Again, a freeze often happens during this stage, but what if it doesn’t?
The inevitable end, where Woodford investors found themselves, is that people remaining in a fund suffering a liquidity crisis end up owning the most illiquid ‘junk assets’ that are left behind after the ‘smart money’ – the early redemptions – has run out the door with anything that could be readily liquidated. They have trapped in a zombie portfolio, which must now be frozen as it has no liquidity left to draw upon.
In some cases, those zombie assets will slowly die, but in others they will be liquidated over time and capital will be returned to investors. The problem is that investors have no control over when that might occur and their timing needs may differ from those of the people liquidating the fund.
Timing is, of course, critical in cash-flow planning. To have control over when an investment is cashed out wrenched away involuntarily can be devastating.
This scenario will be familiar to most financial advisors. A client bought investments with the expectation that they would produce a steady income – banks, real estate investment trusts and infrastructure often feature heavily in these portfolios. Over time, their financial plan provides for them to supplement their regular income with some scheduled withdrawals of capital from those investments.
Suddenly these clients are, potentially, in a perfect storm. Their income is falling as company dividends are being slashed or, in the case of many banks, suspended. At the same time asset prices are down across virtually all classes, so generating income from sales requires more of the portfolio to be liquidated than was previously anticipated. To suffer a freeze on part of that portfolio takes away more options from a list that had already been cut short.
Without help some clients may go on to create their own unique zombie portfolio trap, as they sell liquid ‘winners’ and hold on to the less-liquid ‘losers’ in their portfolio.
Dealing with illiquid assets
Illiquidity, which is unexpectedly foisted upon you, and takes you by surprise, is bad. But that does not mean that all illiquid assets are bad. Many are, in fact, very good.
Huge parts of modern economies are not listed on stock markets. They are businesses and infrastructure that are owned by individuals, families, private equity, retirement funds, investment trusts and sovereign wealth funds. Some individual assets, such as a CBD office tower or an airport, are also inherently illiquid by nature as they cannot commonly be sold quickly, and the pool of potential buyers is small.
These can be profitable investments, even though they are not freely traded. But part of their reward is an illiquidity-premium, which compensates for the lack of flexibility. Investors with sufficient resources to endure delays in accessing the capital can find these investments attractive — and they know upon entry that the investment is illiquid, so they can plan accordingly.