Avoid Being Left Standing When the Music StopsJuly 21, 2016
It’s reared its ugly head in the past. It strikes quickly, sometimes over a matter of a few days, and as quickly as it comes, it evaporates taking with it billions in investors’ assets. The Third Avenue Focused Credit fund was one of its recent victims; however, despite the fund’s particularly high weight to S&P rated CCC and lower bonds, it wasn’t the fund’s credit risk that was the culprit, but the silent killer: liquidity risk.
In mid-2015, the Third Avenue Focus Credit fund requested a delay on their fund redemption liabilities from the SEC. The managers were unable to liquidate their holdings in the thinly traded debt instruments at a pace fast enough to keep up with growing redemption requests and at the same time fetch a fair price for the assets. The event highlighted the often ignored risk that illiquid investments can pose to investors when the investment herd makes a run for the one exit in the room.
More recently, a wave of illiquidity has run over the U.K. as a result of the uncertainty posed by the Brexit. M&G Investments, Aviva, and Standard Life have all halted redemptions in their real estate portfolios. The issue of liquidity risk can be particularly problematic for thinly traded instruments such as real estate, REITs, bonds, and small cap and micro-cap stocks. Also susceptible to liquidity risk are sovereign debt, securitized debt such as MBS, infrastructure financing, auto loans, and other pooled debt instruments.
In the case of many of these U.K.-based funds, the funds may be holding a direct investment in an actual piece of real estate. Unlike with a stock which constantly trades throughout the day and whose price is easily observed, real estate can be listed on the market for months, maybe even years before a sale is made. Even after an agreed upon price, there are a myriad of issues related to the transaction of the asset that could push the sale out several more weeks. Funds have some cash on hand ready to provide the NAV for investors upon redemption; however, holding all that cash is a significant burden for funds, and when redemptions are high, the cash still might not be enough to satisfy redemptions.
There is growing concern that ETFs that hold illiquid assets are exposed to significant liquidity risk as well. When the price of an ETF rises significantly above its NAV, authorized market participants will issue more shares and purchase more of the underlying basket. One big question that remains yet to be answered is what will happen when the tides change and investors want to shed their ETF holdings en masse. According to an article on dailyreckoning.com titled, “ETFs at Risk of a Run,” the steep market sell off of August 26th, 2015 gave us some insight into what may happen. Roughly 1,300 trading halts occurred during the day due to securities hitting their daily volatility limit, 78% of which were for ETFs.
How then can advisors position their clients to avoid being stuck in a “burning crowded theater” of low market liquidity? For those investors who chose to hold those aforementioned asset classes, there may be little recourse. In such cases, unfortunately, many times advisors won’t appreciate the liquidity risk of their investments until they can’t close their positions at a fair price. There are, however, some signs that the crowd is starting to move should investors decide to venture into these thinly traded instruments:
- Increasing volatility – Rapid spikes in volatility can signal trouble ahead. This effect includes not only the market of the illiquid asset, but other markets as well, as beta expansion can occur, causing volatility to spread.
- Widening bid ask spreads – This signal can be a telltale sign that the demand for an asset is quickly drying up, potentially leaving those wishing to sell without a chair when the music stops.
- Decreasing number of market makers – All else equal, fewer market makers means less demand for an asset, and could indicate an increase in bid ask spreads.
- Increasing frequency of zero trading days – This factor is another telltale sign that market participants willing to take the opposite side of a transaction are disappearing.
While there are no foolproof warning signals that liquidity is about to evaporate, understanding the risks of client’s assets, knowing the red flags, and if all else fails managing and tempering client’s expectations for liquidity can help to brace for a rush for the exits.
Please Note: Content Limitations: The above content is a general discussion only, and should not be construed as a substitute for the receipt of specific advice or counsel from Folio Dynamics (dba FolioDynamix) or the professional advisors of the reader’s choosing relative to a reader’s specific situation or circumstances. To the extent that the above references any general investment-related issues, please remember that different types of investments and/or investment strategies involve varying levels of risk, and there can never be any assurance that any specific investment or investment strategy will be either suitable or profitable.
This blog post was written by Greg Fierros, Investment Research Analyst with FDx Advisors.