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Managing liquidity risk in portfolios
MOST investors would recall the selloff around Christmas last year, with the S&P 500 declining more than 7 per cent in one week. Markets, however, quickly rebounded and reversed all the losses. With the benefit of hindsight, one might attribute the market moves to fundamental drivers such as trade tensions, US Federal Reserve Bank tightening and global growth concerns.
However, given that those factors were much in play throughout the second half of 2018, the extreme volatility has more to do with market illiquidity than with fundamental pricing. In recent years, markets have also seen more instances of "flash crashes", the most recent being the sharp drop in the USD-JPY in early-January this year.
Market liquidity is characterised by how quickly an investor can purchase or sell an asset without causing a drastic change in the asset's price. Cash is considered the most liquid asset, while private markets, such as physical real estate or art collectibles, are relatively illiquid.
Illiquidity is compensated for by the markets by a risk premium. The best example of this is corporate bonds. It has been observed across many markets that the level of credit spread over-compensated investors for actual credit losses, a phenomenon known as the "credit spread puzzle".
However, the credit spread puzzle can easily be explained if we consider the liquidity risk in corporate bonds. Investors would recall the unusually high bid-ask spread in bonds during the Global Financial Crisis (GFC) in 2008.
A case in point would be the bid-ask spread of the CapitaLand 4.35 per cent 10/19 bond, which reached a high of 12.5 basis points during the GFC, according to Bloomberg data (See Chart, Figure 1).
Investors should be concerned about liquidity because liquidity or market depth in some asset classes may have deteriorated recently, while market depth may also ebb and flow with the changing risk appetite of investors. Since the GFC, the value of global financial assets has risen sharply. The global tradeable bond market is now estimated at US$52 trillion, up from a pre-crisis US$25 trillion, while global equity market capitalisation stands at about US$80 trillion, up from about US$60 trillion (Figure 2).
Financial institutions and capital markets are important as they build trust and also reduce the problem of uneven information between the producers and consumers of capital. However, the capacity of financial institutions to play the role of intermediary has declined. This is the result of various financial reforms, proposed by the Basel Committee on Banking Supervision, which sought to strengthen financial institutions and avoid systemic repercussions if they were to fail.
Due to higher capital charges, primary dealers have been reducing inventory positions accordingly. During market shocks where investors are looking to reduce positions at the same time, the downward price impact will be amplified.
During the late-2018 selloff, it was argued that prudential regulations on the G-SIB's (Globally Systemically Important Banks) buffers could have led to a decline in liquidity as dealers de-risked to avoid hefty capital charges at the year-end. The recent conclusion of the Fundamental Review of the Trading Book by the Basel Committee will likely dampen market-making capacity further. Besides regulations, the micro-structure of financial markets since 2008 has also evolved in ways that might impact market liquidity. One such change is the move towards passive investing, which has led to a decline in the share of actively managed funds.
According to JP Morgan, assets under management of the Exchange-traded fund universe has grown from about US$700 billion in 2007 to US$5 trillion in 2018. In addition, the market has also seen the proliferation of quantitatively oriented strategies, including volatility targeting, trend following and other "risk-based" models, in response to the huge draw-down experience during the GFC.
The common feature in these strategies is an automatic de-risking mechanism during periods of market weakness and/or higher volatility.
Consequently, bouts of market fear and uncertainty could result in a large number of sell orders seeking to rebalance risk. Unfortunately, this raises the level of volatility even higher. This was evident during the February 2018 decline, where many underlying assets were liquidated and performed poorly.
In aggregate, JP Morgan estimates that 90 per cent of the market trading volume is now dominated by Quant, index, ETFs and Options-related strategies, while contribution from actively managed funds has retreated.
Traditional actively managed funds could have provided liquidity in such a scenario, given their value-oriented and long-term approach. A value investor will buy assets when their valuation has cheapened, and is generally less sensitive to near-term developments.
Warren Buffet, the investing pundit, famously said that one should be greedy when others are fearful and be fearful when others are greedy, enshrining a contrarian philosophy, that is antithetical to the momentum-driven ones.
However, with the almost US$3 trillion shift towards passive investing, a large pool of potentially offsetting liquidity flows are no longer available. While volatility may have structurally declined, there will be more occurrences of "fat-tailed" or large moves in the market.
Implications for investors
- Investors should assess their short- to medium-term liquidity needs and ensure their portfolio can provide for short-term liquidity accordingly. Investors should be aware that some positions may be less liquid.
- Bond market liquidity is a function of issue size and credit ratings. For other products, liquidity is also driven by complexity.
- For leveraged portfolios, it is not advisable to maximise loanable value, but instead allow some buffer to tolerate mark-to-market movements. Liquidity events can have a contagion effect across other assets and correlation also rises during a period of market stresses.
- For investors holding long-term capital, liquidity can be extracted as a premium. Cash or liquid assets can be a strategic asset to take advantage of in a liquidity-driven sell-off.
- Taking a long-term approach and focusing on quality will reduce the relative importance of liquidity risk.
- The writer is chief investment officer, UOB Private Bank.