Andrew Gawith: Liquidity means not having to take a bath

The global financial crisis showed what happens when the taps are tightened. Photo / Greg Bowker

The colossal mess the world's financial system got itself into over 2008 and 2009 was a crucial reminder of just how important liquidity is.

Liquidity can be a difficult concept to define and can mean different things to different people but at the end of the day it is your ability as an investor to turn your investments into cash.

Can you get your money back when you want and without taking a bath in the process?

Some assets will always be more liquid than others. A bank account is highly liquid, you roll up and withdraw your money (unless there's a run on the bank).

Likewise most shares tend to be fairly liquid. Where there are lots of willing buyers and sellers you can generally put your order on and make your transaction quickly without moving the price too much.

Property is something we tend to think of as being reasonably illiquid even under normal market conditions. Trades happen infrequently and there aren't usually as many willing participants.

Within these broad parameters there are always shades of grey. For example the liquidity of shares can vary.

While a market like the US is broad and deep, it can be more difficult to transact in a thinly capitalised market, such as New Zealand.

Liquidity can also vary for individual shares.

This is usually related to the size of the company being bought or sold. It's often much easier to transact shares in larger companies than it is in smaller ones.

The ability to transact can also be affected by the size of the parcel in question.

Liquidity is multi-faceted and the majority of investment managers carefully consider it when structuring portfolios.

The manager should ask the question when making any investment - how easy or difficult will it be to exit the position, because clients might want their money back and some of the investment has to be liquidated.

Or it might simply be because an investment theme has run its course and it's a matter of wanting to change the balance of the portfolio.

As an investor there is nothing worse than being trapped in yesterday's product or having an exposure to an investment that is well past its use-by date.

There is also a cost associated with illiquidity. If there is a shortage of buyers and an investor is keen to complete a transaction then it's likely to "cost" her because she will usually have to drop the asking price to close the deal.

Many home sellers will have first hand experience of this "squeeze" in the past couple of years.

Of course there is a benefit for long-term investors - they can either hold assets through periods of liquidity preference, or they can pick up assets being sold under liquidity duress.

Investors should understand and be comfortable with the concept of liquidity and also appreciate that it is not a constant.

The global financial crisis highlighted that liquidity can evaporate very fast - here today, gone tomorrow.

And it wasn't just the mum and dad investors that got caught. Professional investment managers were hit too.

Besieged by redemption requests for funds that had been invested in failing assets, managers were forced to sell the most liquid assets first.

That solved the immediate problem of paying out investors wanting to leave but it left remaining investors in the fund with a vastly changed risk profile as they ended up with the more illiquid and in some cases worthless assets.

As we know, some funds were eventually closed or frozen, but not before a lot of damage had been done to investor wealth. A case of first out, best dressed.

KiwiSaver has been immune from any liquidity disasters to date. That is due to the way it is structured and the fact that the regime is in its infancy.

Cash has been steadily flowing in, and the redemption requests that have been permitted have been easily met from the flood of contributions from members, employers, and the Government.

Liquidity obligations in KiwiSaver will rise as members in these funds approach retirement and want their money back. Most managers will be able to adjust the liquidity profile of their investments over time to accommodate this.

But what happens if investors decide to transfer en masse out of a scheme?

The underlying investments of any scheme and current market conditions at the time will dictate the ability of the manager to meet those requests in a responsive and equitable fashion.

That scenario has yet to be tested. But as the financial crisis has demonstrated the unlikely, or almost impossible, can happen. The finance/property sector debacle has been a painful reminder of just how important liquidity can become.

Liquidity is about getting your money back when you want it - to assure yourself that that is likely to be the case you should know where your money is being invested.

* Andrew Gawith is a director of Gareth Morgan Investments.