KEY POINTS:
After the recent problems in the finance company area people might think that "liquidity issues" relate to not having enough cash available to pay the bills. But in a stockmarket context liquidity has a quite different meaning.
The finance textbooks define liquidity as the ability to buy or
sell an asset quickly with little price change from a prior transaction, assuming no new information. In order to determine how liquid an asset is, one should ask two questions:
* How long will it take to buy or sell the asset?
* What will be the effect of my transaction on market prices?
In an ideal world transactions should be instantaneous and have little impact on market prices. High liquidity is thus a fundamental requirement if a stock is to attract the attention of most institutional investors. Generally they prefer markets where they can anonymously trade in or out quickly and without pushing prices around too much.
Our most liquid stocks are the likes of Telecom and Fletcher Building and they are often used by international investors as proxies for buying NZ Inc.
Illiquid assets, like residential property, for example, cost more to deal in in terms of fees and the impact on price.
Liquidity also relates to the size of the investor: what is a viable market to deal in for Mum and Dad with $10,000 to invest might not suit the NZ Super Fund.
In a study a few years back the UK financial regulatory body, the FSA, concluded that price impact was a major component of transaction costs - often more important than brokerage to institutional investors. This raises the issue of declining economies of scale - liquidity costs can actually be higher for larger investors rather than lower as fund managers might have us believe.
So liquidity is desirable but in the finance world the obvious answer is not always the correct one. At the same time that the "market" agrees that liquidity is highly attractive in an asset, many big investors are today falling over themselves to buy illiquid assets.
The NZ Super Fund is a prime example - management are increasing their weightings in forestry, private equity and unlisted infrastructure vehicles.
Why? There are at least two reasons, neither of which may be entirely valid: return and risk.
Institutional investors like Harvard University and Yale have in the last 10 years made very good returns from unlisted assets (like buying Fletcher Forests in New Zealand at the bottom of the forestry market a few years back), which looks especially clever when stockmarkets are heading south.
The theory is that while liquidity is great, you pay for it via a lower return, so if you are an investor with an especially long investment horizon - so that you don't need liquidity - you may be able to earn a few extra basis points by buying illiquid assets which are underpriced because there are fewer buyers and sellers involved.
With everyone jumping on the bandwagon in recent years, and prices rising, some of this liquidity premium has been lost, but this makes the track record of the Harvards and Yales even better, putting more pressure on local trustees and Mum and Dad to get with it!
The second reason is risk or, more particularly, covariance. Covariance is the extent to which two prices move together and one of the big selling points of illiquid assets like forestry has been that their values have historically been uncorrelated with stockmarkets.
This too sounds great - you can reduce risk without impacting returns - until you realise that often as areas like commodities, oil and gold become popular, their correlation with shares suddenly rises.
In a particularly timely piece of research the Australian office of US institutional investor Frank Russell warns that illiquid assets, while potentially offering higher returns, have some not so nice characteristics which may make them particularly inappropriate to any great degree within Mum and Dad's portfolios.
"Liquidity is a complex concept in investment markets: it is abundant when it is not needed, and evaporates when it is," the Russell report states. It makes four important points about liquidity:
* Illiquid assets typically cost more to transact.
* Illiquidity can result in a failure to transact.
* True asset value is often unknown.
* Historical performance may be misleading.
As well as Russell's four points, liquidity also has implications for "price discovery", which is of particular relevance to retail investors.
All other things being equal the more liquid a market for an asset is the more confident one can be that the market price adequately reflects the investment fundamentals of that instrument, due primarily to the research efforts of institutional investors, stockbrokers etc.
For Mum and Dad in Pukekohe, without their own top-quartile research team, the price discovery attributes of a liquid secondary market are invaluable and indeed are one of the few things fund managers give away for free. If you buy a share in Fletcher Building you can be reasonably confident that it is fairly priced on current information.
A recent local example of the dangers of illiquidity as it relates to price discovery is the finance debenture market, the pricing of which, in hindsight, did not effectively capture the risks involved, especially relative to similar bonds overseas. The debenture market has always been notable for its lack of institutional involvement and in most cases a non-existent secondary market.
Illiquid markets also permit the unscrupulous financial planner or hedge fund manager to get up to all sorts of mischief, not least of which is garnering higher fees.
With an illiquid market the price of an asset is often determined by valuation rather than reference to market prices. Hedge fund managers eager to get their performance fees have been criticised for shopping around to get the valuation for illiquid assets that optimises their performance bonuses.
The Financial Times reports that this sort of thing has been going on recently in the CDO market. Price manipulation happened on a huge scale in the unlisted property market in Australia and, to a lesser extent, locally, with one fund manager commissioning, at unit holders' expense, an "experts" report saying in effect that the prices of listed property trusts were fundamentally flawed and its own, higher, unlisted valuations were the way to go.
A variation on the same theme periodically happens in New Zealand whereby rogue financial planners "engineer" valuations of thinly traded assets to make Mum and Dad's portfolio look better than it is.
As the authors of the Russell report stress, liquidity is elusive: "There is no liquidity for a crowd. It is like crying 'fire' in a crowded theatre and then announcing that no one can leave without finding someone to take his seat." If, as in 1987, everybody tries to sell the biggest stocks at the same time, the reality is that no one can exit.
* Brent Sheather is a Whakatane-based investment adviser
