Liquidity risk is now front-of-mind for advisers and clients. There is a danger that the wrong lessons will be drawn from recent events. When money is flowing strongly into a fund, liquidity is usually good in that fund and in the broader stockmarket. But investors should question: is the fund vehicle well-matched to the strategy, and has the manager put any capacity limits in place that recognise liquidity in the investible universe? The issues are not just from small companies, or unquoteds. Big percentage holdings matter whatever the company size.
A fund manager should be able to demonstrate to clients that processes are in place to monitor liquidity, reported to independent governance. Liquidity monitoring should also be firm-wide – there is little value in knowing that an individual fund’s position is liquid to the desired degree if that information is not combined with all the similar holdings in other funds run by the same manager. This points to the dangers of scale. In the drive for harmonisation of portfolios within an investment firm, stock concentration has been encouraged. At the same time, the largest capitalisation, most liquid stocks, have been disappointing – over the very long term outperformed by the indices of mid-cap companies.
Open-ended funds are designed to scale up and down, but unquoteds cannot do this readily. Of course, even with a policy to avoid unquoted investments, a manager still needs to maintain a fair value pricing process. From time-to-time companies will be suspended, markets closed for the day, or low liquidity requires a stock price adjustment.
In the stockmarket, liquidity and pricing are closely linked; the right price to sell a large position may be a much lower price. Unfortunately, the focus on cost has side-lined risk management, long term performance and stewardship.