Liquidity On My Mind – Part 2

by on September 8, 2018  •  In Howard Marks

Part of 2 highlights and excerpts from a March 2015 Howard Marks memo on the topic of liquidity:

Liquidity During Times of Crisis

“‘In times of crisis all correlations go to one.’ The prices of everything move in unison during crises because investors are driven by mob psychology, not fundamentals. Thus – and for the same reason – in times of crisis liquidity often goes to zero…

…it’s either hard to buy but easy to sell, or hard to sell but easy to buy. Sometimes, however, when everyone’s confused and intimidated, the market freezes up and it can be hard to do both.”

“…in the crisis, institutional investors had to sell liquid assets at steep discounts and redeem from the most liquid hedge funds because of the heavy allocations to illiquid strategies and gated funds elsewhere in their portfolios. The resulting elevated supply of assets for sale from these funds reduced the liquidity for sellers in those markets and put downward pressure on assets that shouldn’t have been so affected.”

Liquidity & Contrarianism

“Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there.”

“Why not sell the things people are bidding for most strongly and buy the things they’re eager to dump? That sounds like a good idea. It is, and that’s why smart investors flock to…contrarianism…to buy from sellers who outnumber them…who are in a hurry…who have to sell regardless of price. To achieve ‘immediacy’ (a term for a quick exit coined by Richard Bookstaber), the sellers tend to sacrifice something else: price. And the price discount they accept makes an important contribution to the bargain hunter’s excess return.”

“…illiquidity is neither a winning nor a losing strategy per se…it’s advantageous to bear illiquidity when the incremental return for doing so is high, but a bad idea when it’s not…liquidity premium is neither always there nor always generous.”

Liquidity isn’t always a good thing:

“A high degree of concern over illiquidity can push investors to avoid it to excess…Liquidity is a good thing (everything else being equal). But is it smart to require that a portfolio be able to provide more liquidity than is ever likely to be called on? Let’s remember that liquidity isn’t free. There’s usually a cost, and it comes in the form of return forgone.”

“…it may not be a good idea to always sit with a large amount of cash so as to be able to provide liquidity and scoop up bargains in a once-a-decade crash. This may equate to sub-optimizing. It would have paid off in 1990-91, 2001-02 and 2008-09, but what about the other 19 years in the last 25?”

“The siren song of liquidity can…result…in (a) emphasis on short-term considerations relative to long-term ones, (b) transaction costs and taxes, and (c) exposure to negative surprises when the liquidity they’ve been enjoying and counting on disappears…

Liquidity can cause you to lower the bar for investments. If you’re thinking about making an investment you know you won’t be able to exit for years, you’ll probably do thorough due diligence, make conservative assumptions and apply skepticism, etc. But when you have something that appears very liquid, you may take a position casually, with little work or conviction, under the assumption that it would be easy and cheap to get out.”

“When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. An abundance of liquidity can be a handicap in this regard.”

“It’s hard enough to make an occasional well-reasoned long-term decision, but much harder to make a large number of correct short-term decisions.”

Perils of Asset-Liability Mismatch

“Some hedge funds provided an example in the last crisis. They raised capital with which to buy assets of uncertain liquidity, sometimes using leverage, and they promised investors the ability to withdraw their money quarterly or annually. But when the end of 2008 rolled around, the desire of LPs for liquidity overwhelmed the capacity of the marketplace to absorb the assets that were for sale (or perhaps the GPs wisely refused to sell because a fair price couldn’t be obtained). When that occurred, the funds told LPs they couldn’t have the liquidity they’d been promised. Illiquid assets went into locked-up ‘side pockets,’ and ‘gates’ came down delaying the effective dates of withdrawals. These little-known provisions gave LPs an unpleasant surprise, demonstrating that in a crisis, the promise of withdrawal from a vehicle holding illiquid assets can easily turn out to be too good to be true.”

“Financial innovations created in good times often fool people into thinking a silver bullet has been invented…Many recent innovations have promised high liquidity from low-liquidity assets…however, no investment vehicle should promise more liquidity than is afforded by its underlying assets. Do these recent promises represent real improvements, or merely the seeds for subsequent disappointment?”

In the memo, Marks provides insightful commentary on the liquidity mechanisms of mutual funds, ETFs, etc. Interesting further reading for those curious about the structure of these common investment vehicles.


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