Why liquidity mismatch matters

on Tuesday, 4 December 2012. Posted in ,
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TWO ANGLES

liquidityOne of the things that make us different to other advisors working with expatriates is that we discuss liquidity quite a lot. Liquidity can mean two things to investors. The amount of trading in a given stock and also the ability to access your money.

We are going to discuss the second today: when should you demand access to your money, and when should you not?

Liquidity Mismatch

We think all investors should understand the words, “liquidity mismatch”.  To us, this means that the liquidity terms of your investment product should match the underlying assets.   If the assets you are buying are liquid (say shares or mutual funds), then so should be your product.  If your assets aren’t liquid (say property or private equity) then your product should be the same.

When not enough liquidity burns

A lot of investment products have limited access, “initial periods” or “terms”.  There are lots of reasons for this, but none that we can think of that are good for the actual investor.  They suit the investment company and the advisor, effectively looking the client and his money into the product.  To consider the raft of reasons why, consider a previous article we wrote.

Less access should demand higher returns.

If you have less access, you should demand higher returns.  This seems strange until you compare it to bank accounts.  Your bank will give you a higher interest rate if you put it in a fixed deposit for 1 year.  It will be higher again for two.  Unfortunately there is no way that shares can offer higher returns for less access however.  As academic research shows, the liquidity premium is supposed to exist, but doesn’t.

When too much liquidity burns

Prior to the financial crisis, and in its aftermath we have been presented many funds that suffer from the opposite problem.  The have illiquid assets (usually property, but sometimes medium term loans) in a fund that has weekly or monthly trading terms.  The most famous that affected the expatriates in Shanghai was Brandeaux Student Accommodation that was sold to many.  The fund has a solid strategy: buying buildings and renting them to students.  It achieved an acceptable yield after fees of 3-4% and the properties conservatively drifted up in value based on the inflation based increases in rent giving a total relatively stable return around the 5-8% range.  So far so good.

Then the crisis hit, and the redemptions started

The financial crisis caused a lot of people to be short of money.  Those who had their loans called, or who fell behind in their mortgage or because they borrowed too much to invest in shares (called a margin call).  Many of these sought to encash even performing investments to cover these loans.  Others were even smarter and saw all this coming, so moved all their investments to cash.  The Student Accommodation fund, like many saw a quick and sudden demand for cash (called redemptions in the fund world).

Property can’t be sold quickly… but the fund was…

There are two ways to sell a property.  Quickly via auction for cash, which is a sure way to sell for a very low price.  Or slowly promoting it to buyers and offers via tender over a period of 3-6 months that allows purchasers to arrange finance if necessary.  Even a quick sale takes 2-3 weeks.  The fund however needed money more quickly than that, so it had to freeze the fund.  This meant stopping money going in or out of the fund until a fix could be found.

A hot response to a frozen fund

This caused most consternation as you can expect.  Some investors intended to sell in six months to buy a house, but couldn’t.  The freeze did happen for a good reason since a firesale of assets would have resulted in severe losses for all investors (our guess is 50-80% given the difficult in finding willing buyers in late 2008).  As it turned out, more than 2 years later the fund was progressively re-opened with some restrictions on investment and the fund value was mostly unaffected.  A good outcome apart from the people who desperately needed their cash back.

We believe however that this fund should be traded quarterly with 90 days notice period, a roughly 3-6 month term.  If that is like the sales timeframe to sell their property, its no accident.

mismatchSo why are these funds more liquid than their assets?

It’s a good question.  We aren’t the only person smart enough to figure out what is going on.  Sadly there are some mind tricks going on in some of the insurance companies and their compliance departments from what we can determine.

The scenario goes like this

  • Insurance companies demand that all funds have monthly trading terms with no notice period to avoid complaints from investors who can’t get their money (which is ironic given how illiquid their platforms and products are) .
  • New fund managers therefore start with that fund liquidity terms and try to reverse engineer a liqudity management approach that will prevent their fund and its illiquid assets falling victim to what amounts to a bank run.
  • The fund manager meets the tick-list request from the insurance company, and gets the fund approved.  Meanwhile senior managers and Chief Investment Officer, cross their fingers and hope that the next liquidity event will be in 10 years, long after they have left for their next job.

Professional investors avoid this stuff

Private Equity and Venture capital have even longer term strategy and therefor structures to match.  Professional investors don’t make the liquidity mismatch mistake.  As of yet no fund manager, no matter how creative has figured out a way to even pretend they can fit their PE or VC fund into a monthly trading structure.  Pension funds invest in private equity partnerships that are often 7 years with a 3 year option, knowing at the outset that  it will often be a 10 year investment term.

Bottomline:

Professional investors insist on the same liquidity terms as the assets they buy.  So should you.   These are the questions to ask.

  • What assets am I ultimately buying?  (Shares, bonds, property, cash etc)
  • How liquidy or easily sold are those assets normally?  In bad times?
  • What terms exist on the fund or structure I’m using?
  • Is there a mismatch?
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