We hope you are having a pleasant summer so far, and that you remain healthy and safe. Along with you all, we are closely monitoring the rapid spread of the COVID-19 Delta variant, its impacts on the markets and on everyday life. In our office, our focus remains on safety, and we have maintained protocols designed to limit the spread of the coronavirus through practices such as social distancing and flexible remote work schedules. Despite this, we are heartened by the ever-increasing vaccination rates and look forward to seeing you in-person once again – we hope to do so soon!
In this letter, we’d like to take a brief look into a topic that many public market investors take for granted: market liquidity. In a June 24 opinion column for the Financial Times, Rishabh Bhandari of Capstone Investment Advisors points out a potentially worrisome trend – despite historically low interest rates and a huge increase to the money supply, broad market liquidity is actually in decline and has been for over 10 years. Below, we discuss this trend, the importance of market liquidity, some of the reasons for its recent decline, along with the resulting impact on investing.
What is liquidity? The common understanding of the term “liquidity” refers to the amount of one’s assets in cash, or in assets that can be quickly converted to cash. In financial markets, this concept is taken a step further. Liquidity in a financial context is a measurement of how easy it is to buy and sell assets in a market or on an exchange. In other words, a highly liquid market is one where the availability of an asset is well-matched to the demand for the asset. In such a market, say a liquid stock market, the bid price for a security (the price the buyer is offering) will be near the ask price (the price the seller is willing to accept) – this narrow “spread” between the bid price and ask price is a characteristic of a highly liquid market and allows large amounts of buying and selling to take place without drastically moving the price of the security.
Some financial markets are more liquid than others. Currency is considered the most liquid asset, having a bid-ask spread of zero, or nearly zero (as I write this, I would gladly swap $5 USD for your £3.60 GBP to prove the point). On the other hand, the real estate market is much less liquid (there’s a small chance that you and I would both gladly agree to swap houses) – as any homebuyer or seller knows, large shifts in supply and demand occur all the time, and the resulting bid/ask spread can be significant, sometimes favoring the buyer and other times the seller. Within the public equities market, some stocks also tend to be more liquid than others, as evidenced by large trading volumes and low bid/ask spreads. U.S. large cap stocks fall into this category with high investor demand typically met with an ample supply of sellers; however, small- and micro-cap stocks tend to have wider bid/ask spreads due to lower demand, lower supply, and lower overall trading volume.
Shocks to the system. As discussed above, a highly liquid market can accommodate large amounts of buying and selling without significantly impacting asset prices, resulting in modest short-term price movements (i.e., lower volatility). Increased volatility can be a sign of increased illiquidity, reflecting the mismatch between supply and demand inherent in less-traded markets. In fact, episodes of short-term volatility in the U.S. stock market have greatly increased in number since the 2008/2009 Global Financial Crisis (GFC). As Mr. Bhandari observes, the number of daily moves of 5% or more in the VIX index (a measure of the market’s volatility expectations) was nine from 1994 to 2007. Since the GFC, there have been 62 such spikes. This period includes some memorable examples, beginning with the so-called “flash crash” of May 2010, when major U.S. stock indices fell by nearly 10% in less than 15 minutes, only to recover just as rapidly. On August 24, 2015, the S&P 500 Index fell ~5% within minutes of opening. A lack of liquidity played a large role in both instances. For example, in the case of 2015, the number of sellers dwarfed the available buyers, causing some stocks on the NYSE to delay opening due to a lack of bids. This prevented ETFs that held these stocks from being fairly valued, triggering trading shutdowns that exacerbated the liquidity crunch even further.
In the modern U.S. stock market, the aforementioned “triggers” that cause massive buys or sells, or seize up the number of available securities, are not often pulled by human fingers. High-frequency traders, governed by algorithmic computer programs that monitor and react to market activity in real time, account for a large share of transactions. In fact, most trading in the U.S. stock market occurs in the first and last hours of the day (when high-frequency traders are most active), with fewer transactions in between. These transactions, made by rules-based, computer-driven funds (including passive funds) are often directionally synced, pushing prices higher or lower and distorting supply and demand.
The dangers of illiquidity are even more apparent in the bond market. Unlike stocks, fixed-income assets, including corporate and government bonds, are typically traded over the counter in markets that are much less liquid. Despite this, many of these instruments are available to investors in open-ended ETFs that offer the ability for daily redemptions. This mismatch between the underlying illiquidity of the bonds held in ETFs and the highly liquid terms offered to bond ETF investors poses a risk – if investors all try to exit at once, bond prices could fall rapidly as the funds seeks to sell a large amount of bonds into an illiquid market.
Macro liquidity versus market illiquidity. In conclusion, the decline in market liquidity in recent years paradoxically coincides with a huge increase in the overall liquidity of the global financial system. Central banks, through historically low interest rates and large increases to the monetary supply, have fueled a global liquidity boom. In the equity market, significant inflows into passive and other computer-driven funds have caused herding, risking big volatility swings as the market is pushed and pulled by high-frequency traders. In the bond market, an explosion of debt securities (sparked by low interest rates) can be purchased via open-ended, daily liquid funds, the terms of which may not reflect the relative illiquidity of their underlying holdings. The overall effect is an increase in macro liquidity that has fueled asset bubbles, but a decrease in market liquidity, causing more volatility and risking a longer-term crisis as investors pile into overvalued assets that may not be easily exited.
How do we mitigate this risk for client portfolios? For one, maintaining exposure to active managers can help offset potential herding by passive strategies, which are often affected by momentum-driven, algorithmic trading. Additionally, maintaining diversified portfolios (by asset class, geography, sector, etc.) of both public and private market investments through a variety of investment vehicles reduces risk. Finally, disciplined portfolio monitoring and rebalancing can take advantage of increased volatility by opportunistically harvesting gains and redeploying them in undervalued assets when large dislocations occur (as further explained in our 4Q2018 letter).
As always, we welcome your questions and conversation – please reach out to us anytime you would like to chat.
The Mangham Associates Team
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