Liquidity vanishes when you need it most.
That isn’t an especially original observation. It’s like saying that the exit doors are always jammed precisely when you need a quick exit quickly.
Amin Rajan gives us a forceful statement of this point inspired by the “current travails at Woodford Asset Management.” Rajan is the CEO of CREATE Research, a UK-based think tank that focuses on fund management issues.
Woodford, Rajan says, suffered from a classic liquidity mismatch. It was dealing in and settling trades in its units in a shorter time frame than it could reasonably have been expected to liquidate its assets.
Unlisted Equities and Redemption Demands
Neil Woodford had become one of the best-known fund managers in Britain on the strength of his superior performance throughout the global financial crisis in the first decade of this millennium. But more recently his LF Woodward Equity Income Fund became overly dependent on unlisted equities.
A period of poor performance led to the demand of many investors for redemptions from the equity fund, and concern about those demands led Morningstar to downgrade that fund, calling its portfolio positioning “extreme.”
It’s a UCITs fund, which means among much else that it is subject to a 5/10/40 rule. A maximum of 10% of a UCITs’ net assets may be invested in securities from any single issuer, but investments of more than 5% with a single issuer may be constitute more than 40% of the whole. Woodford is, in short, required to be diversified, and part of the reason for that requirement is to ensure liquidity. Should one of the portfolio’s issuers, for example, enter insolvency proceedings, this will obviously impact its ability to trade on that issuer’s securities, but they will be a relatively small part of the whole.
Most UCITs funds, like US mutual funds, can be bought and sold daily. Despite the precautions taken by those who drafted the UCITs regulations, that commitment remains at odds with the realities of trading on the equity of private companies.
More than two months ago the authorized corporate director for Woodford posted an announcement on its website that further trading on the equity fund is suspended. Investors are locked in until further notice.
The statement said, “This period of suspension is intended to protect the investors in the fund by allowing Woodford … time to reposition the elements of the fund’s portfolio in unquoted and less liquid stocks, into more liquid investments.”
Back to Rajan
This brings us back to the liquidity discussion. Rajan observed that Modern Portfolio Theory is of little help on these occasions. MPT presumes that the relevant assets can be bought and sold without affecting their price. When liquidity is an issue, this assumption is simply false.
To compound the problem, Rajan says, the “easy money policies of central banks” in recent years, “have reinforced the illusion that liquidity will always be there while the global economy is awash with cash.” The central banks obviously can’t keep up a policy of quantitative easing forever—at some point savers must be encouraged rather than discouraged, and the value of money as a medium of exchange must be maintained by limits on its quantity. And, indeed, despite rumblings for a certain much-read Twitter account, the Federal Reserve in the US has indicated that it is cutting rates now only slowly and reluctantly. It continues to look for a time and manner of topping off the sea of liquidity on the macro level.
Meanwhile, at the micro level where funds and companies live, liquidity crises can occur even if the macro picture remains oceanic.
Finally, Rajan observes, “the further we advance in the current market cycle—the longest in history—the more unreal asset valuations will become and the more fragile investor sentiment will be.” Central banks won’t be able to ignore these facts forever, and the bottom line of Rajan’s sobering message is that liquidity tensions could intensify a coming correction.