Is liquidity in your investments as important as past performance, size, and brand quality when selecting and shortlisting funds?
Most investors would say “No” in good market conditions, when nearly all investments can be bought and sold easily and without affecting prices.
But liquidity becomes crucial in more volatile climates, when even assets that are considered safe and conservative—like short-term fixed income—can become difficult to trade.
In the wake of COVID-19, we’ve seen liquidity quickly become a significant factor in investment performance. For instance, in late March 2020 as investors scrambled for cash, the massive withdrawals across money market funds, U.S. government bonds, and equities threw markets into turmoil. Understanding the liquidity characteristics of specific investments became more paramount than ever.
In these environments, advisors and investors need flexible, easily-adaptable data, and analytics that can provide transparency on new criteria—like liquidity—as conditions change.
To solve this need, a digitized due diligence platform can help with 1) online questionnaires that can be revised, recreated, and automated to bring fund selectors the data they require 2) intelligent analytics to process and compare collected data.
Just as it’s better to undergo regular health check-ups for prevention rather than wait until issues escalate to emergencies, liquidity should also be an integral factor of a due diligence checklist.
Here are five reasons why:
Reason #1: Enhanced freedom and agility
Liquidity enables investors to exit their investments quickly and easily and allows them to access all (or some) of their money when needed as market conditions shift.
During the pandemic, as markets plunged, many investors found that they couldn’t close their positions, either because of the volume of sales or due to certain contractual obligations.
“Force majeure” or “material adverse effect” clauses, for instance, can allow issuers to restrict redemptions during certain periods. Understanding liquidity constraints, including binding contractual agreements, gives investors a better idea of their options and allows for more maneuvering room when markets turn volatile.
Reason #2: Reduction of forced sales
During tumultuous markets, investors and advisors often must raise cash for normal obligations, such as pension and/or annuity payments; to settle losses from foreign exchange hedging; for margin calls; and to meet capital calls for private equity, venture capital, and other private market investments.
If liquidity dries up unexpectedly, they may have to sell assets just to raise cash. Often liquidity crunches occur when asset prices are falling rapidly. This is the worst time to sell because it locks in losses and can significantly impair long-term performance.
Understanding liquidity and building a cushion to weather difficult markets can prevent these types of sales and enable investors to hold on for the next market upswing.
Reason #3: Minimized swing pricing costs
Swing pricing was designed to protect existing shareholders from the costs associated with unusual buying and selling activity. It adjusts a fund’s net asset value (NAV) to pass on trading activity costs to the investors making the trades.
Most of the time, swing pricing is beneficial because it protects long-term investors from the costs and volatility of unusually high trading activity. However, it can add to costs—and reduce returns—if you need to make a large trade all at once.
Understanding funds’ rules about when swing pricing is triggered and how NAV is affected can help investors plan their trading strategy to minimize these additional costs.
Reason #4: Better insights on the underlying assets
Liquidity is not only about how easy it is to sell an asset, but also about what price you can sell it for when needed.
Understanding the underlying portfolios of a fund as well as the selling strategy are essential to obtaining a good picture of liquidity. For example, with fixed-income funds, it is important to understand which bonds are liquid and which are not.
Transparency can help ensure that investors’ liquidity is more closely matched by the actual liquidity of their fund investments.
Reason #5: Aggregate portfolio preparedness
The aggregate liquidity profile of a portfolio is a top-down decision. Being able to build an aggregate liquidity profile of a portfolio enables investors to ride out periods of volatility and ensure they have the resources to position their portfolios for the next upturn. It allows them to avoid the worst-case scenario of getting locked in at the bottom of the market, unable to prepare their portfolios for future growth.
Investors should have the ability to balance between higher long-term returns of less liquid assets on one hand, and the cost and cash-management benefits of highly-liquid assets and strategies on the other.
Prioritize fund liquidity with Diligend
Liquidity may not be the first characteristic investors focus on when evaluating funds and investments, but in volatile markets, it’s an important one. Adding liquidity measurement to a due diligence process can help weather tough environments while minimizing unanticipated risks.
Getting a handle on liquidity won’t prevent turbulent market environments, but it will allow for more efficient and cost effective navigation.
Contact us for a demo today to learn how our digitized due diligence platform can optimize liquidity assessment process across managers, providing fund selectors with an overview of liquidity terms on fund-specific or an aggregated level.