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How much liquidity do you really have?

Liquidity is the ability to buy or sell something whilst incurring normal transactions costs. How does one measure liquidity? In a managed fund, it is complicated. It depends on many inter-related factors such as: Are we in a period of risk aversion (e.g. 2008-9)? How much stock needs to be traded? Over what time horizon? How many dealers are active in the market? In what volume are they active and how often?

Reduced liquidity in some securities can leave investors raising cash via a common subset of other more liquid stocks. Ironically, managed funds often experience larger-than-normal cash inflows and outflows during periods of decreased market liquidity. Funds therefore need to take particular care of their liquidity situation. A large fund selling in such an environment may cause prices to fall leading to more investors looking to sell and so on – a liquidity spiral.

How liquid are managed funds today? Many are conservatively managed, and liquidity is prioritised. But many are not. For example, several fixed income funds currently display Sharpe ratios in the 7-10 range1. Such stellar risk-adjusted returns may be caused by assets in the fund being so illiquid that little mark to market pricing is available. In this way price volatility is artificially supressed. Low volatility makes these funds attractive to investors, but those with long memories will remember similar products that did not end well in 2008-9. Despite offering daily liquidity in their PDS, fund closures and delayed redemption proceeds were common.

So, buyer beware – managed funds with yields in the Cash +3-4% range or higher should experience negative monthly returns from time to time. If your fund hasn’t, then be aware that your capital may be inaccessible in times of stress.

1 Sharpe ratio is a measure of returns per unit of volatility. A skilled manager may might generate a Sharpe ratio of 1-4 in the long-term.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.