Liquidity, its meaning and why it’s important for investing

Liquidity is far more important than many investors may believe. Many of the greatest financial crises - from the collapse of Barings Bank in the 1990s to the 2008 Global Financial Crisis (GFC) - have been started or accelerated by poor liquidity management.

What is liquidity in finance?

The meaning of liquidity is, put simply, the ease with which an asset can be bought and sold. Is there a ready market to sell an asset at a reasonable price? In other words, is there market liquidity? If not, investors risk having to sell out at a knock-down price simply to exit the trade, or not being able to sell at all. In theory, this can happen in any asset class, but in practice, certain areas are notably more vulnerable.

Why is liquidity important?

Liquidity should always form part of a trading strategy – even more so when trading on margin.
Traders always need to understand their potential losses, potential margin calls and what they can afford to lose to avoid a liquidity squeeze.

For longer-term investors, liquidity can also be a problem for certain collective funds. Fund managers of open-ended funds, such as unit trusts and OEICs generally offer daily dealing. This works fine when holding large cap equities where millions of shares change hands each day. However, it is more difficult in areas such as fixed income or commercial property.

It is impossible to sell a building in a day to meet investor redemptions. So usually, open-ended commercial property funds will hold some cash or property shares to help meet redemptions. However, there will be times when this is not enough – in the wake of the UK Brexit referendum vote, for example, or during the depths of the pandemic. In both these cases, funds were forced to suspend redemptions and some closed completely.

This is problematic for investors who may be unable to access their cash for long periods of time. The UK regulator, the Financial Conduct Authority (FCA), has consulted on the liquidity mismatch in open-ended property funds, which may result in investors having to give providers up to 180 days’ notice to redeem in future. The FCA is also consulting on a possible new Long-Term Asset Fund (LTAF), which could help certain investors who want to invest in more illiquid assets to do so.

While there were many disparate elements at work in the 2019 collapse of Neil Woodford’s Equity Income Fund, at its heart was a liquidity mismatch. Former star manager Woodford couldn’t sell the small, illiquid companies he was holding fast enough to meet a wave of redemptions. This eventually forced the closure of his business, with more than 300,000 investors still trying to recover at least some of their money more than two years later.

The corporate bond market has also had its fair share of liquidity concerns for fund managers. Investment banks had previously provided liquidity, but many exited the market in wake of the 2008 GFC. Banks became subject to far greater regulation and now corporate bond managers have to work harder to find pockets of liquidity in the market. For the largest bond funds, this can be a real headache.

Managing investment liquidity

As an investor, there are several points to keep in mind when thinking about liquidity.

• Time: the best way to manage financial liquidity risk is to leave yourself time to ride out difficult periods in the market. If you invest for the long-term, you won’t be subject to the same pressures.
• Diversification: holding a balanced range of assets makes it more likely that you will always have something to sell should liquidity pressures emerge. During the pandemic, for example, there were fewer buyers for retail or leisure companies, but plenty for technology shares.
• Trading volumes: investors in single stocks can monitor trading volumes to ensure that there is enough liquidity to sell. This can highlight normal liquidity in a stock and also when liquidity is coming under pressure.
• Investment trusts: investment trusts are ‘closed-ended’ collective funds in that they have a fixed amount of shares. They do not have to sell assets to meet redemptions and so don’t face the same issues of ‘forced selling’ in difficult times as open-ended funds. Increasingly, fund groups use investment trusts for their illiquid strategies, such as smaller emerging markets, microcap companies or property assets.

Illiquidity can be your friend as well as your enemy. Areas such as private equity can carry an ‘illiquidity’ premium, which means investors receive a higher return for taking liquidity risk. If you don’t need to sell, you can use it to your advantage.

However you choose to manage liquidity risk as a trader or investor, the Fineco platform lets you explore your investing and trading options with Powerdesk, which allows you to create a personalised workspace and trading experience.