Article | 17 September 2019 | Investments
Liquidity, which indicates how easy it is to buy or sell an investment, has been the big story of recent months. A number of star fund managers have been caught out chasing high portfolio returns by adding hard to sell assets. This has resulted in a fall from grace because they have experienced liquidity issues with their portfolios. We look at how this came about and how at Architas we look to avoid the pitfalls of investing in less liquid assets.
Perhaps the greatest challenge for investors in recent years has been the quest for yield against the backdrop of central banks’ supportive action. Massive bond-buying programmes, also known as QE, have pulled bond prices higher, pushing bond yields lower. This has tempted fund managers who promise investors a certain level of yield to boost income by ‘capturing the illiquidity premium’. In simple terms, this means investing in assets which offer a higher yield because they trade in less liquid corners of the market. After all, a higher yield compensates for the risk of owning any particular asset. And that risk can be the lack of liquidity. Problems arise when fund managers are unable to meet client redemptions because they have too much invested in illiquid assets.
When a fund builds up a lot of illiquid exposure and a lot of investors withdraw their money this can put stress on the fund forcing it to temporarily prevent trading. This was the case in recent high profile examples which has led to unhappy investors locked out of their money.
Consider a fund that was invested in large-cap stocks, typically big, stable, well-known companies that are usually easy to buy and sell - a fairly trouble-free part of the market. However, the fund was also able to hold shares of private limited companies - up to the value of 10% of the fund - that are not traded on a recognised stock exchange. Following a period of underperformance, investors sought to access their money, but to enable this, the fund was forced to sell assets. ‘Liquid’ assets are easier to sell than the more illiquid stocks held in the 10% portion of the fund. This left the illiquid stocks as a bigger and bigger percentage of the fund. Finally, the 10% limit was breached and the fund was closed for some time, trapping investors.
So how best avoid this? For the average stock market fund manager the process is a fairly simple one. A look at the how often the stock is bought and sold - sometimes called the ‘average trading volume’ for a stock - allows a fund manager to judge if they can sell a position when required. This is less easy to judge for a fund of funds manager like Architas. A fund of funds investment structure where a fund invests in a portfolio composed of a selection of other specialist funds, rather than investing directly in stocks or bonds, can be less easy to judge.
At Architas we have a set of metrics which we apply before investing in a fund. For some funds, such as investment trusts, daily averages of its trading volume are readily available. Otherwise, we can do this analysis and calculate an internal liquidity score. As a fund of funds specialist, we can also drill down into the underlying assets of a fund and analyse its portfolio positions.
Among other factors, we consider the general nature of the asset, for example whether it’s student housing or aircraft leasing. We then apply our own scoring system, to judge where the investment sits on a scale between very liquid and very illiquid.
We also constantly monitor the underlying assets of a fund, to gauge where liquidity and other risks might arise. This look-through analysis requires a good relationship with a fund manager, as these details are not typically found on a fund’s factsheet.
Liquidity management is a key concern when managing the Diversified Real Assets Fund as it is naturally drawn to less-liquid, physical assets. We are careful to be diversified across a number of asset classes. In fact, the fund is highly focused on liquidity and has so far avoided choosing a fund for the portfolio that has stopped investors being able to redeem their investment. We currently hold a particularly cautious view, always on the look-out for liquidity issues.
While we do a lot to prevent liquidity issues, we cannot guarantee they will not occur. With all the potential investment risks out there, the approach that Architas would favour is simply to remain diversified. We will continue to monitor liquidity and engage with the fund managers we invest in, paying close attention to changes in their portfolios.
The value of investments and any income from them can go down as well as up and is not guaranteed, and you could get back less than you originally invested. Some of the Fund’s portfolio is invested in alternative assets which are different to the more traditional assets classes such as equities and bonds. During difficult market conditions these may be hard to sell at a fair price, referred to as being illiquid, which may in turn cause prices of these assets to go up and down more sharply than usual.
Past performance is not a guide to future performance. This fund may not be appropriate for investors who plan to withdraw their money within five years.