Jamie Clark

What is liquidity and why does it matter?

Jamie Clark

Recent events in the asset management industry have reminded everyone that there are more issues than headline performance numbers to consider when managing or investing in funds. For a UK equity income fund like ours yield, how returns are being generated (stock selection and portfolio construction), risk management and liquidity should all be at the forefront of managers and clients’ minds. In this first of a series of articles, we start by discussing the topical issue of portfolio liquidity and explain how it informs our stewardship of the Liontrust Macro Equity Income Fund.

 

Most of us would agree that liquidity can be reasonably understood as the ease with which we might buy or sell an asset.

 

By this measure, US Treasuries are like water, whilst fine art might seem like setting concrete. Shares in companies sit somewhere between these poles. As we all know, however, liquidity in the equity market is far from uniform. Dealing in a mega-cap should feel as smooth as a glass of good wine, whilst an infrequently traded small-cap might have the viscosity of granny’s lumpy custard.

 

This is borne out by the data. As at the end of May 2019 has seen £3.3bn of FTSE 100 shares traded on an average daily basis. That equates to a notional £32.8m of activity per stock, or roughly 0.14% of the average UK large-cap’s market value.

 

As you might expect, the numbers are more modest for less liquid, smaller companies. Over the same time, the average member of the FTSE Small-Cap Index saw £120,000 of daily trading activity, or turnover equivalent to 0.37% of its market capitalisation. The numbers for the AIM All Share are comparable [1].

 

For some investors, this kind of illiquidity is attractive. Parse the academic literature and you’ll quickly find that illiquidity is typically associated with excess returns, or a larger risk premium. Intuitively, we expect a bigger payback due to the difficulty of buying and selling an illiquid asset. The research suggests that this effect increases in proportion to an investment’s illiquidity [2]. This is simply another expression of the age-old trade-off between risk and reward.

 

It’s also likely that liquidity plays a big part in explaining the size effect, or the idea that long-run returns to smaller companies should exceed those to large-caps [3]. In combination with the higher cost of capital and business risk that might characterise smaller companies, their comparative illiquidity means that investors demand higher returns.

 

Is it not then rational for each of us to hold a portfolio consisting solely of illiquid, but high return businesses? The short answer is no. Financial market liquidity is a shifting, inconstant quantity. Abrupt changes in liquidity have been shown to lower stock prices, as investors demand a bigger payoff for holding the same asset [4].

 

This effect can hurt illiquid assets disproportionately. During October 2018’s market sell-off, the FTSE Small-Cap Index declined 6.42% as the cash value of trading activity fell 19.6%; and the AIM All Share lost 11.3% as volumes rose 22.2% on the same measure. Contrastingly, the FTSE 100 declined by only 4.66% on a meagre 1.34% dip in volumes [5].

 

It’s likely that this effect also accounts for why illiquid equities are punished more severely for profit warnings. Data from Ernst & Young shows that in the last decade, profit warnings produced an average 6.25% decline in the share price of a FTSE 100 company. This compares to a drop of 13.8% for the FTSE Small-Cap and 15% for the AIM All Share [6].

 

What’s more, financial regulation may yet amplify this effect. For all its good intentions, it is felt that MiFID II will ultimately reduce liquidity in cutting the availability of mid- and small-cap stock research [7].

 

It is worth stressing the caveat that no two mid or small-cap businesses are the same. When we address investment factors like liquidity, or size, we talk in terms of averages and much subtlety is obscured. Even during episodes of illiquidity, we would expect to find buyers at an acceptable price, for good mid- and small-cap companies; profitable businesses that represent sensible long-term investments.

 

This said, recent industry events have starkly demonstrated the perils of illiquidity, reminding us how difficult it is to unpick the allure of excess returns from its associated dangers.

 

Happily, at Liontrust we have a robust culture of oversight and a seasoned approach to risk that offer investor safeguards against such hazards.

 

But there are steps that we, as fund managers, can take to further insulate investors against the consequences of illiquidity. For our part, in the last several years we have made a strategic call to shift the portfolio up the market-cap scale. As shown in the below chart, since May 2016 we have increased our FTSE 100 exposure from 58% of assets under management (AUM) to its present 76.5%. This has been achieved by cutting our mid-cap exposure and eliminating our AIM weighting.

 

Macro Equity Income Fund Market-Cap Exposure Through Time

Source: Liontrust

 

Whilst theory might imply that we have surrendered excess returns, the evidence tells us that the portfolio is less vulnerable to the damage illiquidity can wreak. A more liquid portfolio means we can transact fund business without disturbing the price of most portfolio holdings.

 

To be clear, however, liquidity is only one of several inputs into our decision to increase the Fund’s FTSE 100 allocation. Given the increasing, post-Global Financial Crisis divergence between the valuation of cheap and expensive companies, a Brexit-impacted FTSE 100 feels like a goldmine of opportunity for anyone with an interest in value stocks. A key expression of value is dividend yield and for Income investors like us, the FTSE 100 is currently packed with a wealth of companies offering eye-catching income opportunities.

This is a very exciting topic in its own right and will be the subject of our next blog.

[1] https://www.londonstockexchange.com/statistics/historic/secondary-markets/secondary-markets-archive-2019/secondary-market-factsheet-may-2019.pdf;

[2] Amihud and Mendelson, Asset Pricing and the Bid-Ask Spread (1986);

[3] Fama and French, Common risk factors in the returns on stocks and bondsJournal of Financial Economics (1993)
[4] Amihud, Illiquidity and stock returns: cross-section and time-series effects (2002);[5] https://www.londonstockexchange.com/statistics/historic/secondary-markets/secondary-markets-archive-2018/secondary-market-factsheet-october-2018.pdf;[6] https://www.ey.com/uk/en/issues/capital-and-transactions/restructuring;
[7] Peel Hunt/ Quoted Companies Association, Mid and Small-Cap Investor Survey: MiFID II, the Search for Research (2019); 

For a comprehensive list of common financial words and terms, see our glossary here. 

 

 

Key Risks

 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

 

Disclaimer

 

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, June 27, 2019, 3:19 PM