Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Understanding liquidity and why it matters to buying and selling investments
Liquidity is one of those investment words which sounds rather too vague and complex to really worry about. Yet liquidity can determine whether you make a profit or loss on an investment and, crucially, whether or not you can get your hands on your money when you want it.
In plain English, liquidity is about being able to buy or sell an investment when you want, in the amount you want, at the price you want.
If an investment is deemed to be illiquid it could mean you aren’t able to put your money into it when you would like or, perhaps more importantly, get your money out.
Why does this happen? Because there are not always the same number of buyers and sellers in the market.
SUPPLY AND DEMAND ISSUES
Think of it like going into the supermarket to buy three loaves of bread and finding there is only one for sale. There’s nothing you can do about it, you just have to wait until more become available. On the other side of the trade, it’s like having an item to sell that no one wants.
Particular types of investment are more prone to illiquidity than others and it’s an important consideration when choosing where to allocate your money.
Smaller companies, for example, tend to have fewer people trading their shares, particularly the very small businesses. That means when you want to buy or sell some of the stock it could take longer to find someone to take the other side of the trade than, say, a FTSE 100 company.
The downside of this situation is that the price can change while you are waiting, meaning you could end up paying more than you want to buy or selling for less than you had hoped.
THE PERILS OF LIQUIDITY
Russ Mould, investment director at AJ Bell, says: ‘There will (nearly) always be a trade to be done but in a panic, it may be at a price that is a lot lower than you want. Liquidity is never there when you really need it, so you should never depend on it.
‘This is why it’s best to invest in things for the long-term and because you believe they are fundamentally strong and attractively priced, not just because you think shares will go up and you can quickly sell them to someone else.’
Property is a prime example of an illiquid asset – while a company share might take a few days to offload, a property can take months or even years to sell.
The consequences of this were felt around the financial crisis in 2008 and again after the EU referendum in 2016 when property funds suspended trading, preventing any investors from buying or selling units in various funds.
Fund managers were worried that so many people would try and sell units in property funds that they would be forced into a fire-sale of their assets just to meet investor redemptions.
For this reason, investment trusts are often viewed as a less risky way to access illiquid investments. While their share price may fall, they won’t suspend trading and a manager won’t be forced to sell their assets because there are a set number of shares in issue, unlike funds where units are created and disposed of depending on demand.
In the property turmoil, for example, property investment trusts continued trading – investors may have had to endure a share price plummet but they could sell if they wanted to.
THE FUND MANAGER’S VIEW
As fund manager of Miton UK MicroCap Trust (MINI), Gervais Williams is well versed with the challenges of liquidity. His investment trust focuses on businesses with a market capitalisation of £150m or less (to put that into context, the market cap of companies on the FTSE 100 ranges from Rightmove (RMV) at £4.4bn to Royal Dutch Shell (RDSB) at £204.6bn).
Because investing in the smaller end of the market brings illiquidity risk, Williams invests in a greater number of companies than other funds might typically hold, with at least 100 stocks in the portfolio. He says when there is a market sell-off it can take several weeks to complete a
‘Liquidity is always a consideration and there are some companies whose shares hardly ever trade, so you have to be confident and understand it will take longer to get out of those positions. You need to balance those risks by having a well-spread portfolio,’ he adds.
‘In the most extreme cases, it can take several months to buy or sell shares. We are ok with that because we are long-term investors and know that we also have investments we can liquidate within a couple of days if we need to.’
OTHER ISSUES TO CONSIDER WITH LLIQUIDITY
Williams says illiquidity can also be your friend. He explains that smaller companies can often prove more resilient when there is a market shock precisely because they are difficult to sell, whereas it is very easy to trade large-cap stocks so investors can easily dump these shares.
While liquidity is often talked about in the context of not being able to offload an investment, it can also stop you accessing an asset if it is in demand and there is a lack of sellers. In this instance investors may have to wait to invest or be forced to pay a premium for the asset.
A recent example of this situation is infrastructure investment trusts, many of which have traded at double-digit premiums in recent years because investors have been attracted by the reliable, high-income they pay. Other illiquid asset classes which have been popular in recent years include private equity and specialist assets such as renewable energy. (HB)