There has been quite a lot of commentary recently about how markets are becoming “less liquid”. Numerous articles have appeared lamenting this phenomenon (here), and even the IMF and the Financial Stability Board have weighted in on the issue. Most of the concerns centre on the Bond market, rather than Equities, but the concerns have peaked, (not coincidentally) , with market disruption events, such as happened at the end of August. This article points out that there have been thousands of trading halts, so-called flash crashes, and circuit-breaking events, a sign that the market is not able to provide all the required liquidity. High Frequency Trading has been blamed, as they tend to be major players, and, it is alleged, only provide “phantom ” liquidity, or a liquidity mirage (as the New York Fed put it). It isn’t just the regulators though- Hedge funds too, are using them as the scapegoats for their own failure to generate market beating returns.
Given the number of articles penned referencing a (possible ) sudden evaporation of a bid (or offer), we should be very surprised (and concerned ) were investors not aware of this reality. It has not escaped the gaze of some US ETF providers, who have been lining up new bank guarantees and extending current ones worth billions of dollars to guard against the negative effects of mass redemptions in their products, necessitating a fire-sale of assets to cover these redemptions; using this borrowed cash will allow them to keep the assets until (hopefully) asset prices rise again.
Some Fund Managers advocate an alternative way out of the problem. It is in essence to be a liquidity provider rather than a demander. This means that the funds will buy and sell securities, but on THEIR terms, not those of the market. Thus, they will bid for a share (for example), but it will be at their price, not that demanded by the market. This eliminates both the bid-offer spread , and the market impact issue of trading, since the fund itself is “dictating terms”. If the market is not prepared to deal, the fund will wait until it is.
This seems like an eminently sensible way of approaching the problem, but it may already be out of date. To my recollection, in 12 years of being a Fund Manager, (and previously 13 years as a trader/broker in the City), virtually never did I give or receive an order to buy or sell at market (i.e. immediately). [Incidentally, the floor traders of the 1980’s and 90’s used a crossed fingers sign to relay “market “orders to traders, a sign of the inherent uncertainties in such a trade]. It would be open to abuse, especially in the era of High Frequency Trading Algorithms etc, and no Institution would use them except in extreme cases- in the event of major market -moving events, the market will have probably discounted these factors in the price mark-up or down anyway. Most Managers use “limit” orders (i.e .to buy or sell at a specific price), or aim to achieve an average price around the VWAP (Volume Weighted Average Price), for the day,week or month of investment, so as to minimise performance differentials vis-a-vis their benchmark or target return.
These worries appear to part of a recent trend.The more the markets rise, the bigger and more vocal the concerns raised. The market appears to be climbing a “wall of worry”: alongside the usual economic concerns, participants appear fixated with the market’s seeming inability to facilitate an immediate and costless exit from whatever asset they happen to be holding at any given point. But why should investors demand others take their unwanted positions at a moments notice ? Someone has to be the liquidity provider of last resort ..the Government, Central Banks, the Taxpayer ? Dealers cannot be expected to be continual buyers of last resort, as their time horizon is vastly shorter than that of their clients. As this Bloomberg article points out , it is Long Term Value investors who fulfil this function (at a price). The concern might be that what Value Investors consider fair value is not what current investors consider to be “fair”. But that is an issue of valuation not liquidity.
There is a solution: don’t trade. There is ample evidence against market-timing being a route to excess market returns, and the more one trades, the more you are fighting this fact. There is no need for permanent liquidity for Long Term Investors- indeed, if there is a liquidity premium (there is room for doubt on the issue), then this should lead to higher expected returns over time to compensate for the increased risks. If one invests, it should be on the same principal as that espoused by Warren Buffet : “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
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