This article was written by Sid Ahl, Taylor Graff, Adam King and J.R. Rodrigo, members of Brown Advisory's Investment Solutions Group.
Liquidity risk is a critical issue for investors at all times, and especially so in the current environment. The background liquidity conditions for capital markets have changed substantively since the 2008-09 financial crisis, and to some extent these changes have contributed to the liquidity crunch in various segments of the market in the wake of the coronavirus outbreak.
For the past year, we have been preparing client portfolios for the end of the extended bull market run that began in 2009—building cash and liquidity reserves, and also exploring opportunities in private and alternative asset classes that historically have offered lower correlation with public markets. The end of the bull market took a form that no one predicted, and the downturn we have experienced has been exacerbated by a lack of liquidity in key markets (this is especially true in fixed income segments like corporate and municipal credit). But if we have done a good job in structuring clients’ portfolios to appropriately accommodate their shorter-term spending needs, then they are in a good position to weather the liquidity challenges that have accompanied the downturn. In this article, we discuss the factors that have changed market liquidity conditions over the past decade, how the “new liquidity reality” has impacted several markets during the recent market downturn, and our views on potential steps going forward.
Liquidity, like many concepts in the investment world, is simple on the surface but becomes far more complex when one examines it more deeply. Essentially, liquidity refers to how quickly an investment can be turned into cash. Consider how we defined investment risk in our 2018 asset allocation publication, Confronting the Unknown: “The probability that a portfolio will not meet an investor’s needs.” To state the obvious, it is impossible for a portfolio to meet an investor’s needs without an effective conversion of investments to cash; one cannot pay for a house with fund documents or a holdings report.
Therefore, whenever we think about taking on illiquidity in portfolios, we must determine whether benefits such as higher return or potentially reduced risk are likely to compensate us for the potential risk of not being able to access capital when needed. In some cases, these decisions may be more focused on structural liquidity—in other words, whether it makes sense for a client to commit capital to a private equity or real estate fund for a period of years. In other cases—especially during periods of market stress—we may need to focus more on market-based liquidity—in other words, whether investors can, if they need to sell for any reason, quickly find buyers for an asset and expect a fair price (and whether adverse market circumstances might cause an investment’s theoretical liquidity to dry up).
Both forms of liquidity are important to keep in mind when building a long-term investment plan. A mix of publicly traded holdings and “locked-up” investments in private and alternative funds can offer healthy diversification and access to a broad range of opportunities. Additionally, it is crucial to understand that true liquidity can only be found in holdings that can be readily turned to cash at a reliable price, at a moment’s notice, and therefore it is prudent to hold enough cash and liquidity reserves to cover short- and medium-term needs, to avoid being forced to sell longer-term investments at an inopportune time.
RECENT TRENDS AFFECTING LIQUIDITY
In the years preceding the 2008-09 financial crisis, many observers celebrated a “golden age of liquidity.” Thriving Wall Street trading desks, alongside levered trading hedge funds, had driven bid-offer spreads on many assets, even high-yield bonds and structured products, to the lowest levels ever seen. As we now know, this celebration was premature. The system was rocked by the 2008-09 financial crisis; leverage dramatically declined within the financial system, and so-called “prop desks” (units of financial firms that traded proprietary firm capital for profit) were banned by the Volcker rule and the Dodd-Frank Act.
Another major shift in the market has been the rapid growth of passive investing. As indexing takes share from active investment managers, markets (or at least some market segments) become agnostic to price and trade far less frequently. High frequency trading strategies in theory are a force that would increase trading volume, but because many of these strategies are driven by momentum, they often pull back from the market during periods of market stress. Broadly, equity markets have seen a dramatic decline in trading volume since the financial crisis.
The decline in liquidity in fixed income has also been profound. Because bonds are traded “over the counter” (in contrast with stocks or commodities that trade via exchanges), dealers are the conduits of liquidity in the bond market; dealers are necessary to facilitate trades between buyers and sellers that otherwise would have no way of finding each other. Before the financial crisis, big institutional dealers were willing and eager to hold large inventories of bonds and trade to and from those inventories. This greatly aided liquidity and positioned dealers to profit on their holdings. However, due to the strict capital testing enforced on institutions in the wake of the crisis, dealers have dramatically decreased the size of their balance sheets and bond inventories, and today are only willing to match buyers and sellers. Meanwhile, the market must accommodate trading for a large and growing pool of securities; there are about 4,000 publicly traded U.S. stocks, but more than 30,000 U.S. bonds (any institution can have many different bonds outstanding at a given time). This figure is likely to grow in the future; post-crisis capital restrictions have pushed most banks away from the corporate lending business, so companies are more reliant on the bond market for debt capital.
Liquidity in Public Markets: A Decade of Decline
Equity trading volume has declined markedly since the financial crisis (top chart); meanwhile, dealer trading volume relative to the size of the corporate bond universe has fallen from 60% in 2007 to less than 10% today (bottom chart).
Source: Federal Reserve Bank of New York.
These dynamics have dramatically shifted the liquidity landscape across financial markets. Broadly, equity markets have seen a steep decline in trading volume since the financial crisis, and dealer activity relative to the size of the corporate bond universe has also dropped off dramatically (see charts), making the heavy volumes we’ve seen in February and March all the more shocking to the system’s current capacity.
In the weeks following COVID-19’s rapid advancement from China across the world, we saw how the liquidity factors discussed above interact with a truly stressed market. In equity markets, there was not quite as much homogeneity as we might have feared given the “indexation” of the equity fund universe, and there was discrimination between the broader, fear-driven sell off vs. sectors in deeper danger from protracted lockdowns and social distancing (energy, airlines and hotels are notable examples). However, bond markets were hit surprisingly hard during this period as investors of all stripes sought to convert investments to cash. Despite the U.S. Federal Reserve’s steep rate cuts in March, bond yields broadly rose due to widespread sales of fixed income assets. Municipal bonds sold off to the point that their tax-free yields rose substantially higher than the taxable yields of other bonds of similar duration and quality. Corporate credit was also brought low in March, with blue chip names like Disney, J.P. Morgan and others trading at spreads that were reserved for high-yield credit just a few weeks earlier. In back-to-back weeks ended March 13 and March 20, investment-grade corporate bonds experienced their worst and third-to-worst weeks on record; municipal bonds experienced their worst two weeks on record during the same period.
The lack of dealer volume in the fixed income market today vs. 10 years ago almost undoubtedly accelerated the downturn in bond values. As noted in the chart below, outflows in municipal bonds during late March reached historic levels. A more substantial backstop of market-makers would not have prevented this selloff, but it may have helped to cushion the sharp reaction in bond prices if there were institutions in the market prepared to take assets onto their balanced sheets.
The municipal bond market saw unprecedented outflows in mid-to-late March 2020, leading to an extremely sharp reversal in bond prices. Liquidity was very likely a factor exacerbating the downturn in prices; a larger pool of institutional dealers could have softened the blow of the mass selloff by taking inventory onto their books.
Source: Muni bond prices represented by the Bloomberg Barclays Municipal 1-10YR Blend Index. Weekly fund flows represented by ICI Municipal Bond Estimated Weekly Net New Cash Flow. All data sourced from Bloomberg.
Prior to this downturn, we have experienced “bumps in the road” since the financial crisis that provided hints that the market had become less resilient to system shocks. In past pre-recession periods (in 1999-2000 ahead of the tech bubble, and in 2007 ahead of the financial crisis), volatility escalated gradually, but in 2015 and 2018 we had no warning in advance of dramatic ramp-ups in volatility. We’ve also seen several short-term dislocations in recent years, which quickly corrected for the most part, such as the “Flash Crash” of 2010 (in which the Dow Jones Industrial Average dropped 600 points point within five minutes and largely bounced right back within a half-hour), as well as other similarly dramatic one-day events since (see chart). In these moments, the price of liquidity ramped up significantly, as key sources of liquidity such as passive index funds and high-frequency traders essentially exited the trading environment for stretches of time.
Big Market Swings Are No Longer Once-In-A-Generation Events
In recent years, capital markets have produced several severe one-day events that seemed almost impossible from a probability standpoint. High standard deviations from the norm tells us that these events were extremely unlikely (the 2010 "Flash Crash" was, according to statistics, a once-in-404-billion-years event), but they all happened, suggesting that modern market conditions are more conducive to such occurrences than what we have seen in the past. In each case, the “air pocket” effect of liquidity drying up was a contributing factor; the same is true of the multiple days during March 2020 when markets swung with unexpected force.
|Reference Market/Index||% Change||No. of Standard Deviations|
|5/6/2010||S&P 500 Index||-6.9||7.6|
|10/15/2014||10-Yr U.S. Treasuries||-15.0||6.8|
|8/24/2015||S&P 500 Index||-5.0||5.5|
|10/7/2016||British Pounds Sterling||-6.2||11.2|
|2/5/2018||VIX® (Volatility Index)||164.0||20.3|
|3/16/2020||S&P 500 Index||-11.98||10.1|
|3/16/2020||VIX® (Volatility Index)||43.0||6.2|
Source: BLOOMBERG as of 3/31/2020. Standard deviation measures the extent to which the data points in a group are spread out from the mean or expected value of that group. In normally distributed data sets, two-thirds of the data points are within +/- 1 standard deviation from the mean; data points that are multiple standard deviations from the mean are considered outliers.
MANAGING LIQUIDITY RISK
A critical element to our management of liquidity risk is to straightforwardly ensure that a portion of every portfolio we manage for clients is held in cash or “cash equivalents” (i.e., highly liquid and stable investments like money markets or T-bills), in an amount that allows clients to meet any near-term spending requirements and gives them the confidence to leave long-term investments intact during a market downturn. We believe that maintaining this “operating bucket” for clients effectively separates financial decisions and emotional reactions from investment decisions. Just as importantly, having liquidity on hand when the market is under fire can be a major advantage, giving us the flexibility to capitalize when the market offers us rare value.
Looking beyond the “operating bucket,” most clients can also benefit from an allocation to assets that offer a combination of cash flow, high liquidity and reasonable stability as a source of capital for medium-term needs. The current, unprecedented market has challenged previous assumptions about the safety of some investments in this category, such as intermediate-term corporate or municipal bonds; there is a reason why we deem some holdings as part of a client’s “operating bucket” and not others. However, the price dislocation we have seen in many of these market segments is just that—a price dislocation—and in many cases, the near-term drop in value does not indicate dire financial stress or a heightened probability of impairment. For holdings where we feel confident that the issuer can weather this storm, we are advising clients to simply collect the unchanged income payments from these holdings and to wait until valuations rebound or (in the case of bonds) until the underlying securities mature.
Once we have taken steps to meet short- and medium-term spending requirements, we can more confidently consider various levels of illiquidity across the remainder of the portfolio’s longer-term investments. As noted earlier, accepting illiquidity is a path to potentially higher returns; for asset classes such as private equity, private real estate and private credit, we seek illiquidity premiums of between 1.5% and 3% per year over public-market counterparts (a range in line with what these asset classes have produced in the past 10-15 years). That level of premium is lower than one would have expected 20 or 30 years ago, because private markets today are bigger, more accessible and more competitive today than in the past. Still, the ability to earn an additional 2% or 3% in annual return can easily be the difference between success and failure in a long-term investment program. Moreover, we aim to add additional value in manager research and selection, which can hopefully further enhance returns beyond what clients would expect from the asset class overall.
Committing capital contractually for years is not a decision to be taken lightly, particularly when interim liquidity decisions are ceded to a private fund manager. To some extent, objective logic can be your guide—if an investment earns a premium return it can help you meet long-term portfolio growth goals, so a long-term commitment to that investment may make sense as long as you do not need those funds for interim spending needs.
But decisions around illiquid investments involve multiple subjective factors as well. At the moment, the predominant concern for nearly all investors is the volatility and uncertainty surrounding the COVID-19 outbreak and its potential impact on the economy and markets. Choosing to commit capital for long periods of time is a meaningful step under any circumstances, and certainly needs to be viewed even more cautiously in the current environment. Beyond this fact, we need to consider the investor’s emotional makeup, known spending needs and potential future obligations, as the investment cannot be viewed as a success if it prevents a client from meeting an obligation, fulfilling a lifestyle goal or sleeping at night. Moreover, today’s market presents deep challenges and conditions that do not have a great deal of historical precedent. We do not assume that all private fund managers will be able to navigate these trends, and generate illiquidity premiums, by default. As such, we discuss private and illiquid investments with clients in a highly customized manner, to ensure that recommendations fit their specific circumstances, and we devote ourselves to manager research to ensure that we only work with managers in whom we have the highest confidence. Given the current market backdrop, these core elements of our work with clients only become more important.
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
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