Liquidity in the securities markets is an important concept for investors to understand. It refers to how easily or quickly a security can be bought or sold in a secondary market without affecting its market price. Liquid investments can be sold readily and without paying a hefty fee to get money when it is needed. Illiquid investments are the opposite and cannot be easily sold or exchanged for cash.
Some examples of liquid investments are most publicly traded stocks, exchange-traded funds (ETFs), and some government bonds. These investments have high demand and transparent market prices. They can also be sold for cash within seconds or minutes. Liquid investments are suitable for investors who want flexibility and low transaction costs. On the other hand, some examples of illiquid investments are individual bonds, real estate, and private equity. These investments often have low demand and opaque market prices. They can take days, months, or even years to sell for cash. Illiquid investments are suitable for investors who are comfortable with a long-term commitment of capital and thus do not need to access those committed funds.
According to investment convention, illiquid investments are often viewed more favorably than liquid investments because they are less volatile. Less volatile assets are more highly valued since their prices are more stable. However, this conventional wisdom ignores the fact that illiquid investments are not truly less volatile than liquid investments. The apparent stability of illiquid assets is due to their lack of price discovery rather than their inherent characteristics. Price discovery is the process by which buyers and sellers determine the fair value of an asset based on supply and demand.
Illiquid assets have less frequent and less reliable price signals than liquid assets because there are fewer transactions and fewer participants in their markets. This means that their prices may not reflect their true value or risk at any given time. For example, a real estate property may appear to maintain its value over time until it is appraised or sold at a significantly different price than expected.
Real estate is a notoriously illiquid investment. Every property is unique, so determining value through methodologies such as looking at comparable prices is more of an art than a science. Inventories of properties can also fluctuate dramatically depending on interest rates, demographics, regulatory issues such as building permitting and other local factors. When the real estate market is weak, many sellers remove their listings rather than accept “market” prices at that point in time.
Another example of an illiquid investment is private equity. There is not a publicly traded market for private companies, so these companies usually change hands through private funds set aside to buy and sell. The funds themselves often have 10-year lockup periods where the investors are unable to access their money until after that period expires. Additionally, pricing methodologies tend to smooth volatility. Many private equity firms use a combination of Comparable Company Analysis and historical transactions in the industry sectors where investments are made. Comparable company analysis compares the valuation multiples of a private company with those of similar public companies in the same industry and region. The valuation multiples can be based on different financial metrics, such as revenue, earnings, or EBITDA (earnings before interest, tax, depreciation and amortization). Prices from this method and historical transactions in the private markets are blended based on market conditions as determined by the fund managers themselves.
Finally, bonds can also be quite illiquid. We managed individual bonds in the past and stopped doing so because of liquidity issues. For instance, when we established a new bond position, we would get bids from a handful of brokers, buy millions of dollars of a particular bond, and place that bond across client portfolios. The purchase price we received from the bond brokers would be competitive and within the range of expected prices as quoted by our Bloomberg terminal. However, whenever we had to sell these bonds from client portfolios as the need for funds arose, the prices were usually at least 2% less than true market values. Bond brokers wouldn’t offer a competitive price since the volume was low, the trade was small, and they knew that other brokers wouldn’t care to compete for the business.
In contrast to the above illiquid investments, liquid assets have more frequent and more reliable price signals because there are more transactions and more participants in their markets. This means that their prices more closely reflect their true value or risk at any given time. For example, a stock may fluctuate in value over time as new information about its performance or prospects becomes available.
Eagle Ridge invests in extremely liquid investments such as common stocks and ETFs that hold bonds. If a client needs funds immediately, we can sell his or her securities and convert them to cash within a matter of minutes in almost all instances. It takes two days for stock trades to settle, so the proceeds would not be available until then, but the amount realized would not fluctuate after the sales. Liquidity is a vital characteristic that cannot be discounted, especially during periods of market stress. Liquidity should also be considered when constructing a portfolio that contains less liquid elements to ensure that there is access to sufficient funds should the need arise.