Liquidity refers to the ability to purchase or sell an asset without drastically changing the price. Cash is considered to be the most liquid asset as it can easily be converted into other assets. Assets traded over an exchange like Exchange Traded Funds (ETFs) and most stocks, are liquid, as they are traded frequently and with relative ease.
One way to measure liquidity is through the bid-ask spread. Bid refers to the price at which a buyer is willing to buy, and an ask is the price at which a seller is willing to sell. A small difference in the bid-ask prices (narrow spread) is a sign of greater liquidity because traders don’t have to adjust their price as far to match their order.
Traders should also be aware of volume because of its relationship with liquidity. Volume refers to the number of shares that have been traded. A larger volume indicates that the stock is being traded more frequently which usually means greater liquidity. Different stocks will have different volumes for a variety of reasons; most commonly, volume is a product of investor interest. A mega-cap company like Microsoft averages more than 20M shares traded per day, representing more than $6.5B worth of trades. On the other hand, some small caps, even those with over $1 billion market caps, can trade under 10,000 shares in a day representing less than $5 million worth of trades.
Different stocks will also offer different levels of liquidity. Those traded over the counter are generally less liquid than those traded via an exchange and can sometimes be more volatile. This presents a problem when trading in large quantities.
There are a few methods we use when trading large quantities in thinly traded stock. Most often, we split large orders into multiple pieces and send them to the market one at a time. By sending pieces gradually, we minimize the effect we have on the stock’s price, which in theory results in a more favorable execution price. The downside is this can create multiple small transactions for an account for what is actually one trade.
Another method we frequently apply is to set up the trade as a limit order. A limit order is an order in which stock is purchased or sold only at a specified price or better. Limit orders are beneficial in volatile conditions when the stock’s price is changing rapidly, or if we believe our orders could push prices in an unfavorable direction.
So why invest in a less liquid stock if it is harder to trade? Some of the main advantages include discounted prices and diversification from an index. As stated, volume is partially a result of investor interest. So those stocks with lower volume may also have less investor interest, meaning there is less information available, which can lead to pricing inefficiencies. These inefficiencies can lead to some stocks trading under their fair value.
Indexes are mostly weighted by market cap, so larger companies make up a larger percentage of the index. For example, the largest 500 stocks in the Russell 1000 make up roughly 90% of the index. If we were to invest only in larger names our performance would mimic the index. By buying less liquid, quality names we add diversity that can improve the portfolio performance.
Liquidity can also be affected by macro conditions stressing the market. For example, in March 2020 there was a lack of buyers in the fixed income markets due to Covid-19 fears. As a result, bond prices quickly dropped as sellers kept lowering their price to find a buyer. Bond prices were able to rebound quickly when the Federal Reserve started buying bonds, supplying the market with enough liquidity to keep prices stable.
Liquidity issues can also impact portfolio construction. Unlike stocks or ETFs, the majority of bonds are traded over the counter and as a result, are not as liquid. We use fixed income ETFs as an alternative in our portfolios. Fixed income ETFs provide us with a way to buy exposure to hundreds of individual bonds quickly and at smaller price points. The high liquidity that ETFs provide makes it easier to trade them at fair value.
Ultimately, how does liquidity affect your portfolio? The bottom line is, while it can take more than a day for us to enter or exit positions as a firm, any individual account at Eagle Ridge could be liquidated in one day. We may use some of the tactics discussed above to minimize the effect on the market. This minimizes the negative impacts of less liquid stocks for each account while capturing the potential market inefficiencies and diversification.