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Robertson: Ain’t Nobody Home

Written by David Robertson | Dec 13, 2019

One of the great challenges of financial markets is that certain important events only happen infrequently – which makes it all the easier to overlook them during intervening periods. One of those important situations is when it becomes extremely difficult, if not impossible, to sell an investment because too few people are both willing and able to buy it.

Through the course of a cycle the phenomenon of illiquidity occurs periodically but is normally contained to very specific situations and does not affect broader markets. Increasingly, however, there are signs that liquidity could be a problem in the foreseeable future, so it is a good time to review the risks.

To start with, there is nothing inherently wrong with illiquid investments. In fact, illiquid investments can produce higher returns for investors who don’t need immediate liquidity. As a result, they can make great sense for long term investors like pension funds and endowments. Indeed, David Swensen has made famously good use of this characteristic with the endowment at Yale.

Of course, many other investors who might need the liquidity are also attracted to those incremental returns, and especially so in an environment of exceptionally low yields. As a result, many investors have succumbed to the temptation by plowing into private equity, venture capital, real estate, structured credit, fixed income ETFs and all kinds of other investments for which liquidity can be a problem.

As investors pursue this course of action, however, a couple of things happen along the way. One is that the prices of illiquid investments get bid up and therefore the prospective returns come down. Another is that as progressively more money flows into investment vehicles that can be difficult to exit, systemic risk increases. I described these phenomena in “A formula for losing money“.

As the risk of systemic illiquidity increases it can challenge, and overtake, the risk of slowing economic growth as a key risk factor. This change manifests itself in a subtle way. Unlike in 2017 when markets rose in a climate remarkably devoid of volatility, this year there are a number of rumblings underneath the calm veneer of market index performance. The Financial Times reports:

“Yet, through all of this, the sanctity around the market price has remained. Most don’t question whether basic formation of market prices is faulty. What if market gyrations are less to do with shifts in expectations on the economy or company performance, and more to do with participants coming to terms with a less well-functioning market?”

It is now time to add another worry to the list: the unravelling of the market liquidity illusion.

The “unraveling of the market liquidity illusion” is both a worthy consideration, and increasingly, a timely one. Further, there is a growing body of evidence to support the hypothesis. As the FT spells out, increasing bond market volatility is a signal:

“’It’s impossible to know the catalyst, and this market is good at shrugging off bad news. [But] bond market volatility is a good sign of the fragility,’ Mr Croce said. ‘We’ve seen steadily rising bond volatility this autumn, and that will eventually have an impact on asset prices’.

Auctions in fixed income markets have also been highlighted by Zerohedge:

“The number of high yield credits trading at spreads over a thousand basis points over treasuries has been rising all year long. Also, you’re seeing a lot more volatility in the leveraged lending space. Credit Investors increasingly are firing first, and ask questions later.”

Russell Clarke provided similar foreshadowing in a Realvision interview dated September 18, 2019:

“Like I said, the weird classic macro indicators are diverging radically from what equities are doing. That does happen sometimes. Usually, the macro indicators are right.” 

In addition, another signal can come from broader market factors. Since the relationship of supply to demand for securities is relative, whenever sellers overwhelm prospective buyers, deficiencies in liquidity can arise. This phenomenon often occurs when investors chase a common theme, as the FT describes:

But Marko Kolanovic, head of quantitative strategy at JPMorgan, says there is still ‘extreme crowding’ in the more defensive, bond-like parts of the stock market, as well as in stocks enjoying positive momentum. He said this was evidence of the ‘prevalence of groupthink … across investment strategies’.”

With several signs all pointing in the same direction, the chances of some kind of liquidity event appear to be increasing. Importantly, many of the warning signs are virtually invisible to investors and advisors who rely primarily on market indexes for information content.

Lest investors forget what happens when liquidity dries up, Russell Clarke provides a useful refresher:

Speaking of the Lehman bankruptcy in 2008, Clarke described: “Then suddenly, and it was very weird, didn’t make a lot of sense. Then suddenly, it broke in way. That’s typically how markets work. They force everyone into an asset at exactly the wrong time and then liquidity just disappears, and you are stuck in it.

The notion of suddenly being “stuck in it” was also crystallized by the FT in a recent report. The UK Mexican restaurant chain Chilango issued mini-bonds and intentionally lured investors with an attractive yield: “Free food for four years! Plus 8 per cent APR!”

The only problem was, just months after its last mini-bond offering, the company’s solvency came into question and it was forced to hire restructuring advisers. While Chilango is reminiscent of WeWork’s bond offering to sophisticated investors, there was one major difference:

“While red-faced hedge fund managers can sell their WeWork bonds at a loss and move on, Chilango’s bonds are explicitly non-transferable. The doors are locked.”

Unfortunately, retail investors are learning another lesson from institutional debt markets the hard way: liquidity matters.

In simple terms, there is no way for investors to get their money out of Chilango’s mini-bonds. They are stuck. This is exactly what can happen when liquidity vanishes for whatever reason. Although there may be some recovery down the road, there will be no access to those funds for the indefinite future.

This leads to a few important lessons regarding liquidity risk. One is that it is an insidious risk. It gathers gradually, over time, without revealing at what point it might strike. Indeed, markets can be most alluring at the most dangerous times. As Clarke notes, “They [markets] force everyone into an asset at exactly the wrong time.”

Liquidity is also nonlinear – and this is very hard for many investors to fully appreciate. It is easily available for long periods of time and then suddenly vanishes. When investors start running for the proverbial exits, many end up getting trapped inside. While it is true that this happens only infrequently, it is also true that there are no do-overs – the damage can be permanent.

Finally, when liquidity shuts down, it can be contagious. When it becomes impossible to exit illiquid investments, investors have only one choice if they need cash – and that is to sell what they can – and that is usually more liquid assets. As a result, problems in a relatively small niche of illiquid investments can easily infect a much broader realm of assets. This was an important dynamic in the financial crisis of 2008 when problems with subprime mortgages started surfacing. It is a lesson that still applies today.

An important takeaway is that investors should not be unduly focused on a market crash as the worst possible outcome. Crashes happen but can be recovered from. However, if investors urgently need liquidity and cannot access it, they can suffer permanent harm. Indeed, insufficient access to cash, not a market crash itself, many be the greater risk for many investors.

The risk of losing liquidity is a real one for investors, but it is often underappreciated. B.B. King illustrates the same basic point in his classic song, “Ain’t nobody home”, in a way that is both personal and memorable.

He describes how he once fawned over a girl and followed her “wherever you’d [she’d] lead me” and in the process, endured some “pain and misery”. After he finally decides he’s had enough, she begs him to come back. By then, he is no longer in a forgiving mood and lets her know, “Ain’t nobody home.”

In a similar way, liquidity can seem so ample and forthcoming at times that it is easy to take for granted. When the tables turn, however, investors had better beware. Just when they need it most, there might not be anyone home.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2019/12/13
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