Why everything you thought about liquidity may be completely wrong.
People are obsessed with liquidity. It is the reason why UCITS funds are so popular, which provide investors the ability to get their money back on a daily or weekly basis. The regulator also views liquidity as the main risk to any investment strategy. As such, alternative investment funds, commonly known as hedge funds, that do not provide instant liquidity are deemed too risky for non-professional investors. This has created a very large divide in the marketplace, as so-called retail investors can only get access to a clearly defined set of investment opportunities based on regulatory classification.
It is easy to see why these rules and regulations were put in place. Lest we forget the heydays of financial services in the nineteen eighties and nineties, when unscrupulous salespeople took advantage of hapless investors, and fleeced them dry. But has the pendulum now swung too far in the other direction and are we overprotecting a broad section of the public restricting them from having better investment portfolios? It certainly seems so, and to define risk mainly in terms of liquidity is much too narrow. There are many investments that are highly liquid, yet highly risky. Individual equities can go to zero, bonds can default, and even country or sector indices have been known to drop by a very large margin in a very short space of time.
Ah, but if we can sell on a daily basis, then surely we can get out when we see signs of looming danger? Yes, with the gift of clairvoyance we would have the ability to sell all of our holdings within an instant. But predicting crashes is rather difficult. Timing the entry and exit points is the holy grail of investing, and as of yet, even the professionals get it wrong, just as often as they get it right. The other thing about having sold all of our holdings, is the difficult question of when to get back in?
As it happens, I knew a few people who had been lucky, as they were sitting on cash when the credit default crisis presented them with a golden opportunity to buy in at historically low prices. Unfortunately, crashes can induce panic amongst all investors, even those potential ones sitting on the side-line. Like everyone else, we all thought the world would end in March 2009, that’s why the markets were crashing. By the time we realized the worst was over, the markets had already recovered much of the losses. Just think how horrible it would be if we got our timing completely wrong, sold everything at the bottom, and then bought it all back at much higher prices. Are these really decisions anyone would want to make?
The most important reason though, as to why we should not overindulge in liquid investments, is that there is a cost. Clearly, tying up our monies for longer means we need to be incentivised, otherwise why would anyone do it? With cash yields near zero, the current premium you can earn from making illiquid investments is massive. Private equity, private debt, or real estate funds have had extraordinary returns for a very long time. Some of these investment opportunities are actually quite low in risk, offer much security, and even government support.
Unfortunately, retail investors cannot get access to these types of investments. Apparently, it is all too complicated, too illiquid and not suitable for the general public who don’t understand how to calculate the efficient cross-correlation coefficient of a market neutral portfolio. I find that ironic, as I also do not understand the inner mechanics of the combustion engine, and yet I am allowed to drive a car whenever I please. Instead, the regulator gave the most inexperienced and unqualified investors a loaded gun, taunting them to pull the trigger and potentially getting it completely wrong. Begs the question: who exactly are we protecting here and from what?