Risk: Liquidity

When an invester buys an investment there is always an element of risk. When you undertake this purchase, you want to get a more than you invested but you also want to get your money back. You probably understand that you may get less back but generally you dont want to lose all of your money!

Liquidity, or the ease of buying and selling an investment, has been at the centre of one of the big stories of recent months. The Woodford Fund run by Neil Woodford. Liquidity, or rather the lack-of, has contributed to the downfall the former star fund manager.

Capturing the illiquidity premium

Perhaps the greatest challenge for investors in recent years has been the quest for yield against the backdrop of central banks’ supportive action. Massive bond-buying programmes, also known as QE, have pulled bond prices higher, pushing bond yields lower. This has tempted fund managers who promise investors a certain level of yield to boost income by ‘capturing the illiquidity premium’. In simple terms, this means investing in assets which offer a higher yield because they trade in less liquid corners of the market. After all, a higher yield compensates for the risk of owning any particular asset. And that risk can be the lack of liquidity. Problems arise when fund managers are unable to meet client redemptions because they have too much invested in illiquid asset

Fall from grace

Recent high profile examples are instructive, not least because their punishment was so dramatic. Consider a fund invested in large-cap stocks, a fairly trouble-free part of the market. However, the fund is also permitted a ‘trash bucket’, investing in unquoted stocks, up to the 10% maximum allowed under the UCITS structure. After a period of underperformance, the fund is hit by redemptions.

Holdings at the more liquid end of the portfolio are sold to meet the redemptions, meaning these illiquid stocks grow bigger and bigger as a percentage of the fund. Finally, the 10% limit is breached and the fund is closed to further redemptions, trapping investors for a period of time.