Defending Portfolios Against a Liquidity Vacuum

06.05.2015

Anyone who reads my blog with any regularity knows that I believe risk is ever-present and does not repeat or manifest itself in any predictable form or short-term pattern. I also believe that traditional asset allocation that focuses entirely on public stock/bond indices is almost certain to disappoint investors’ expectations—both in terms of portfolio volatility and returns.

The cause of these disappointing outcomes isn’t so much the impact of short-term market turbulence as it is the irrational long-term investor decisions that typically follow. Giving in to fear, investors routinely demand liquidity at the absolute worst time—often sabotaging their own portfolios in the process.

A recent Bloomberg article points out once again that the “sacred cow” of liquidity is, in reality, a farce. The question should be “liquidity at what price?” The price in my opinion is two-fold: the potential for incredible volatility and the shocking decline in prices that can and does occur when there is simply not enough liquidity on the other side of the transaction to restore the natural balance of buyer and seller.

We have recently seen indications in our markets that, at a nominal level, would not concern investors—but at a catastrophic level, are painful to even contemplate. We are talking about declines in relative liquidity across our treasury, corporate and municipal markets ranging from 70 percent to 30 percent, respectively. Even a 30 percent decline in relative liquidity is cause for alarm. Are investors prepared to see the high-yield bonds currently valued at $106 on their portfolio statement drop below $85 in two days because of a liquidity vacuum? Worse yet, there may not even be a buyer.

As portfolio designers, we must approach asset diversification with the risk of a “liquidity vacuum” in mind. I am not suggesting that you avoid these markets, as that is no better than market timing. What I do suggest is that permanent capital funds may be an effective way to manage some of this risk. My reasoning is simple. Permanent capital funds do not force the portfolio manager to sell into market distress to meet investor demands for liquidity.

Sure, the trading price would feel the same impact as other funds, but what matters is whether the manger is forced to sell or not. Open-end funds and exchange traded funds have to sell in order to meet investor liquidity demands. Exchange traded closed-end funds do not have to sell their assets at bargain basement prices to meet liquidity demands—which could make a striking difference between meeting—or not meeting—portfolio goals in the long term.

It’s really a question of outcome. Because the permanent capital fund manager can stay the course, weeks or months later, it’s possible for asset value to recover. On the other hand, the open-end fund manager will likely be forced to sell into a 7-sigma liquidity trap, negating any chance of recovering asset value. Which strategy would you recommend to your clients?

 

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Frank Muller

As CEO and president of Provasi Capital Partners, Frank Muller brings nearly 30 years of experience in building and managing multi-channel distribution services. Frank has been a featured contributor in numerous industry publications, bringing his unique insights and perspectives to relevant issues impacting financial advisors and their clients.

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