Liquidity has become a virtue of late.
Hedge funds fill their monthly letters and conference calls with details of how quickly they can liquidate their portfolios within increasingly shorter timescales. Many managers now have strict stated limits on their ability to take so-called illiquid investments. Investors are focusing more on liquidity throughout their due diligence and the flow of funds to ‘liquid’ strategies reflects their growing domination. The number of funds offering monthly, weekly, daily liquidity multiplies by the day in response. And regulators actively champion this hunt for liquidity as an aspiration for the financial community.
That is frightening. Though a virtue in moderation, liquidity rapidly becomes a vice in excess.
On the surface, the reasons for this paradigm shift are easy to fathom. Investors – be they direct (like funds) or removed (institutional investors) – increasingly want the ability to recover their money at short notice, particularly if there are any unexpected downturns. There is a growing appreciation that to get to the long-term return, one has to navigate successfully through the short-term and for most, that means having ample liquidity in your portfolio. Many are also still nursing painful memories of 2008 and the sudden inability to realise their investments. Like religion and politics, gates and side-pockets have become sensitive topics best avoided in polite company today.
However, dig deeper and it becomes clear that fear is the key motivator. What began as a crisis of credit has now become a crisis of confidence. The current macro volatility and potential for sovereign contagion has made everyone wary, and there is a growing realisation that this is a balance sheet problem. The purest expression of that growing fear has been the increasing focus on liquidity from the top down and across the board.
For central bankers, the only tool they have left is liquidity. The need to demonstrate to the markets that they are doing something has meant a steady deluge of money into the global financial system through various bouts of quantitative easing. The result is a set of yield curves that look increasing like the doodles on my son’s Etch-a-Sketch and change even more rapidly.
Meanwhile, banks have a new found distrust of their peers. Consequently, excess reserves in the US now total some $1.6 trillion – a far cry from the $6 billion at the end of 2007. In Europe, bank deposits at the ECB are now some €237 billion ($319bn). Banks would rather take the lower rate on offer from a central bank than entrust their precious cash to the interbank markets.
Money market funds and domestic deposits continue to see strong flows, despite the pitiful interest rates on offer. The M2 money supply, which includes currency in circulation, bank deposits and retail money market funds, now stands at $9.6 trillion. That represents some $7.4 trillion of retail money market mutual funds and deposits.
And why not? Businesses have lots of cash and little appetite to deploy it. Individuals are already overburdened with debt, worried about the future and focused on righting their little balance sheets.
For investors, opportunities seem scarce and the outlook bleak given the deleveraging to come. The old rules no longer seem to apply in this new world and forecasting is an art somewhere below astrology in terms of accuracy. Uncertainty now dominates over risk and the former carries greater emotional weight, resulting in an increasing focus on having cash today. In early August, the yields on 1-month Treasury bills even briefly went negative during this headlong rush and today, sit barely above zero.
The result is a dysfunctional market. A functioning market requires participants with different liquidity preferences. Unfortunately, within every long-term investor hides a short-term investor and right now, they are all coming to the fore.
Investor horizons have become increasingly shorter – a logical consequence of this greater desire for liquidity. For managers, it is their clients’ preferences on these matters that drive their investment philosophy and strategies.
Risk on, risk off is the new tap dancing. Investors now live day to day from each central bank opining to every political posturing, slaves to their daily P&L. Where pension funds may have taken five year views, they now scrutinise every monthly and quarterly report. Where a hedge fund may have held positions for 3-6 months in the past, they now trade with a 1-2 month view. Where traders and algorithms had a horizon of days, they now are looking intra-day.
There is a problem with this. The more investors crowd into the short end, the more efficient it becomes. Technicals and trading dominate, making crowd behaviour all important. Correlations rise across all asset classes, beta dominates and the lower the future returns are for investors. For many, their experience will be akin to a weather buoy – for all of their furious movement, they will be where they began at the end of it all.
The true opportunities now lie in taking illiquidity. The panic – for there is no other word to describe this behaviour – today presents those who can afford to have a longer-term investment horizon with a unique time arbitrage. As others deleverage and rush headlong towards greater and greater liquidity, inefficiencies and dislocations coalesce at the other end. These are all returns to be harvested for the future.
Today, economic fundamentals may be irrelevant to the markets as shorter-term sentiments dominate but in the long run, they have a habit of asserting themselves. After all, no country ever went bust forever.
Author Bio:
Dr Bob Swarup oversees alternatives, thought leadership and risk management at Pension Corporation, a leading player in the pension buyout space. He sits on the Advisory Board at Adveq, a leading European private equity fund of funds, and is a member of the CAIA Exam Council. Bob has written extensively on diverse topics across the financial spectrum, most recently working with Bloomsbury Publishing to put together QFINANCE – a book of essays on all aspects of global finance by leading academics, policymakers and practitioners across the world. He is currently a Visiting Fellow at the London School of Economics and is writing a book on financial crises to be published by Bloomsbury in 2012.