What is Liquidity? (Part VII) by David Merkel, CFA of Aleph Blog
For those that want the quick hit and don’t care about the underlying ideas, here is the main idea:
A vehicle holding assets may appear more liquid than the assets themselves, but that is only true in bull markets. When bad times come, the liquidity proves elusive, particularly for large trades.
ETPs are wonderful things, but there is one thing that ETPs can’t do. They can’t change the underlying assets that they own. Merely because you have the ability to buy or sell at will does not change the performance of the assets held. Like most investment products, the amount of assets invested expands in a bull market and contracts in a bear market.
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People follow trends. As they follow trends, they tend to lose money, because they buy and sell too late. As such, average investors in ETPs tend to lose money relative to buy and hold investors.
In this sense, liquidity is not your friend. Just because you can trade, does not mean that you should. Speculators tend to lose to the longer-term investors, who hold for longer periods of time. Trading itself is a zero-sum game, but bearing risk is a positive sum game, if done with a margin of safety.
Also, if you are trying to do an institutional-size trade in an ETP, you will find that the market impact costs are significant. Just because there is an exit door in the theater does not mean that everyone can get out instantly.
But here is my favorite bugbear in liquidity: repo transactions. Repurchase transactions turn a long-term asset financed short into a short term asset. Now the Fed thinks that it can control the repo market.
Honestly, the easy solution is to disallow the accounting treatment of repos, and force those who do them to display them as a long asset and a short liability. Why?
Because in crises, the long assets are illiquid, and as such the value shrinks when liquidity is prized. The liquid liabilities still demand to be paid at par.
The accounting change would be better than what the Fed thinks that it might do. You can’t make long-dated assets liquid. The cash flows are distant. Yes, there may be some interest payments that are near, but ultimate repayment of principal is distant.
Let me suggest a better concept of liquidity: assets are liquid to the degree that you can turn the underlying into cash. When I say that, I do not mean trading big blocks of stock, but selling companies for cash. That is liquidity, and as such most risky assets do not have significant liquidity, though many trade every day during bull markets.
Liquidity is a scaredy cat, it disappears when it is most needed. That happens because people think they can sell at par when they can’t.
All for now, but remember this — liquidity is a bull market phenomenon. People are far more likely to trade when they have unrealized gains rather than losses.