Liquidity And Its Limits: ETFs, Repos And Bull Markets

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.

Charlie Munger: Invert And Use “Disconfirming Evidence”

Charlie MungerCharlie Munger is considered to be one of the best investors and thinkers alive today. His thoughts and statements on investment research, investment psychology, and general rational behavior are often incredibly insightful. Anyone can learn something from this billionaire investor and philosopher. Q2 2020 hedge fund letters, conferences and more If you’re looking for value Read More


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.

Repo Transactions

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.

Previous articleTesla Motors Inc (TSLA) Patents Target Fire Prevention
Next articleValueX Vail: Closed End Funds – A Unique Opportunity
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.