How Much is that Asset in the Window? (II)
Q: So what is an asset worth?
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Q: Yes, but we never really got through it. Suppose on a nonvolatile day I want to sell $100 in shares of an open end mutual fund. Now suppose I want to sell 5% of the total shares of the same fund. What are my mutual fund shares worth?
A: This problem isn’t any different than that for an individual stock. Liquidity carries a price. If you want to buy or sell a lot at any given time, and you are the one demanding the trade be done, you will have to pay up for that privilege. People who are less motivated than you will have to receive compensation for taking the other side of the trade.
Q: But on a mutual fund, why should the price move on a big trade? Shouldn’t everything be tradable at the closing NAV?
A: Can you sell the whole world at the close? To whom? Where will you get all of the cash?
A: Only a tiny fraction of all the assets in the world trade on any given day. There isn’t a lot of reason for most assets to trade — in the long run, we make money when we hold , not when we trade. Trading itself is a small net economic loss, with money paid to brokers.
This is why there are primary markets, secondary markets, and within secondary markets, block trades. Any big trade in stocks or bonds requires special handling — either a trader has to break it up into a bunch of little trades, or he has to hand it off to a specialist who finds someone willing to take the other side as a whole for a price concession, or the block trader takes the trade himself for a concession and tries to cover the position through small trades.
The thing is, there is not one price for an asset at any given point, but many prices — and they change depending upon how many want to buy or sell, and how quickly. More buyers? Crawl up the supply curve. More sellers? Slide down the demand curve. There is no one price — and when we do name one price, it is a shortcut — a convenience.
Q: I find that confusing.
A: Look, economics has almost always moved in the direction of greater subjectivity over time. An asset does not necessarily have the same value to you as it does to someone else. Consider my house as an example.
Q: I’ve been to your house — it’s a bit of a hovel. You couldn’t pay me to live there.
A: And I love it. I have a lot of happy memories there.
Q: Aren’t we off track? There’s a lot of difference between a unique house, and a share of a mutual fund.
A: That is only true because we sell identical tiny slices of a mutual fund. If you wanted to sell all of the assets of the mutual fund as a whole, it is the same problem.
Liquidity in markets is always limited. Always. A small stream of trades helps validate prices for a given asset and related assets, but is inadequate to answer the question of what happens to the price when you want to do a big trade in a short period of time. After all, supply and demand curves are theoretical constructs — it’s not as if you can look them up in the daily newspaper.
Q: What’s a newspaper?
A: Humph. Are we done yet?
Q: I guess for now. Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?
A: Probably. I had a knee-jerk response to it, but as I read more about it, I became convicted that I had to study it more before I birthed bits and bytes into the cold abyss of the internet. Remember, last time I wrote, I sent it to the SEC, and even talked with their legal staff. Off the cuff most of the difficulties could probably be solved by loads that get paid to the mutual funds any time shares are created or liquidated, but that’s just a bias. I like simple solutions because perfect regulations are a terror — perfection is impossible, so write something simple that covers 90% of it, and ignore the rest.
But all for now — my main question to myself is whether I have enough time to do it justice. There’s their white paper on liquidity and mutual funds. The proposed rule is a monster at 415 pages, and I may have better things to do. If I do anything with it, you’ll see it here first.
Q: Until then.