What is Liquidity? Assets And Liabilities Perspective

What is Liquidity? Assets And Liabilities Perspective

What is Liquidity?: Here are the predecessor posts in this series:

  • What is Liquidity?
  • What is Liquidity? (Part II)
  • What is Liquidity? (Part III)
  • What is Liquidity? (IV)

This series has been very irregular.  But it does include the first real post at this blog.  It is something that I think about frequently, and my best summary for what liquidity means is:

What does it cost to enter or exit fixed commitments?

Tonight I want to take a slightly different approach, and talk about two aspects of liquidity: assets and liabilities.

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On the liability side, we can look at publicly traded assets and say that they are liquid, though many may only be fungible.  When I was a bond manager there were some trades that took days or weeks to set up.  Some were public bonds coming to market that were complex, others were asset- and mortgage-backed bonds that took some time to research.  Some were pure privates where you were trading the whole chunk or nothing — it was not far distant from being a bank.

With many investments, there is a liability structure.  Yearly, quarterly, monthly, daily liquidity.  Funds are locked up for three or five years.  Funds are locked up until assets are liquidated, and you might be paid in kind, not cash.

The ability to get cash is an important aspect of liquidity.  But so is the ability to preserve value, and that is the asset side of the question.  After all, liquidity means that you have assets that preserve value, such that you can liquidate and spend it.

From an asset standpoint, stocks are liquid as far as trading goes, but not liquid in terms of preserving value in the short-to-intermediate run.  Equity is illiquid, whether public or private.  It offers no protection of value.  Think of it this way: if you were going to buy a house in a few months, would you invest your down payment in stocks?  It would not be wise to do that.

There are various ways of owning equities, and other investments.  It is more important to understand the riskiness of the assets, than the shell in which the assets are held.  The shell may offer liquidity at intervals, but that has no effect on the underlying value of the assets.

Thus I will say it it is far more important to focus on the value of the assets, than on when cash will be released to you.  As one of my bosses said to me:

Liquidity follows quality.  The better the asset is, the more liquid it becomes.

As a result, those wanting to do best in investment management should keep a supply of short-to-intermediate high-quality debt as the performance of risk assets may vary considerably, which will affect the ability to achieve fixed commitments.

Liquidity is the ability to preserve value for near-term spending.  Thus both asset and liability aspects of investments have to be considered when considering liquidity — it is not only ability to liquidate, but to receive value back in real terms.

By David Merkel, CFA of Aleph Blog

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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.

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