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For investors, it is of utmost importance to “know what you own.” One never knows what markets might have in store for you. Particularly, in times of market stress, you might be forced to hold onto certain securities that become illiquid.
The types of securities that may experience a lack of buyers in strained markets include small-company stocks, smaller bond issues, and complex securities or funds. When buyers disappear, an investor that must sell will only be able to do so at fire-sale prices.
On the other hand, the most liquid securities when markets are under duress are typically Treasury bonds and blue chip stocks. This is why you often hear the talking heads say there is a “flight to quality” when markets get unnerved.
Some investors have more need for liquidity than others. If your investment time horizon is short, and/or your emotional makeup is such that you cannot tolerate, say, a 30 percent decline without having the ability to sell, you should stick to liquid investments.
Conversely, investors who have long-term outlooks and the temperament to hold less-liquid securities, can take advantage of the opportunities presented in illiquid markets by scooping up stocks and bonds at discount prices.
Recent discussions in this column have talked about problems with some mutual funds and ETFs that have a liquidity mismatch. In other words, the funds’ shares are liquid and can be bought and sold with ease by investors; however, the actual securities the fund has invested in may become illiquid when markets get sideways.
Such was the case with Third Avenue Value Focus Credit Fund that halted investor withdrawals because they could not feasibly liquidate the underlying securities it held to meet all investor redemption requests.
Open-end mutual funds and ETFs that classify themselves as Liquid Alternative Funds, or “liquid alts,” should be reviewed carefully before investing. These funds have become popular with advisers, with some recommending a 20 percent portfolio allocation to these vehicles that purport to allow retail investors to invest like a hedge fund.
First, it’s puzzling why any investor would want to replicate the dreadful multiyear underperformance of hedge funds. And second, also like hedge funds, liquid alt funds usually charge much higher fees. As they say, liquid alts “are sold, not bought.”
Open-end liquid alt funds and ETFs might hold derivatives and other hard-to-value and hard-to-sell securities. As one astute investor counseled, the liquidity of the fund shares should not be greater than the liquidity of its holdings.
One exception to the fund-liquidity dilemma is a closed-end mutual fund where the shares outstanding are fixed. Bond king Bill Gross recently suggested investors might find bargain prices in the closed-end shares of funds holding junk bonds and distressed debt that investors have sold in panic.
Finally, just because you can’t sell an illiquid security doesn’t necessarily mean its value is impaired and you should panic. Your home isn’t priced daily in a liquid market. The stock market closes on weekends and the world doesn’t end. Most investors would do well to ignore daily prices and instead focus on the value your securities might bring five or 10 years down the road.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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