A Commentary on Liquidity

Lately, there has been some boring news  or maybe I am to busy studying for an upcoming exam on Saturday that I have not really put too much thought on them ; yet I could not help myself to read one article on the Journal that talked about a former partner of Long Term Capital Management, a rock star of the nineties.

LTCM was a hedge fund with annualized returns in the double-digits, including two years with returns over 40%, that had a really short life due to liquidity issues. The importance of this firm was not how much money it made but how it change Wall Street just with one trade. It may sound unbelievable but it certainly did happen and it was unremarkable.

Imagine being present in discussion at now defunct Salomon Brothers (imagine Lehman Brothers in case of doubt), at one end of the table you have Craig Coats who can only be described as being the man everyone wanted to be, and at the other end you have two professors, Scholes and Merton, who could both easily disappear into the background.

Coats bought $2 billions of newly issued 30-Year US Treasury Bonds, he was confident and everyone believed he was right. However, our two professors were dumbfounded because they knew he was wrong. So, they did two things, shorted Coat’s trade and bought $2 billions of 30-Year Us Treasury Bonds that were issued three months ago. These two professors may have been raised in ivory towers but nonetheless they were real cowboys unlike John Wayne.

The results were that Coats lost $75 millions while the professors gained $200 millions. The professors eventually become an integral part of LTCM as Coats became a nobody.

However, you may wonder what does this has to do with liquidity? Everything, my friends. The professors knew what was going to happen because they had studied what now is known as “liquidity premium”. In short, they knew that if investors were presented two securities that look almost identical, they would pay more for the one that is more liquid. However, this premium paid is only temporary as later it will cost the same as one that is quite similar to. Thus, the one they short its price went down and the price of the one they bought went up. Simple economics at work.

This lesson is quite important because if you investing profile is akin to mine, you want to have your money in securities that can be easily be sold in case you need cash in your account even in exchange of some potential additional return, which sometimes is non-existent.

For example, I tend to disagree with a colleague that loves mutual funds due to liquidity issues as some mutual funds are easy to invest but hard to either take money out (time constraints) or to move from one account to another (it can take weeks) or even both. He quotes instant diversification and top managerial presence, I counter with fees and fees that minimize your expected return. Furthermore, the Journal published an article, “The Morningstar Mirage”, which basically states two things.

First, most of all funds regardless if they had a five-star or a one-star rating ended up performing like a three-star rating.  For example, only a tenth of the US equity funds with ratings of five-stars remained five-stars funds over the next three years, and with every additional year that number just keeps getting smaller. With that logic, if most funds end up being three-stars funds, so you may end up having a better bang for your buck if you choose to invest in either one-star or two-stars funds.

Second, most investors use it as a way to escape responsibility when investments go south as the adviser can blame Morningstar for the outcome. Thus, one should demand their adviser at least a second reference of why to invest in that particular fund.

Exchangeable-Traded Funds (ETFs) tend to be a better alternative as you can trade them like a stock and their fees are much lower than a mutual fund. Moreover, there are broad ETFs, such as the IVW that follows the Russell 3000 Index, or more niche ETFs, such as GDXJ that follows small gold mining companies.

In the end, every investor has a different profile but  be wary of liquidity because in the bad times you cannot afford to be illiquid, LTCM went out of business because regardless of how solvent it was it lack the liquidity to survive day to day.









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