Dealing with a liquidity crisis

At a recent Vienna conference, academics discussed the effects of liquidity on asset management, examined why hedge funds were not able to benefit from dislocations
in the markets and how the illiquidity premium declined. Lukas Sustala reports

Liquidity is not a problem, until it is. The recent financial crisis has materially changed the way investors think about liquidity, and how to enter and leave markets without facing sizeable trading costs.

When liquidity in the US money markets evaporated in August 2007, the hazards of illiquidity became apparent, freezing a lot of fund managers’ holdings in their portfolios.

Reading through investor and CFOs’ surveys published in the first half of 2011, liquidity still tops the list of concerns for many market professionals.

It was also the subject of a conference in Vienna organised by the Gutmann Center for Portfolio Management, a joint initiative of the Vienna University (WU) and Bank Gutmann, the Austrian private bank. 

Illiquidity question

All agreed that liquidity, or, more accurately, the lack of it, matters. But it is a Janus-faced factor.

Illiquidity offers risk and opportunity in various fields of the financial industry, from corporate bonds to hedge funds to mutual funds.

Alois Geyer, speaker of the Gutmann Center, argues that while there are many reasons for the recent financial crisis, lack of liquidity can be viewed as one of the key factors that amplified its consequences.

Illiquidity has become an buzzword as industry giants such as Morningstar have started to point out to clients how it can boost returns.

It was David Swensen, chief investment officer of the Yale Endowment fund, who first made popular the idea of illiquidity premia in asset classes such as timber, hedge funds or private equity, in a formula that became known as the Yale Model.

So, illiquidity is not the secret sauce in the perfect portfolio recipe, but a well-known ingredient to refine the taste.

Researchers have been swift to ­confirm that investors get compensated for holding illiquid assets.

Yet Azi Ben-Rephael from Tel Aviv University told the symposium that the illiquidity premium fell sharply, at least in the US stock market.

Together with Ohad Kadan from the Washington University in St Louis and Avi Wohl (Tel Aviv University) Ben-Rephael revealed that as investors flocked into illiquid securities the premium associated with illiquidity fell sharply.

The associated alpha (risk-adjusted outperformance) of a strategy buying illiquid stocks and shorting the liquid ones declined from 0.61% between 1964 to 1974 to virtually zero for the latest available period.

Thus, liquidity, measured by three volume-related proxy variables, contributed greatly to returns before the 1990s. But the relevance of an illiquidity premium diminished significantly. 

Ben-Rephael argues that the results are obvious. “The sensitivity of liquidity and liquidity premia declined significantly for the stock markets,” he says. But they find positive premia for non-common shares listed on the exchanges, such as real estate investment trusts (REITs), closed-end funds and penny stocks.

One possible explanation for the decline in the illiquidity premium is the proliferation of index funds, which offer exposure through highly liquid instruments, lengthening the investment horizon of investors and thus decreasing the liquidity premium achievable in the market.

Another part of the story is the increased competition of investors for alpha by buying illiquid securities.

But the authors of the study go one step further when it comes to the long-term expectations for stock markets.

They conclude that a significant part of the high stock returns of the second part of the 20th century were driven by a decline in the liquidity premium.

As liquidity’s role for long-term returns declined over the past decades, the opposite was true for the short term, as the liquidity crash of 2008 and 2009 offered “great mispricing”, argues Stefan Nagel, Associate Professor of Finance from Stanford University.

At the height of the crisis in October 2008 the profits from a simple reversal strategy (as a proxy for the profits of market making) rose markedly.

Nagel finds that rising volatility, as measured by the Vix Volatility Index, benefited liquidity providers.

In his view, a sharp rise in the profits associated with liquidity provisions proves that the crisis of 2008 and 2009 was a liquidity crisis at heart. 

Nevertheless, evidence suggests that institutional investors were less able to profit from the massive dislocations in the markets of 2008 and 2009 that were driven by illiquidity.

Hedge funds were forced to reduce their equity positions markedly around the time of the Lehman collapse, driven by redemptions from clients and financial restrictions from lenders, argues Francesco Franzoni, an assistant professor at the University of Lugano and junior chair with the Swiss Finance Institute.

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