How Much Do You Pay for Liquidity?

January 2, 2020

Source: Bloomberg Source: Bloomberg

In the history of finance, innovation from financial intermediaries has been concentrated on building a system that transforms illiquid assets into liquid securities. For example, a company’s capital could be traded as a share of equity, a government’s tax revenue could be bought as a government bond, your monthly mortgage payments could be sold as a mortgage-backed security, your cell phone installments could be bought as an asset-backed security, entire stock or bond market indices could be traded as a share of an exchange-traded fund (ETF), and so on.

The most important prerequisite for a liquid asset is a capital market in which to trade the security, so that all possible information regarding the value of the security is discovered and incorporated into the price. More trading volume can achieve more economy of scale so that the cost of trading can be inexpensive, and the pursuit of profit reduces any possibility of arbitrage and the asset price is as fair as possible to both buyer and seller.

The role of financial intermediaries in providing liquidity to the capital market is also crucial. They must ensure safe transactions of those assets. Intermediaries should slice and dice those assets into small units so that average investors have the ability to buy with a small investment, transform the maturity’s flexibility so that investors can liquidate the asset quickly and regulate credit risk within a basket of assets so that any investor can assume consistent risk across securities.

The innovation of the capital market encourages both entrepreneurs and investors around the world to find the best opportunities for economic success. Capital markets continuously, and quickly, transform an economy to its most efficient form.  Economic activities are often funded by the capital market, and stakeholders are able to act economically using information gleaned from that market. Therefore, efficient capital markets have become a fundamental building block of the market-based economy - the most prevalent economic system around the world.

While the benefits of liquid assets are tremendous for the economy, liquidity can be difficult to understand. Liquidity comes at a cost, albeit difficult to measure. Its impact is largely insignificant to investors in normal circumstances, but can be a major source of problems when financial intermediaries fail to maintain it. The difficulty of measuring liquidity is compounded by less liquid assets in an ETF when there is a mismatch between the liquidity of the fund and the liquidity of underlying assets.

The chart of the week illustrates liquidity conditions of major fixed income sectors, as well as the equity market and gold for reference. From January 2008 to November 2019, the cost of liquidity of a sector has been measured by a percentage difference between market prices of major ETFs in those sectors and their net asset values (NAV). NAV is the weighted-average bid prices of all underlying assets of the ETF, so the cost of (buying) liquidity in the underlying securities can be easily measured by the difference between NAV and the market price of the ETF. ETFs are constantly traded on the capital market and usually have very good liquidity, resulting in a very low bid-ask spread. ETF investors willingly pay the difference between the price and NAV to financial intermediaries for managing the underlying securities. In the chart, on average, the market price is higher than its NAV by a small amount due to this cost of liquidity.

What if those institutions are not able to provide enough liquidity? For example, at the height of the financial crisis in 2008, the market price disparity of high yield ETFs and its NAV was as high as 11% and as low as -2.5%, which is about 8 and -2.4 times the standard deviation event, respectively. First, could financial intermediaries make an 11% return by arbitrage in December 2008? Could ETF investors make a 2.5% return by redeeming the ETF to its underlying portfolio in September 2008? The answer is most likely no in both cases, because the liquidity is not likely enough for any market participant to trade with a reasonable bid-ask spread. Secondly, could investors just simply close their ETF position to avoid this liquidity crunch? Or could the investor wait until the turbulence is gone? In hindsight, the answer is yes; however, it's not as clear in foresight. Indeed, liquidity levels returned to normal when the financial crisis ended, but the market did not correct itself alone. Instead, the government helped to resolve the crunch, but the damage was already done as a result of the price drop during the liquidity crunch.

Key Takeaway

Liquidity comes at a cost and bears risk caused by the friction in the vast network of financial intermediaries and investors. The high liquidity of exchange-traded funds is not necessarily translated into liquidity in the underlying securities, which can be problematic when the market experiences a liquidity crunch. As seen in this week’s chart, high yield, emerging market fixed income and gold ETFs can be vulnerable during periods of market turmoil as a result of the illiquid nature of their underlying securities.



Tags: Liquidity | Fixed income | capital market | Exchange Traded Funds (ETFs)

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

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