Fund Selector: Beware liquidity crunch

The economist said its adequate provision was “critical for the smooth operation of an economy”.

“Its sudden erosion in even a single market segment or an individual instrument can stimulate disruptions that are transmitted through increasingly interdependent and interconnected financial markets worldwide,” he said.

“Despite its importance, problems in measuring and monitoring liquidity risk persist.”

There has been much rhetoric about levels of liquidity across markets in recent times. However, because liquidity is not one dimensional, it is not easily defined.

The most coherent definition for liquidity I could find is “the ability to absorb smoothly the flow of buying and selling orders”, according to Pu Shen and Ross Starr.

Revolutionary monetary policy has coincided with significant reforms across the financial spectrum, resulting in market liquidity being structurally lower today than for quite some time.

Central banks have ‘created’ something in the region of $7-$10trn (£4.6trn-£6.6trn) since the financial crisis, but this has not guaranteed a smooth flow of funds through markets.

There are many contributing factors to this, of course. But perhaps the one that stands out is the regulatory reform that reduced the ability of investment banks to act as market makers and take stock onto their own trading books.

So in spite of the fact the banking system is arguably more robust than it was pre-2007, the by-product of that development is the resultant lack of liquidity.

That same revolutionary policy has suppressed rates to historically low levels and held them there, which has fuelled an abundance of cheap debt issuance into a marketplace that is not accommodative.

The lack of market liquidity is not so obvious in a rising market, but will become much more apparent when the markets head lower, amplifying the volatility and downside in certain quarters.

Asset managers tend to trade with herd mentality and consensus, which at inflection points can make rotating out of positions at a competitive price extremely difficult.

The top 20 asset managers in the world now account for 30 per cent of all bonds and equities – up from 15 per cent 10 years ago – which further magnifies this dynamic.

As of January 2015, Vanguard held some $497bn in bonds (up from $170bn in 2008), Pimco accounted for $404bn (up from $210bn), and Fidelity held $249bn (up from $116bn) – a small sample, but evidence of the surge in assets under management surge and concentration in bond funds.

A lot is resting on the Federal Reserve to engineer a comfortable transition away from a zero-interest-rate policy, and it’s commonly accepted that at some point one doesn’t want to be in bonds – but nor does one want to be trampled in the rush.

When sentiment shifts away from bonds, we shall see whether the market has “the ability to absorb smoothly the flow of buying and selling orders”.

James Sullivan is investment director at Coram Asset Management