Always have an escape plan

The US$9.9bn redeemed from Pimco’s flagship Total Return Bond Fund in June this year might well make many investment boutiques want to cry – what is a small percentage of total assets under management for the behemoth that is Pimco probably dwarfs the total AUM of many companies. But small percentage or not, the best part of $10bn in outflows from a fund does sound alarm bells on what happens when liquidity dries up.

The problem when markets get tough – just as they have, particularly in US treasuries in recent weeks, is that everyone runs for the door at the same time. Now, however much we might like to think we are all slim enough to fit through that door at the same time, or that the door is infinitely wide, the fact is that sometimes this is not the case. Perhaps Pimco can handle $9.9bn in outflows in a month, perhaps it could handle $19.9bn, but could it handle $99.9bn? And for many managers, in many other strategies, the numbers will be much lower.

Of course, we all reassure ourselves with quantitative tests that look at liquidity, not least the perennial favourite of average daily volume. Now as we all know averages fall into the category of “lies, damned lies and statistics”, but nonetheless we tend to rely on them.

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Consider two questions: firstly, should we look at average daily volume now, or in a crisis; and, secondly, should we consider one-third or one-fifth of daily volume to be readily tradable? In most cases, these assumptions seem to pass without much consideration – perhaps a good investment manager will be conservative in their assumptions (is one tenth of daily volume fair?) but the reality is that we gain more comfort from such calculations than we should.

My biggest bugbear – in liquidity if not life in general – is the seeming presumption that we will only try to liquidate positions in situations and market conditions when others are not trying to do exactly the same thing.

But, as I have said, we all tend to run for the door at the same time. So a manager seeing a 10 per cent outflow from a fund in one month – or even one week – might not be concerned if they are alone in this situation. But what, for example, if the top 100 UK equity fund managers all saw an outflow of 10 per cent of their AUM in a week? Or the same for bond fund managers in the US? Suddenly, all bets are off on calculations of liquidity – we are in a multi-standard deviation event – the type that statistically happens every thousand years, but in practical terms happens at least every decade.

What an investor must remember is that not only can it take much longer to exit an investment in times of crisis than is ideal, but you are likely to be selling into a falling market – meaning the longer it takes to exit a position, the more value you have destroyed in the process of waiting.

One thing that I learnt from 2008 – aside, that is, from the fact that those with a nervous disposition should not work in financial markets – was that liquidity squeezes, when they occur, can be very painful. I recollect even supposed short-dated government bond funds that could not meet redemptions.