investment viewpoints

    Liquidity: an investor’s friend or foe?

    Liquidity: an investor’s friend or foe?
    Alexis Maubourguet - 1798 ADAPT Lead Portfolio Manager

    Alexis Maubourguet

    1798 ADAPT Lead Portfolio Manager

     

    Need to know

    •    Rising volatility and a stressed trading environment have put the spotlight on market liquidity. Liquidity refers to the ease at which investors can buy or sell an asset without substantially affecting its price.
    •    To take into account the pivotal role of liquidity as a driver of risk and return, our 1798 ADAPT alternatives strategy has designed a liquidity risk management framework. 
    •    This framework aims to keep investors on the right side of liquidity squeezes, playing on the offence and not only on the defence. It actively seeks to take advantage of liquidity events through volatility and convexity positioning, as well as monetising some liquidity premium.

     

    Nickel market disruption

    Examples of liquidity events are widespread, and one recent instance stands out in nickel. This market – which previously enjoyed decent depth, speed and execution of trade – has become increasingly difficult to trade, from either a long position or a short position.

    As of 25 March 2022, 12 of the past 13 business days experienced trade disruption:

    • on one day trades were cancelled
    • on five days the market did not open
    • on four days declines were large enough to trigger limit down trading restrictions and
    • on two days rises triggered limit up restrictions1

    Such rising volatility and a stressed trading environment have put the spotlight on market liquidity. It is a complex topic, as liquidity - or the lack thereof known as illiquidity - can be either friend or foe, depending on the position, strategy, size and timing requirements.

    Indeed, we believe liquidity is a pivotal driver of risk and return that we put at the fore of our ADAPT strategy’s investment process.

     

    What is liquidity?

    Liquidity refers to the ability to convert a position into cash, or the ease at which investors can buy or sell an asset without substantially affecting its price. Greater liquidity means the ability to buy or sell more quickly, in larger size and with a smaller price impact. A lack of liquidity can diminish the amount traded, potentially distort pricing significantly and could prevent trade altogether.

    Volumes, volatility and the bid-offer spread of prices are three measures of the structure of a market, and they form the principal components of liquidity. Liquidity itself, however, is not directly measurable but rather multidimensional.

    Furthermore, liquidity is not symmetric: it can differ widely whereas investors have a requirement to buy or sell. Liquidity can also prove fickle and vary tremendously in time. A market may have a certain depth one day that evaporates the next with no fundamental cause. Both internal and completely exogenous factors can impact liquidity dynamics, such as a displacement of available capital to a different market, driven by an idiosyncratic event that is not related to the first market.

     

    LOIM’s liquidity framework for alternatives

    Liquidity represents a complex and multi-dimensional risk for a portfolio. Like all other risks, it must be monitored, quantified and limited. And like all other risks, it has a price and should come with a reward for investors. If managed correctly, liquidity could be a source of performance, in our view. Using the right framework, it is possible to build favourable risk-reward and risk-profile trades around liquidity considerations.

    Liquidity risk management has always been core to our alternatives investment philosophy. We dedicate ample resources to research and develop our liquidity framework, which works at the trade, portfolio and strategy levels.

    • At the trade level, liquidity risk management enables us to take advantage of capturing liquidity premia in a responsible way that avoids taking undue or additional risks.
    • At the portfolio level, it enables us to remain robust and balanced with regards to liquidity risk, featuring both long and short liquidity positions.
    • At the strategy level, it guarantees a good match between the liquidity of our assets (or positions) and our liabilities (to investors).

    Moreover, liquidity risk management provides us with precious insight about the impact of liquidity (or illiquidity) on the dynamic and future path of assets. This gives us a potential edge when we trade their volatility.

     

    Illiquidity is spreading

    Beyond the extreme and notorious example of nickel, liquidity appears to be currently drying up across the board, from the most niche listed contracts to the most used contracts, ultimately leaving markets fragile and vulnerable to gapping prices.

    For instance, figure 1 shows Nikkei dividends plunging some 20% between 1-9 March, before rising back again without a fundamental reason. Figure 2 illustrates S&P 500 futures depth becoming frighteningly low, as the notional amounts being presented on the bid and offer diminish.

     

    Figure 1. Nikkei dividend volatility, May 2021 - March 2022

    1798-ADAPT-Liquidity_Nikkei-volatility.svg

    Source: Bloomberg, LOIM. For illustrative purposes.

     

    Figure 2. S&P 500 futures liquidity over 10 years

    1798-ADAPT-Liquidity_10yr-futures.svg

    Source: Susquehanna Financial Group, Bloomberg, LOIM. For illustrative purposes. Top of the book notional refers to the notional amount that sits in the order book of the exchange on the highest bid and lowest offer.

     

    Gaining positive exposure to illiquidity

    Illiquidity is a concern for most investment strategies and styles. This is because traditional approaches tend to be exclusively short liquidity risk without necessarily being compensated enough to carry this risk, in our opinion.

     

     

    Alternatives, such as our ADAPT strategy, are designed to capture prospects arising from continued lower liquidity or even deteriorating conditions. Such positive exposure to illiquidity can emanate from specific expertise on the topic, as well as from the ability to use volatility and convexity positioning in a tailored approach.

     

     

    Sources

    [1] Source: Bloomberg, LOIM. For illustrative purposes only.

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