Author: Stephen Tunley - CEO Balmain Funds, David Chin
For quite some years, it has been common investment orthodoxy
that investments need to be liquid. But as the GFC painfully revealed,
liquidity, for all its good, comes with a high price ....volatility.
not be recognised by some investors is that volatility has risen sharply since
mid 2007. This fact, when combined with a recent trend for investment platforms
to demand liquid investments at the expense of illiquid investments, – poses the
question – is the price of liquidity too high?
What is volatility?
Simplistically, it is a measure of dispersion (ie variance) in price over a
specific period of time. This measure is the standard deviation and is expressed
as an annualised percentage. The higher the percentage, the higher the
volatility or, the higher the probability of returns being much more, or much
less, than expected.
For example, from 1981-2010, the annualised return of the
ASX 300 Share Accumulation Index (dividends included) was 11.72% pa and the
standard deviation 17.78% pa. That means that 68% (one standard deviation) of
the time, the share markets returns were 17.78% above and below the mean return
of 11.72% pa. That is, +29.50% to -6.06%. Great new if you are retiring when
volatility allows you to cash –in when returns are above the mean, but not so
great when volatility drives returns below the mean! Standard deviations move up
and down over time, driven by fear and greed, or to paraphrase former US Defence
Secretary Donald Rumsfeld, they are impacted by ‘known knowns, known unknowns
and unknown unknowns!’
Some readers may have heard of the VIX (or ‘fear’) index.
Figure 1 the CBOE Volatility Index® (VIX®) - a key measure of market
expectations of near-term volatility (as conveyed by S&P 500 stock index option
prices.) Since its introduction in 1993, VIX has been considered by many to be
the world’s premier barometer of investor sentiment and market volatility for
the US equity market.
FIGURE1: CBOE Volatility Index® (VIX®)
In figure 2, notice in 2004 to 2007,
while the stock market was gradually rising, the VIX (volatility) fell to record
lows. Then the GFC hit, volatility rocketed and liquidity disappeared as asset
prices fluctuated wildly (down!) due to uncertainty, fear and panic. And because
liquidity disappeared, institutions that needed cash (to repay investors who
clamoured to get their money back) were forced to sell ‘liquid’ assets such as
blue chip stocks and bonds, causing these assets to fall further. Thus liquidity
FIGURE 2: VIX® and S&P 500 Indexes
It is estimated that
around 80% of retail investments (Mum and Dad investors) now pass through Master
Trust or WRAP’s (platforms). These platforms typically demand that the
investment products they include are liquid and able to be liquidated in less
than 90 days, regardless of the underlying securities.
As a consequence, more
and more investment funds wanting to be included in platforms are now investing
in exchange-traded (listed) products in order to be liquid. These include listed
property (A-REIT’s), listed infrastructure funds, listed investment companies
(LICs), listed income funds, listed private equity, and listed hedge funds. But,
note the chart (below) that shows the standard deviation over the past three
years for Australian shares. Volatility has been rising at the same time that
platforms are demanding that investment products must be liquid (usually meaning
listed) before they can be included!
FIGURE 3: ASX 300 Share Accumulation Index
Rolling annualised volatility 2007-2010
investment products that contained non-market tradable assets were able to meet
liquidity requirements by managing the relationship between cash, investment
maturity and net flows. Added to this was that while no formal market may have
existed for the underlying investments, demand-driven informal markets provided
comfort that assets could be liquidated with ease and therefore the product were
considered liquid as defined by the Corporation Act.
tradable products are typically unable to be included on platforms as they
cannot meet the platform’s liquidity requirements. As a result, investors that
use platforms may be exposed to increasing levels of listed and thus more
volatile investments. As well it also means that valid and valuable non-liquid
investments are simply not seen by investors for no other reasons that the
arbitrary demand of their platform provider.
As we saw during the GFC, in times
of crisis, listed investment prices can suffer extreme trading ranges, even for
so-called liquid stocks. Discounts to NTA widened dramatically. Even now, many
LICs and A-REITs have discounts to NTA in excess of 25 percent.
issue then is the increasing volatility risk when investing (via platforms) in a
range of investment products that are themselves investing in exchange-traded
products...just to be ‘liquid.’
This investment orthodoxy for liquidity has also
much to do with the structural issues of managing a platform. Platforms prefer
exchange-traded investments because their IT systems are more easily integrated
with exchange-related reporting and back-office systems, and because listed
investments are more portable between platforms. (Of course, there are also
other benefits in exchange-traded investments including more transparency in
reporting, and an additional layer of exchange regulations which is now being
assumed by the Australian Securities and Investments Commission).
before the advent of platforms, investment portfolio construction typically used
a mix of non-liquid assets and liquid assets, and planners constructed these in
such a way that liquidity was an integral component of portfolio construction,
not just an outcome of being listed. Sadly, it appears this will no longer be
the case, resulting in lazy portfolio construction where listed is the mantra
and volatility could be the price paid.
And volatility becomes an even greater
issue as an investor approaches retirement. It would be wonderful if returns are
well above ‘expected’ in a volatile portfolio, but an investor’s retirement
plans will be dramatically affected if returns are well below what was expected.
Investors, particularly those closest to retirement, are
being directed into listed (and ‘liquid’) investments in an era of rising
While no one can predict that volatility will keep rising, we can
see that it has risen considerably over the last three years. Investors
therefore need to be conscious of the link between liquidity and volatility and
ensure that they remain comfortable with both the benefits and the risks.
worst manifestation of volatility could be seen in the recent GFC and also in
October 1987, when ‘liquidity’ disappeared, investment models (such as the much
used Efficient Market Hypothesis) melted, and most asset performance
correlations moved towards one, skewering assumed portfolio diversification.
an investor close to retirement, common sense dictates one should aim for low
volatility investments, especially as one’s ability to replace lost capital
diminishes. It stands to reason that leverage raises volatility, so
non-leveraged products are important. Investors could do well to consider a
range of investment products that do not have exposure to listed markets, in
order to lower their volatility risks. These products include income funds,
direct property, and fixed income funds and commercial mortgage backed
investments as some of these are capable of tracking a rising interest rate
We hope this article provides a rethinking of investment strategies and
a willingness to challenge the ‘liquidity’ investment orthodoxy.
The information contained in
this document is of a general nature and does not constitute financial product
advice. This document has been prepared without taking account of any person's
objectives, financial situation or needs.
Because of that, each person should,
before acting on this document, consider its appropriateness, having regard to
their own objectives, financial situation and needs. In preparing this paper
BFAL has relied upon and assumed, without independent verification, the accuracy
and completeness of all information available from public sources or which has
otherwise been reviewed in preparation of the paper. The information contained
in this paper is current as at the date of this paper and is subject to change
without notice. Past performance is not an indicator of future performance.
Neither BFAL, its associates and related entities, nor any of their respective
directors, officers and employees, give any warranty as to the accuracy,
reliability or completeness of the information contained in this document.
Except insofar as liability under any statute cannot be excluded, neither BFAL,
its associates and related entities, nor any of their respective directors,
officers and employees, accept any liability for any loss or damage (whether
direct, indirect, consequential or otherwise) arising from the use of this
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