Liquidity Risk: What is it & How to manage it?

Jun 07 2022 | 2 min

Risk is an integral part of investing that cannot be eliminated. But it can be managed to achieve predictable long-term returns. The first step in risk management is being aware of the risks.

Liquidity risk is about the ability to sell an investment at any given time for its fair value. During the Global Financial Crisis (GFC) in 2008, liquidity in the financial markets simply evaporated. The S&P 500 lost almost half its value from 2007 to 2009 as buyers were either unwilling or unable to purchase risky assets.

In 2020, the financial markets were put to the test again. As volatility peaked and markets fell sharply, investments could not be sold at their fair market value.

Howard Marks, co-founder of Oaktree Capital (the world’s largest private credit manager) explained that “things tend to be liquid when you don’t need liquidity, and just when you need liquidity most, it tends not to be there.”

What is liquidity risk?

Two types of liquidity risks must be managed.

The first is company-specific, when a company cannot meet its liabilities. The second is market-wide, which is the focus of this article, when few buyers are available. In this situation, sellers who are unable to hold their investments until the market normalizes must accept substantial discounts. This is a market dislocation.

Market liquidity risk is measured by three inter-related metrics. The first is the bid-ask spread, which is the difference between the buy and sell prices. A tight spread (i.e. small difference) means that the market is relatively liquid. The second is the market depth, which is the total value of the bids on offer compared to the number of willing buyers. The third is resilience, which is the ability to regain losses after temporary market dislocations.

Trading volume is the best indicator of liquidity under normal circumstances. But it can change overnight when the market is stressed and liquidity is widely needed.

Assets can be classified broadly as highly liquid, moderately liquid, or illiquid, depending on the time needed to sell an asset at its fair market value. For example, US treasury bonds are highly liquid, as they can be sold within three days at their fair market value, due to tight spreads and a deep market. On the other end, private market assets, such as real estate, require a much longer time to be sold at their fair market value.

Managing liquidity risk

Managing liquidity risk is of paramount importance.

First and foremost, investors must ensure that they never need to sell assets at large discounts at the worst time. Such losses cannot be recovered.

Second, investors must be ready to take advantage of dislocated assets that are sold forcibly under distressed situations by investors strapped for liquidity.

Third, investors must include less liquid alternative investments in their portfolio for better returns, and be prepared to hold their investments until the best exit opportunities arise.

Financial planning for liquidity risk

Liquidity risk is managed in three steps.

The first step entails cash flow projections in normal and stressed market conditions, based on your investment horizon, liquidity needs and historical liquidity (e.g. redemption activity) in good and bad times.

The next step involves portfolio composition. Based on your cash flow projections, you can structure an optimal portfolio diversified across asset classes and industry sectors that can withstand stressed market conditions.

The third step is to identify funding sources that can be deployed during times of market distress to acquire assets at attractive valuations during market sell-downs.

How can The Family Office help?

Liquidity risk management is an integral part of the investment process of The Family Office.

Based on a clear understanding of each client’s objectives, investment horizon and constraints, we propose a time-tested asset allocation customized for each client.

The portfolios we build are designed to be resilient during times of stress and add assets at attractive valuations during market dislocations through illiquid alternative investments that deliver superior risk-adjusted returns.

We manage more than US$2 billion of tailored portfolios for over 200 affluent individuals and families. Schedule an appointment today to learn how you can build a portfolio that preserves and grows wealth over generations.

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