Little test. Do you know how liquid your investments are? Do you know what liquidity risk is? If the answer is "No", know that it's not a random fact: they haven't told you about it because someone likes it that way.
Let's go deeper, starting from a real situation. Your bank has convinced you to buy a bank bond that yields roughly the same as a BTP, a government bond, safer until proven otherwise. But you didn't notice, you've been customers for twenty years and you trust them. It is essential for the bank that you buy those bonds: they are a fundamental source of funding. However, the bank is silent on the fact that, once in circulation, these bonds do not have a large market: if you decide to sell them, the only potential buyer is your bank. Which, of course, can dictate the conditions.
Time passes and something unexpected happens; you plan to sell the bond. You go to the counter and they tell you at what price they will buy it back: it seems strangely very low. So you ask for explanations and they answer that the bid-ask spread – the difference between the price at which you can buy (ask) and the price at which you can sell (bid) in a given instant – is that, whether you like it or not: a few points percentage. A kind of unwritten penalty. And then you have to decide between liquidating the bond, bearing a disproportionate sale cost, and leaving the money to the bank, managing in some other way.
Whatever your choice, you've just run into the liquidity risk: the risk of not being able to operate on the market, unless at very disadvantageous conditions for you, i.e. at low prices if you sell and high prices if you buy. Up to the extreme case in which the operation is not possible in a short time, not even under disadvantageous conditions, but it takes days, sometimes weeks or even months.
The example shown is not even the most serious situation in which a saver can come across: in recent months there have been extreme acts of defense by some banks which have prevented their operators from buying back bank bonds from private customers, unless there was an explicit contractual commitment to act as a market maker, i.e. to keep the trading market alive for a given security.
If life is difficult for those who own bank bonds, let's not talk about the structured securities: in many cases the market practically does not exist and the bid-ask spread can rise to several percentage points. How to say: sell and lose. The banks have emptied the Italian mutual fund industry by gradually replacing the offer of mutual funds with the issue of bank bonds and structured securities with incomprehensible clauses, behind which generous commissions are well camouflaged. In this way, the banking industry moved household savings from the world of managed savings to the balance sheets of banks, which were able to finance themselves under good conditions even if the institutional market had dried up for them. The "banking locust" then completed the work by hindering the exit of Italian savings with a cage of illiquidity, which makes the sale of bonds and structured loans disadvantageous.
Now do you understand why in the bank little is said about the liquidity of investments (and they always offer you bank and structured bonds)? Be careful though, liquidity risk can also affect other financial instruments, albeit to a lesser extent. In my experience as a mutual fund manager, I've run afoul of it liquidity risk also with ETFs and ETCs, shares and government bonds.
For example, at the height of the "Lehman Brothers crisis" I decided to sell a BTPs with a maturity of less than 2 years. A broker's statement sums up that moment well: “I'm sorry, we can't buy it; if I hear of some other customer who wants to buy, I'll call you”. Never heard from again. By calling some brokers I knew, I finally managed to sell the stock, but at a much lower price than its real value. Warning: it was a BTP, not a Kenyan government bond (respectfully speaking) – the sovereign debt crisis was still far from the collective imagination and the BTPs were considered safe. Also bank deposits, in theory highly liquid, often present attractive returns only on condition of accepting time constraints which, in practice, limit liquidity. Instead, liquidity risk does not concern, if not very indirectly, mutual funds and Sicavs, on which you trade at the day's NAV, with no bid-ask spread and there is no specific cost linked to the sale.
However, sometimes the customer runs into entry/exit fees. Liquidity risk generally increases when there is great uncertainty and pessimism on the financial markets. In such cases, the prices of securities fall (market risk), we start talking about bankruptcies (credit risk) and liquidity risk is also growing, which seems to feed on other types of risk, causing a dangerous spiral that many savers have come to know at their own expense in recent times. Therefore, if an investor decides to sell a financial instrument whose price has fallen due to the market effect, he may lose further due to low liquidity.
For us at Advise Only, liquidity risk is a fundamental concept. That's why we tend to advise our users who request the advisory service financial instruments as liquid as possible (all other things being equal). We have also developed a indicator for measuring the liquidity of financial instruments and portfolios: it is simply called "Liquidity" and, together with Risk and Performance, it is one of the three fundamental pillars for "framing" an investment portfolio. It is available on the site www.adviseonly.com and it's free.
How to check liquidity? For each type of financial instrument (ie bonds, ETFs, stocks, etc.) we consider some important factors that escape the saver but which our indicator condenses into a single measurement. For example, for an ETF we analyze the assets under management, the bid-ask spreads, the volumes and continuity of trading on the stock exchange, whether it is physically replicated or not and other relevant factors. For bonds, in addition to the factors already mentioned, we evaluate the size and age of the issue, the type of issuer and so on. We also consider both the factors linked to ordinary liquidity - that of "quiet" days - and the factors that can influence liquidity in conditions of extreme market turbulence. The index changes over time as the elements that determine it vary. There are many factors to be evaluated, but we average them and in the end we obtain a single score ranging from 0 (non-existent liquidity) to 100 (maximum liquidity). The indicator is available both at the individual instrument level and at the portfolio level.
THEAdvise Only liquidity index obviously it is not infallible, but it can offer valid help to the saver. We are inspired by Google. Just as the search engine continuously refines the algorithm to make user searches more and more effective, the Advise Only team also has an open building site to continuously improve both the indicator, both coverage in terms of financial instruments, gradually expanding the database according to the requests of our registered users.
With the help (price quotation) by Advise Only or by yourself, it's time to monitor the liquidity of your investments.
