The Importance of Liquidity

In this article, we will look at the importance of liquidity, something that is often overlooked by investors.

What is Liquidity?

In essence, liquidity refers to the ease with which an asset can be converted into cash that is then available to spend.

Why Is Liquidity Important?

We all need cash in order to meet our day to day expenditure and we generally do this using the money in our current accounts.

When we invest our money, we often take a longer-term view intending to keep the money invested for several years, however, sometimes events happen and we need to encash some of our investments, for example, to meet an unforeseen expense. In this situation, liquidity is important.

Typically, where clients hold a collective investment such as a Unit Trust, the investment can be sold (usually via an online investment platform) and the sale proceeds are available in around three to five working days. However, there are types of investments which are not so liquid.

Liquidity Risk

There are some investments which can be considered more illiquid than others:

Unquoted Shares – shares in start-up or unquoted companies tend to be illiquid as there is often no or a very limited secondary market. An example would be where investors are providing venture capital and will then need to wait until a liquidity event such as a company sale or share listing in order to be able to sell their shares.

A classic example of the risks associated with unquoted shares can be seen in the issues surrounding the suspension of the Woodford Equity Income Fund. The fund was unable to meet redemption requests because it held a large proportion of illiquid assets.

Structured Products – these types of investments often require tying up your money for a period of time, usually for several years. These investments are designed to return your initial capital plus an element of growth linked to the performance of an underlying investment index over the relevant period if certain conditions are met. In some cases, there can be a secondary market for these types of investments but often it is the issuer of the Structured Product that will offer to buy it back and the price might be less attractive.

Property Investments – property is often seen as being relatively illiquid given that it cannot be sold quickly especially during times of market distress. When a Property Unit Trust, for example, has lots of investors looking to sell, it may not have sufficient cash reserves to meet those redemption requests. It may then not be able to sell the underlying property assets and, as such, will often place restrictions on how quickly investors can sell their investments.

Fixed Term Deposits – many banks or building societies that offer Fixed Term Deposits may not allow access to the cash during the term of the deposit whereas others will allow withdrawals but with a loss of interest. Care needs to be taken around the maturity date as we have seen maturing Fixed Term Deposits be reinvested automatically into another Fixed Term Deposit which can cause problems if the money is required. This can be particularly problematic if the Fixed Term Deposit is held within a Self-Invested Personal Pension (SIPP) and the money is needed to fund income payments.

Liquidity Risk Premium

When investing in illiquid assets it pays to carry out increased due diligence in order to fully understand the nature of the underlying investment. Most investors would expect to see the potential of higher investment performance in return for tying up their money for a long period of time.

Financial Planning

Illiquid investments can play a role in a client’s overall financial planning strategy in certain circumstances, however, it is vital to be aware of the potential impact on a client’s financial objectives if these investments became difficult to sell or if their value fell significantly. This is where cashflow modelling becomes vital in ensuring that clients have sufficient liquidity to ensure that they can meet their expenditure needs.

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