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What is liquidity and what does it mean your investments?

Liquidity is how easily you can sell an asset for cash — here's why and when it matters.

| 5 min read

You may have heard the term ‘asset rich, cash poor’. If someone has little cash but lots of assets such as property or investments, they may need to raise money quickly by selling some in order to pay for an unforeseen cost. This is an example of liquidity, or the lack of it, in action.

Liquidity is the ease with which an asset can be converted into cash without affecting market value. It is an important investment characteristic and a risk to bear in mind as it affects an investor's ability to access their funds quickly and without significant loss.

How does liquidity vary in shares?

Cash is king when it comes to liquidity. It can be readily exchanged for virtually anything. Various assets can also be considered to be highly liquid. Shares of publicly-traded companies, for instance, can be bought and sold easily on the stock market. This allows investors to quickly convert their holdings into cash if needed, albeit they may receive a less favourable price if market conditions are adverse and there is a period of declining prices.

Yet other shares could be much less liquid – or even considered ‘illiquid’. Smaller stocks where there are fewer investors are looking to buy or sell shares, for instance. This ‘market’ liquidity depends on how big and how constant the market is.

The more liquid a share is, the less difference there will typically be between its buy and sell prices – also known as the ‘bid-offer spread’. This is usually because there is a high turnover of shares and market makers (the third parties through which shares are exchanged) are less likely to be left with an unwanted position on their books. A narrow bid-offer spread can be important for short-term investors looking to profit from a sharp move in price, but is less consequential for a long-term investor looking over several years or more.

Liquidity can also depend on the amount of money involved. Buying or selling a small shareholding tends to be easier than dealing in a much larger quantity of shares in the same company. Those attempting to deal in significant size are more likely to move the market price – or have to wait for greater market depth to materialise. Two investors with the same asset may therefore experience different levels of liquidity. This is important for funds investing in less liquid areas such as smaller companies. If a fund size becomes too large, then a manager may find it difficult to acquire sufficient shares to express their convictions or to sell readily when they want to.

How does liquidity vary across asset classes?

Unquoted companies – private companies that are not publicly traded – are typically much less liquid than stock-market-listed businesses. This is because there is no centralised marketplace to sell their shares, and finding a corresponding buyer can be more difficult and time-consuming. As a result, investors in unquoted companies may face significant difficulties in accessing their funds quickly.

Physical property is also considered an illiquid asset. While real estate can be a worthwhile investment, it can take a long time to sell a property and the process can be complex, especially if the market is slow. Additionally, the value of property can be affected by factors such as local market conditions and the state of the economy, which can result in a poor price being received when making a ‘forced sale’.

Illiquid assets such as physical property or unquoted companies should be held in an investment structure that allows for this characteristic. Past events have shown that open-ended funds do not make a good home for illiquid assets, unless there is a long notice periods for redemptions, or a very high cash balance to fund withdrawals. Both of these come with drawbacks for investors. Although appropriate to the liquidity of the underlying asset, a notice period delays investors receiving their money, while a large cash buffer to fund withdrawals dilutes returns from the asset class if it is too large. Conversely, if it is too small, the money could run out and mean little improvement in liquidity to the investor.

The perennial ‘gating’ of unit trusts and OEIC funds investing in commercial property is a symptom of illiquid assets being housed in an open-ended fund where there is a variable amount of capital that depend on demand from investors. The fundamental problem is that money can flow out of an open-ended fund quicker than assets can be sold. That’s why illiquid assets such as property are best utilised in a structure that has a more permanent size – such as an investment trust.

Similarly, unquoted assets should not feature in any meaningful way in an open-ended fund. Large withdrawals can result in them making up an ever-increasing percentage of the portfolio, potentially creating problems and constraints for the manager if redemptions escalate.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

What is liquidity and what does it mean your investments?

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