Morningstar Magazine - October/November 2017 - 17

The Value of Liquidity
Once you give it away,
you can't get it
back, especially during
a crisis.
THE OLD SQUIRREL

Ralph Wanger

The views expressed here are those of the
author and do not necessarily reflect the views
of Morningstar.
When you invest, there are only a couple of
important things to think about. Let us assume
that you have accomplished your goal of
saving $5,000 to buy a mutual fund. The first
important question is return. If you are
going to become the next Warren Buffett, you
must make a high return on your $5,000, because
even with a high return, it will take a lot of
years to get to $1 billion. Perhaps you should find
the best performing star in the Morningstar
universe and buy that one.

important life events. Mutual funds are designed
to have excellent liquidity daily, a valuable feature.

and then demand that you put up $500,000 in the
seventh month.

I invented a thought experiment about liquidity.
Let us assume that you are out with a buddy,
had a few drinks, and invented a game: Any time
that you ran into your friend, he had the right
to ask you to give him $1,000 in cash. After that,
it you would be your turn, and you could ask
him for the $1,000. If one of you could not make
the payment, there would be a fine of an
additional $1,000, and the game would be over.
Would this be a fun game? It is a fair game,
because neither of you would have an advantage
over the other, but I don't think it would be
enjoyable. Suddenly, you would have to adapt your
habits to carry $1,000 on your person all
the time. You would have to worry about having
it stolen, would have to wear a money belt,
and if you were short of cash, you would have to
start avoiding places where your friend might
show up. This game would be very disagreeable
because of all the distortions it would make
on your conduct. If you could put a money value on
your disagreeableness, that would be the
value of your liquidity.

At the end of the year, the fund will send you
a report. Let us assume that the $500,000 went up
to $550,000. The fund will say that your internal
rate of return was 10%. However, you may feel that
you had committed $1 million, and your return
was only 5%. The fund manager will smile and say,
"Well, you don't know how we do things around
here." But the cost of having to reserve the second
$500,000 for future use is, in fact, a cost to
you, and because the fund can call for your money
any time they feel like it, you don't have zero
liquidity; you have negative liquidity.

About 30 seconds later, you will realize that
there is a second important factor: risk.
Even though the market has been rising a lot for
the past nine years, there is no reason to
think that is going to continue for the next nine
years, and it would be terrible to lose the
$5,000 you worked so hard to put away.
Diversification is a partial answer to risk, so buying
several funds of different types will reduce risk,
although risk never really goes away.

If someone asks you to give them your liquidity,
make sure you get paid for it. Hedge funds
have been very popular with wealthy investors
over the past 20 years, but people are not as eager
to invest in them as they used to be. One
reason, certainly, is that returns for most hedge
funds have not been very high, in large part
because their fees are excessive. Another reason
is that you must give up liquidity. You may
be allowed to withdraw money once a year after
giving three months' notice-a far cry from the
liquidity of a mutual fund. The hedge fund operator
was very glad to get the convenience of the
liquidity you gave up, and it's not obvious you got
anything in return.

After additional planning and worrying, you'll
realize that there is another problem that
you are facing. At some point in the next few years,
your car will need replacing, or your daughter
will decide to get married, or you will really want
to buy a vacation house. These will require
cash. It would be a good idea if you could easily
sell your investment to pay for one of these

Private equity, venture capital, and real estate
funds go one step worse. The hedge fund offers
negative liquidity. The hedge fund manager
has the right to call on you whenever he feels like
the buddy in our game. If an investor or an
institution agrees to be a limited partner in a fund,
with a notional investment of $1 million, the fund
may not ask for any money the first six months,

Could we have a financial liquidity panic?
It could happen, and index funds and exchangetraded funds could be the mechanism. On some
Friday, bad news causes substantial selling,
and the S&P 500 drops 3%. That selling is handled
well enough at first, but over the weekend, many
investors decide that they really should get
out of equities. Monday morning, a wave of selling
starts, and millions of people decide it's time
to get out of their S&P 500 ETF. Prices on the stock
market are forced down by the ETF selling. As
the market heads lower under enormous volume,
the Authorized Participants (APs were put into
business to arbitrage discrepancies between the
S&P Index price and the ETF price) realize
that the market is so unstable that even on a
time frame of less than one second, their arbitrage
programs have become very risky. At that point,
the APs do what marketmakers have always
done in a high-risk period-they shut down. Now,
the price of the ETF and the price of the underlying
index become decoupled, which feeds a general
liquidity panic. After a day or two of panic,
one might see a prolonged bear market as in 1929,
or the market might recover quickly, as in
1987. There are not enough historical examples
to generalize from.
Liquidity is like virginity. You may give it away to
someone pleasant without worrying about it, but
if you ever want it back, you are out of luck. K
Ralph Wanger, CFA, ran Columbia Acorn Funds from 1970
to 2003.

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