The Aleph Blog » Blog Archive » What is Liquidity? (Part V)

What is Liquidity? (Part V)

Here are the predecessor posts in this series:

This series has been very irregular.  But it does include the first real post at this blog.  It is something that I think about frequently, and my best summary for what liquidity means is:

What does it cost to enter or exit fixed commitments?

Tonight I want to take a slightly different approach, and talk about two aspects of liquidity: assets and liabilities.

On the liability side, we can look at publicly traded assets and say that they are liquid, though many may only be fungible.  When I was a bond manager there were some trades that took days or weeks to set up.  Some were public bonds coming to market that were complex, others were asset- and mortgage-backed bonds that took some time to research.  Some were pure privates where you were trading the whole chunk or nothing — it was not far distant from being a bank.

With many investments, there is a liability structure.  Yearly, quarterly, monthly, daily liquidity.  Funds are locked up for three or five years.  Funds are locked up until assets are liquidated, and you might be paid in kind, not cash.

The ability to get cash is an important aspect of liquidity.  But so is the ability to preserve value, and that is the asset side of the question.  After all, liquidity means that you have assets that preserve value, such that you can liquidate and spend it.

From an asset standpoint, stocks are liquid as far as trading goes, but not liquid in terms of preserving value in the short-to-intermediate run.  Equity is illiquid, whether public or private.  It offers no protection of value.  Think of it this way: if you were going to buy a house in a few months, would you invest your down payment in stocks?  It would not be wise to do that.

There are various ways of owning equities, and other investments.  It is more important to understand the riskiness of the assets, than the shell in which the assets are held.  The shell may offer liquidity at intervals, but that has no effect on the underlying value of the assets.

Thus I will say it it is far more important to focus on the value of the assets, than on when cash will be released to you.  As one of my bosses said to me:

Liquidity follows quality.  The better the asset is, the more liquid it becomes.

As a result, those wanting to do best in investment management should keep a supply of short-to-intermediate high-quality debt as the performance of risk assets may vary considerably, which will affect the ability to achieve fixed commitments.

Liquidity is the ability to preserve value for near-term spending.  Thus both asset and liability aspects of investments have to be considered when considering liquidity — it is not only ability to liquidate, but to receive value back in real terms.






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One Response to What is Liquidity? (Part V)

  1. Helical_Investor says:

    You seem to be attempting to more find meaning in liquidity than just define it. At the risk of oversimplifying, liquidity is just the inverse of the cost of transaction. Costs can be as low as sec fees, to as high as full diligence with legal team support. So it makes sense that liquidity varies with scale.

    So, maybe after a point liquidity isn’t such a good thing, as it breeds laziness in the form of an unwillingness to take on costs, such as time and labor, when not strictly required to do so.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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