Minimising liquidity risk in our client portfolios
The problems with the Woodford funds have been well documented. We are delighted that these suspended funds never formed part of Informed Choice’s recommended client portfolios.
The biggest issue with the Woodford funds is that investors aren’t able to access their money now or for the foreseeable future, and this is a terrible position in which to be.
Fund suspension is a situation we would always hope to avoid for our clients. As a result, we have looked carefully at liquidity in our client portfolios. The findings are reassuring.
What is liquidity?
Liquidity is a term which is used to describe how easy it is to take your money out of an investment fund. Naturally, the more liquid a fund is, the easier it is to withdraw money from it.
A fund which tells you that you temporarily (or permanently) can’t make withdrawals, as Woodford has done, is said to be “illiquid”.
The same principles apply in the residential property market – during a housing market boom, it can be possible to sell your house in just a few days, but when things are slow, it can take years to find a buyer.
During the boom time, your house is a “liquid” asset. During a slow time, it is “illiquid”.
In extreme times, even cash can become illiquid. We witnessed this during the Icelandic banking crisis.
The liquidity of investment asset classes (e.g. shares, fixed interest stock, property) can change over time. Some asset classes are more susceptible to this liquidity change than others.
But it’s doubtful that the most significant parts of our client portfolios (listed shares in the UK and the developed world, and government bonds) will ever lose their liquidity.
We don’t feel that we should be complacent. While these assets make up the most significant part of our clients’ investment portfolios, there are other assets where a change in liquidity is possible.
If you have a diversified portfolio, you can’t avoid the risk that the liquidity of some the asset classes and underlying securities will change.
The only alternative would be to invest in a smaller range of assets, and consequently to increase the risks which you face (as your portfolio will be less diverse).
Taking liquidity risk can reduce other threats, and, for that reason, it can be worth considering. There are some assets in our clients’ portfolios which add valuable diversification, but where there is a risk of a change in liquidity.
Our liquidity review
We have looked carefully at the funds in our portfolios, which invest in these asset classes, and conducted some specific research on their liquidity, and what the managers of those funds do to limit this risk.
We reviewed at the underlying holdings (stocks, shares, property and cash) in the funds to check whether any of the assets presented specific risks (Woodford had invested a large proportion of his fund into illiquid, unquoted companies).
We went on to ask the fund managers how they monitor liquidity, and how quickly they could respond to large requests for withdrawals.
We also looked at who else has invested in the funds our clients hold – institutional or discretionary fund managers can create liquidity problems in funds, and we wanted to check that this wasn’t an issue in the funds we recommend.
We focussed our research on the asset classes where liquidity can change – commercial property, emerging market shares, Asia Pacific shares, and high yield bonds.
There have been times when liquidity has been a concern for commercial property investors, and it’s not inconceivable that liquidity could become an issue in the other asset classes.
No anticipated issues
This research concludes that there are no current or anticipated liquidity issues in any of the funds which form part of our client portfolios. All of the funds which we recommend have processes in place to monitor ongoing liquidity and to minimise the risk that the funds could become less liquid.
It would be wrong, however, to tell you that liquidity is a risk which could never affect your portfolio.
It’s possible to imagine, for example, that the Chinese government might decide that foreigners would not be allowed to sell their holdings in companies traded on their stock market, and this would affect some of the funds in which our clients invest.
This type of risk can be worth taking, to have the potential of the higher returns offered by these shares (don’t worry, there will only ever be a tiny percentage of your portfolio in this sort of stock!).
We will continue to monitor the liquidity in our clients’ portfolios, looking at the risk at a portfolio and fund specific level, and considering whether the potential liquidity risk is worth taking.Minimising liquidity risk in our client portfolios - here's how we approach it at Informed Choice, in light of the Woodford suspension Click To Tweet