The article originally appeared in The Financial Standard on 12 April 2021.
In March I took my first business flights for 13 months, though there was a back-up video-conference plan. And at the end of March, I was booked to take a vacation trip to Byron Bay.
At the last minute, Byron became a COVID orange zone, so sadly the flights and holiday had to be cancelled and arrangements changed in a quite a hurry.
These events bring to mind the importance of understanding both the entry and exit conditions of the investments we enter into — not to mention the value of the time-tested advice never to enter any investment unless you fully understand the exit plan and conditions. As they say just before the plane takes flight: take a moment now to identify your nearest exit.
Most of us are familiar with ‘‘t+2 trading’’ conditions on the Australian securities market for listed assets such as shares, hybrids, real estate investment trusts and exchange-traded funds.
Whether it’s purchase or sale, the cash will be settled two days after the trade date. But how easy or difficult it is to purchase or sell listed securities requires more consideration than just the settlement terms.
For every buyer there needs to be a seller. For every seller there needs to be a buyer.
Shallow or thin trade in a security can occur in newer securities, securities nearing a maturity date, some small-cap stocks, securities in adverse conditions and even some of the smaller exchange-traded funds.
Thin trade can actually occur for many, many reasons, so holders of apparently liquid investments need to be realistic about how many days/weeks it might take to actually liquidate any given holding for any determined sell price limit. Instant liquidity can be an expensive illusion.
Similar cautions exist for assets that trade on alternative trading platforms, such as currencies and commodities.
Most currency and commodity markets are relatively deep but as recently as a year ago the traded price of oil went negative for a brief time as demand temporarily collapsed.
In some ways holders of units in managed funds of listed assets can have a more predictable liquidity runway, particularly if the fund commits in its product disclosure statement that it will process all redemption requests in, say 7 days.
However, unit holders should be aware that tucked away in most product disclosure statements is a clause that gives the manager the right to defer, decline or ‘‘gate’’ redemptions in any kind of adverse market conditions such as market crashes or ‘‘runs’’ on the fund.
And it is not just on the way out of funds that there can be a delay. I recently sent an application for a new fund on March 10 and due to its popularity funds were not debited/units issued until March 25.
When funds are comprised of listed securities whose prices change daily, investing in them at a reasonable price can require some luck.
We all just hope that between application date and unit issue/redemption date there are no massive moves in underlying market conditions.
As direct investors in illiquid assets such as real estate, private debt, private equity and infrastructure — assets that are infrequently traded and externally valued — we are all probably most realistic about liquidity.
We know we need to wait for private debt to mature, for private equity to list or have a trade sale, for property to sell at expected prices, etc, before there is a liquidity opportunity for us as investors.
In the past investors have expected a slightly highly return to compensate for lower liquidity — the so-called liquidity premium — though recent evidence suggests that the liquidity premium has been significantly bid away by demand for unlisted assets.
The relatively recent phenomenon of managed funds of unlisted assets is a curious hybrid as some of these are open-ended funds allowing for as frequent as monthly redemption opportunities.
These are often met from incoming monthly applications as the underlying assets are not liquidated.
So all will be well only while all is well and the same clauses for deferring, declining or gating investments as mentioned above will typically exist.
Investor caution about the ease with which they will be able to exit such investments is warranted.
The risk mitigation strategy to reduce the impact that illiquidity can have on your portfolios is of course diversification.
Diversification of asset classes, assets, vintage, geography, style, size, etc, can be done using a set of portfolio construction guidelines that limit concentrated exposures in any one area.
So as we get back into relatively stable conditions for investing, take a moment to locate the exit nearest you, keeping in mind that the closest exit may be behind you. And as the pre-flight warning says, if there is a loss of power, red emergency lights will illuminate on the floor below you, directing you to the nearest exit. Let’s all hope we never need the floor lights, but we do need to know where they are.
Sue Dahn is a partner at Pitcher Partners and has been a member of The List: Australia‘s Top Financial Advisers for the last three years.