The issue of liquidity in open-ended funds has hit the headlines in recent weeks - with much of the spotlight focusing on small and micro-cap stocks.
While stocks at the smaller end of the equity market often exhibit lower levels of liquidity than larger peers, it must be remembered small and micro-cap stocks are less liquid - not illiquid.
Nevertheless, managing liquidity in funds is crucial for delivering long-term performance and meeting investor needs. Liquidity matters at a stock level, for building and exiting positions, as well as delivering target returns. More importantly, liquidity in open-ended funds allows investors to deal on a daily basis.
In closed-ended vehicles, day-to-day liquidity risk is passed down to the end investor, who can buy and sell shares in the strategy. However, they must consider market liquidity in those shares and bear the cost of any discount or premium to NAV. In open-ended funds, the manager takes responsibility for this risk.
The key starting point to delivering attractive long-term returns is having a clear understanding of the capacity of an investment strategy. It is important not to raise more money for a vehicle than the manager can effectively manage. Managers must also communicate the capacity constraints of their strategies to investors.
A lot of managers can have an advantage is they have been investing in illiquid companies for a long time. This is especially the case if they undertake their own dealing, which requires maintaining direct relationships with sales traders at every broker of small and mid-caps. This can be key when trying to achieve liquidity at the smaller end of the market.
Modelling returns for individual stocks must consider assumptions of entry and exit prices, factoring in appropriate liquidity adjustments where relevant. Investors must form a judgement as to the likely liquidity for both entry and exit, taking into account historical trading volumes and size of free float. Managers also need to assess the shareholder register and build a detailed understanding of the market through discussions with trading desks at the relevant brokers.
Stock-level liquidity should be a crucial component of a fund manager's methodology if they are focusing on smaller assets, as it should determine the size of an individual investment within an overall portfolio.
A multi-faceted approach to managing liquidity at the portfolio level should help to mitigate redemption risk. For example, a minimum cash level target relative to NAV, or having access to a short-term borrowing facility of a proportion to NAV, can help. Moreover, portfolio construction should explicitly take into account liquidity, seeking at all times to balance less liquid holdings with more liquid holdings. Finally, if internal and cornerstone investors form a core part of a fund, this will provide a layer of sticky patient capital and ensure available liquid assets are maintained at a prudent level.
Ken Wotton is managing director of quoted investments at Gresham House