Most people believe that past returns are the most important criterion while choosing a mutual fund. That is not strictly true. Those who have seen heavy market downturns will be able to tell you that fund portfolio liquidity is an equally important factor to be kept in mind.
What is Fund Portfolio Liquidity?
Liquidity refers to the ability to buy or sell an asset without inordinately influencing the price at which the transaction is consummated. Fund portfolio liquidity refers to the ease with which a fund’s portfolio can be converted into cash. In other words, the easier it is to turn the fund’s portfolio into money, the better it is for the fund and for you.
Easy portfolio liquidity ensures that the fund will have no problem selling off the securities it holds in order to fund redemptions. Liquidity assumes even greater importance in times of stock market downturns when redemption pressures build up and massive redemptions have to be financed.
Institutions refer to these liquidity problems as their “market impact” costs. Market impact costs are the premiums they must pay above the going market price to buy a stock and the concessions they must accept below the going market price to sell, to accommodate the large size of the positions they need to trade.
How does Market Condition impact Fund Portfolio Liquidity?
In normal times market impact costs on a single purchase or sale for a typical institution may vary anywhere from as little as 1/2 or 1% of the total value of the position for a small trade in a large capitalization company to as much as 20% of the total value of the position for a large trade in a small capitalization company.
Liquidity in the stock market, however, is less of a problem in bull markets such as we have enjoyed over most of the period since 2003. As long as the demand to buy stocks exceeds the demand to sell, though institutions may have to pay substantial premiums to buy, the concessions they must accept to sell are of lesser consequence.
Furthermore, in a bull market, the premiums paid by institutions for individual purchases are masked by the overall rise in the market. For mutual funds with net inflows of cash, liquidity problems are of even less concern. New investment commitments can be made by simply deploying the new cash, and so without having to sell other securities to raise the money needed to buy.
Bear markets and net redemptions for mutual funds, however, put all of the foregoing into reverse. Bear markets can cause net fund redemptions; net redemptions must be accommodated by an excess of portfolio sales over portfolio purchases; and heavy sales exacerbate market impact costs.
How to ascertain Fund Portfolio Liquidity?
A real concern today is that many mutual funds that have grown especially large, and others that have specialized in smaller capitalization companies, may suffer enormous losses if they are required to sell massive amounts of stock to meet shareholder redemptions.
The “quality,” and so the “safety” of a fund portfolio is absolutely identical to the “quality” or “safety” of the securities that make up the portfolio of that fund. The reason for having high-quality securities in a portfolio is not to maximize one’s short-term return; it is to minimize one’s long-term loss. Admittedly, a price must be paid for the privilege of owning high-quality securities. This price is that, when low-quality securities are going up more than high-quality securities, we do not participate in the incremental gains.
Our reward for this sacrifice is that, when low-quality companies go bankrupt and the prices of their securities collapse and never recover, as holders of high-quality securities, not only are our companies more apt to survive the debacle, but they may be even further nurtured by the carnage of the low-quality companies that have failed, as the high-quality companies pick up the business that their low-quality counterparts have left behind.
So to identify if the fund can sustain redemption pressure or not, you should look at the quality of stocks held by the fund in its portfolio. If the scheme invests heavily in small and mid cap stocks and the proportion of the fund’s holdings in these stocks forms a substantial portion of the respective stock’s total market capitalization, then the fund might experience problems in selling the stock during market downturns.
If you know the fund portfolio is liquid, you can be assured you’ll get your money in spite of an unfavorable market situation.
What’s more, depending on whether the portfolio liquidity is high or low, your returns can be affected too. For example, a fund with a low liquidity portfolio may be forced to liquidate blue chip liquid stocks to fund redemptions leaving relatively lower quality stocks in the portfolio. By knowing what Fund Portfolio Liquidity entails, you can avoid being caught in a situation like that!