Swedroe: Ignore Liquidity At Your Peril

December 04, 2015

Another Side To A Global Risk

Summarizing, liquidity is a priced risk around the globe. It’s also a risk that tends to correlate highly with equity risk, showing up at the worst of times (such as when labor capital becomes riskier). It’s also a partial proxy for the size premium, although not the value premium. That said, as is the case with most risk stories, there’s another side to this one as well.

Investors who are able to act as liquidity providers during periods when liquidity is stressed can benefit by earning a larger liquidity premium. For example, a small-cap or emerging market mutual fund that must sell stocks to meet redemption demand will pay a steep price to trade in bad times. Patient buyers on the other side of the trade earn larger liquidity premiums during such periods. Warren Buffett is probably the most-well-known patient buyer. However, there are mutual funds that can also act, at least to some degree, as patient buyers.

A good example is Dimensional Fund Advisors (DFA), which, to my knowledge, was the only mutual fund family to receive net cash inflows into its equity funds during the recent financial crisis. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) Investors in their funds tended to rebalance into stocks instead of engaging in panicked selling. Not being concerned with replicating the returns of a benchmark index allows them to trade more patiently.

There are two important takeaways from the evidence on liquidity risk. First, liquidity risk should be a consideration when you design a plan, both in terms of your asset allocation and your choice of investment vehicles. Second, the fact that IML is a premium for taking risk that shows up in bad times has implications for the type of bonds used to implement the fixed-income portion of your portfolio.

The evidence presented highlights the importance of owning assets that perform well during bad times, when liquidity risks rears its ugly head. Thus, you should strongly consider owning only safe, liquid bonds. U.S. Treasurys are the safest and most liquid of bonds. As such, their diversification benefits tend to show up most strongly when they’re needed most. While their correlation with U.S. stocks is about zero over the long term, during bear markets, the correlation turns highly negative.

Other safe fixed-income investments you should consider are FDIC-insured CDs and municipal bonds that are rated AAA/AA and are also either general obligation bonds or essential service revenue bonds.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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