Balancing the need for liquidity in an investment asset

The euro/US dollar is the most liquid currency pair. PHOTO: BLOOMBERG

When it comes to investing, liquidity has two aspects - first, the ability to convert an asset to cash quickly and, second, perhaps more importantly, the ability to convert to cash without the asset losing value.

In general, it is preferable to purchase something with a good amount of liquidity because you will be able to dispose of it quickly without affecting the asset's value.

Let's take the example of buying currency. The foreign exchange market is the most liquid market in the world, with trillions of US dollars changing hands every day. The euro/US dollar is the most liquid currency pair, with billions of euros and US dollars being exchanged a day.

So if you need to sell US$10 million (S$13.5 million) to buy euros, it would be but a drop in the ocean of liquidity. This ensures that the price that you get for your US dollars would be a fair market price as the market is full of ready and willing buyers of your US dollars.

Unfortunately, not everything is as liquid as the foreign exchange market. Think about trying to sell your house - it could easily take months to even years to find a buyer. That may be fine if you are happy living in your place and can wait for months and years to sell the property, but it could present a problem if you had only a few days.

Don't shy away from less liquid products such as structured notes or insurance products which you intend to hold over a long term. But be aware of how much you are allocating to these investments.

You may have to sell the property at a discount, in order to liquidate it quickly. Furthermore, with the sluggish local property market today, the number of transactions has all but dried up compared with its heyday. The lack of ready buyers may mean an even bigger discount.

There are numerous situations why investors might need cash within a short period of time - for example, they may see a business opportunity or an interesting investment opportunity, or they might be caught in the painful situation of receiving a margin call when their investments turn south.

However, we have also seen many instances where investors panic-sell their investments when markets were falling. There is no individual need for cash in this instance but investors are just trying to salvage what value they can from their investments. This can cause liquid investments to suddenly become illiquid, due to the lack of ready and willing buyers in the market.

A case in point: In the global financial crisis in 2008, many money managers decided to "gate" their funds (that is, not allowing redemptions) so as to prevent selling their assets at a depressed price. This resulted in investors losing their financial liquidity. Financial institutions and their clients all faced a liquidity crunch which eventually caused a meltdown of the banking system.

The experience of the global financial crisis has seen many investors shy away from illiquid assets. Financial products which offer quarterly or monthly liquidity are today quickly shunned. "I have to wait a month before I get my money back? No thanks."

Today, we also see a shift towards portfolios which buy into traditional large-cap stocks and bonds where liquidity tends to be more abundant. Having illiquid assets in your portfolio is now seen as "dangerous".

On the flip side, there remains a good premium paid for investors who are willing to lock their investments with asset managers. With basic fundamental investing being propagated on long-term investing, wouldn't it make sense to allow for a fund manager to grow your monies over a longer period of time?

In fact, during the global financial crisis, despite holding products that could be liquidated daily, most investors held on to their losing positions and waited for them to recover. So are we giving up returns for something that we might not actually need: liquidity?

For more sophisticated private equity investors, many of these products come with a five- to 10-year lock-up period, but they are compensated for the illiquidity with higher return targets. In the same way, many insurance products can provide decent return profiles and also cover an investor's protection needs. These insurance products also offer liquidity but there might be bid-offer spreads and lower surrender values.

The trick is in the lock-up period. The lock-up period allows for the investment professionals managing the funds to have a longer-term horizon to work the power of compounding without worrying about investors who may want to withdraw their funds any time.

So don't shy away from less liquid products such as structured notes or insurance products which you intend to hold over a long term.

But be aware of how much you are allocating to these investments. Keep a portion of your investment portfolio in different liquid investments across asset classes so that you lower the risk of all that liquidity suddenly disappearing if there is a market crash; and, of course, keep some cash aside for a rainy day.

•The writer is head of investment advisory, strategy & managed investments at Standard Chartered Bank (Singapore).

A version of this article appeared in the print edition of The Sunday Times on August 14, 2016, with the headline 'Balancing the need for liquidity in an investment asset'. Subscribe