Does liquidity matter? - The Lemon Fool (2024)

What's your opinion here?

We're often advised to steer clear of illiquid stuff - smallcaps, real estate funds, smaller ETFs with higher spreads etc.

Personally.. it doesn't put me off too much.. so long as the market can absorb the sort of volumes that I typically deal in, which is usually <£5k at a time. The worst thing is the higher spread you have to pay, but if you are a buy and hold investor then at worst this is like a 1% front-loading fee or less. Can also make it difficult to cheaply reinvest dividend income unless you also have a significant chunk of new money you also want to put it... this is true though of liquid stocks, just due to the size of the dividend income in relation to the typical £8-10 buy execution order.

The official price from the exchange can wobble around during the day depending on if the last exchange was on the bid or the offer, but that's just how live pricing works.

I can understand it being a concern for institutional money, as they often have redemption orders they have to meet, often at times of high stress in the markets, so being a forced seller when everyone else is in the same boat will inevitably result in your participation of a panic sell event.

Well I would argue that liquidity is very situational dependent.

For example I've been going through some cash flow issues recently and liquidity and sequence risk have been/are an issue.
A year ago less so.
Two years ago, totally unimportant.

Of course the somewhat obvious solution is to adopt diversification. Holding some quite liquid investments to deal with events. Some people take this as far as having a significant cash holding. As I don't do that I have to scramble to meet bill deadlines.

vand wrote:What's your opinion here?
We're often advised to steer clear of illiquid stuff - smallcaps, real estate funds, smaller ETFs with higher spreads etc.
Personally.. it doesn't put me off too much.. so long as the market can absorb the sort of volumes that I typically deal in, which is usually <£5k at a time. The worst thing is the higher spread you have to pay, but if you are a buy and hold investor then at worst this is like a 1% front-loading fee or less.

The spread can be way more than 1% in some cases of course. I was buying Fixed Interest with c5% nominal spreads, but as you say it doesn't really matter if you plan to hold, so long as the SP moves in the right direction such that eventually you are above water.
If one's hold is situational... example, waiting for the SP to respond to rate cuts, one has to accept that the spread will come into play again at the chosen exit point.
So I'm OK with illiquid stuff, just not too much of it. As Urban said, one may not intend to sell, but stuff happens, sometimes.

V8

I class all of the assets in the OP as liquid for the purposes of a PI. Illiquid stuff is real estate, art, classic cars etc. I have bought a commercial property and feel absolutely trapped by it compared to any tradeable security I hold. My most illiquid security is a bond tradeable only in shapes of 50,000 which practically doesn't have a market. When push comes to shove though, I am confident I could find a buyer within a day or two and get the deal done. The trick is to make sure these positions are kept small.

GS

I don't mind having a significant proportion of my portfolio in illiquid stocks.

I keep enough cash for living expenses and unexpected emergencies. I also have enough liquid stocks that could be sold if necessary.

Furthermore, there are studies out there that claim illiquid stocks outperform the market. That would make perfect sense, if enough people avoid them to depress the buying price. The one that do well and grow become more liquid.

However, what I dislike is the high spread. This has often been around 7% on some of the illiquid stocks I hold.

To me, the problem seems to be the greed of the market makers who push the spread up and therefore create illiquidity. After all, if a particular stock has a high spread, this is likely to deter short term investors.
A few months ago, there was a report on market liquidity. However, as it was sponsored by a market maker, they didn't even consider the effect of the spread on liquidity.

Ideally, we would have a system where every broker allows investor orders to be matched with other investors orders & we just pay a fair broking fee, with zero spread added.

I think it's a bit more of a personal issue for a PI.

If you hold other liquid things then some illiquid holdings shouldn't be an issue. A fund manager might have different problems. You selling £5k of a small cap is probably manageable. The fund manager trying to sell £200k. Look at the Woodford story how things can go wrong.

Generally under normal circ*mstances things are fine but it's when things are not normal things tend to take a turn. Often when markets tank or there is a run on a particular fund/share.

I suppose that's where commercial properties struggle. They can't sell property fast enough. Some are now holding a lot more cash.

For us individuals, maybe having to pay off a house might be a crunch point if it happens when the market crashes. Most talks about finance includes holding 6 months to 3 years spending money. So I suppose it does matter

vand wrote:We're often advised to steer clear of illiquid stuff - smallcaps, real estate funds, smaller ETFs with higher spreads etc.

Real estate funds are definitely a class to be avoided. They have had liquidity problems for many years. REITs are a far better medium for most investors.

TJH

jaizan wrote:I don't mind having a significant proportion of my portfolio in illiquid stocks.

I keep enough cash for living expenses and unexpected emergencies. I also have enough liquid stocks that could be sold if necessary.

Furthermore, there are studies out there that claim illiquid stocks outperform the market. That would make perfect sense, if enough people avoid them to depress the buying price. The one that do well and grow become more liquid.

However, what I dislike is the high spread. This has often been around 7% on some of the illiquid stocks I hold.

To me, the problem seems to be the greed of the market makers who push the spread up and therefore create illiquidity. After all, if a particular stock has a high spread, this is likely to deter short term investors.
A few months ago, there was a report on market liquidity. However, as it was sponsored by a market maker, they didn't even consider the effect of the spread on liquidity.

Ideally, we would have a system where every broker allows investor orders to be matched with other investors orders & we just pay a fair broking fee, with zero spread added.

Yes... actually I work in this area so understand a bit about it.. the market makers' aim is, unsurprisingly, to maxmimize their profit while remaining market neutral. In practice that means they have to finely balance the spread they offer to both attract the orders while making it profitable for them to do so. And of course, the fewer brokers covering the smaller stocks the less competition there is amongst them and the wider the spreads tend to be.

It's a bit of a chicken and egg situation - low liquidity is one of the reasons traders/investors stay clear of the a stock, and because they stay clear, volumes are low so the market makers maximize their profit by widening the spread on such stocks rather than rely on volume on a liquid stock with tight spreads..