This is not the most exciting topic in the world but if you get it wrong when it comes to liquidity you can really suffer. The main thing I would like to make sure you understand is the differences between stated liquidity and the actual liquidity of a fund’s underlying assets. The big difference often lies in the valuation method used.
Many funds trade exclusively in liquid securities such as shares on a major stock exchange, or futures contracts. When things don’t go so well, and investors start to want to redeem some or all of their investments, it is quite easy for these funds to go dump their holdings on the open market to raise the cash required to meet such redemptions.
Generally the funds which trade in very liquid securities have a “mark to market” valuation method. This is easy to do because of the large number of transactions, and thus the last sale is generally a good proxy of the price the fund could achieve if it needed to liquidate its holdings. Slippage is the technical term for the difference in what they would actually get, since their own selling pressure would cause the market to move against them. Generally slippage is relatively small even for a large fund if the markets are very liquid.
Mark-to-model on the other hand, requires a much more complicated estimation of the net asset value, or what the shares of the fund are actually worth. Property funds tend to be mark-to-model out of necessity, since there is no exchange for buying and selling properties. In practice the models can be somewhat misleading sometimes, since there is a conflict of interest involved. Obviously, the more favourable the model used, the better the returns look and the easier it is to market the fund.
This is where you can get caught in a trap if you aren’t careful. Most mark-to-model funds promise unrealistic liquidity terms. They may trade monthly and if all is going well you can redeem and be paid out in a month. However, and this a big however, if it all goes wrong it can very quickly turn into a situation where you wait years for your money back.
As there have been several high profile failures in property funds recently, there has been a small backlash against mark-to-model funds in the international advice industry. Many advisors are selling out of them en masse and this actually makes the problem worse, as some funds end up suspended out of nothing other than fear.
My advice is to simply manage the liquidity based on the underlying holdings as opposed to avoiding mark-to-model funds altogether, since they can provide a much needed bit of diversification and non-correlation to traditional asset classes.
In recent times where when things go bad, traditional asset classes have become more and more correlated and this is a very difficult thing for investors to deal with. Simply make sure the vast bulk of your portfolio is in funds which trade in liquid underlying assets. I would keep it to a maximum of 20 percent of your portfolio. This way, if all of the mark-to-model funds you hold get tied up simultaneously, you ought to have no reason to worry about having liquidity troubles.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK pension transfers. He can be reached at firstname.lastname@example.org. Faramond UK is regulated by the FCA and provides advice on taxation and pensions.