By John Bowman, CFA, Senior Managing Director at CAIA Association
"Of the maxims of orthodox finance, none, surely, is more antisocial than the fetish of liquidity”
- John Maynard Keynes
Fashioning a common enemy is the work of a brilliant politician, military general, or coach. When well executed, it results in unmatched solidarity and emotional loyalty. In the capital markets, however, it is intellectually lazy and foolhardy. Mr. Market doesn’t care what the “smart majority” believes. I fear we are beginning to see this tactic emerge in the growing demonization of illiquidity.
Liquidity of an asset is neither inherently good nor bad – at its root, it is the ease of converting an asset or security into cash. If the world operated in a ‘ceteris paribus’ framework, immediate access to transactional currency would obviously be an attractive feature of any security. But the capital markets are far from black and white and anyone that has spent a minute in this industry has the scars to prove it. One of the first principles of asset management is the tradeoff between liquidity on one side and a return premium, complexity, asymmetry of information, and lack of uniformity in disclosure on the other. As such, prescribing the appropriate amount of liquidity need is purely a function of an investor’s time horizon, sophistication, and risk tolerance.
A recent article from the FT columnist, John Plender, fell into this same trap. Plender rightly outlines how the global banking system’s lack of liquidity and capital levels were exposed during the GFC. He then applies these lessons to the steady rise of private capital allocations of global pension funds; arguing that even Keynes would be worried about our current “fetish with illiquidity.” But here’s where swinging the proverbial hammer at every nail breaks down. Banks must ensure appropriate capital levels to provide access to short-term retail deposits, money market funds, and overnight loans. Plender is therefore absolutely correct that the Basel and Dodd Frank reforms were sorely needed to protect monies and grease the system where high liquidity is essential. But we must not confuse short term bank deposits with the multi-decade and sometimes timeless horizons of pensions, sovereign wealth funds, and endowments. These pools of capital certainly need to meet varying current liabilities but are largely in existence to protect and serve future generations of laborers, citizens and students. The investment offices charged with fiduciary responsibility to meet those investor outcomes are right to take advantage of the illiquidity premiums and inefficiencies of private equity, private debt, real estate, infrastructure, and natural resources. Alpha, after all, is simply undiscovered beta.
This fetish with liquidity has led us to try to convert highly complex assets into regulated, retail mechanisms. Whether it’s liquid alternatives, the recent SPAC craze, or various other attempts at stuffing private capital into 40 Act or UCIT’s wrappers, the result is always the same. When the asset is neutered of the elements that differentiate it from the public, short-term, highly-regulated markets, you sand much of the polish off. There is no doubt that these private fund structures need effective reform, but we must stop setting these mutually exclusive approaches to investing against each other and recognize they both have advantages and weaknesses. A wise investor should take advantage of both. A 25-year-old building her 401K allocation should have very little concern about liquidity. In fact, as founding AQR principal Cliff Asness wrote in December of 2019, perhaps we should accept a lower return for the benefit of illiquidity, you know, to protect ourselves from ourselves. Likewise, a 65 year-old must prioritize liquid income in building his asset allocation.
It doesn’t escape me that I write this the first day of trading of the Robinhood IPO. Here’s a case of the other extreme where over-liquefying a marketplace has resulted in disappointment, confusion, and massive wealth loss. The marketing tagline that “we were all born investors” sounds democratic and populist but is a manipulative tactic that places unprepared individuals at serious risk. It’s as if the capital markets are nothing more than an alley bowling game at Chuck E Cheese: “Here are your game tickets; T+0 for everyone!” This is not investing, it’s gambling with a young person’s future dignity.
Teaching the next generation financial literacy and building accessible and even fun platforms that equip them to save and invest is a wonderful aspiration and I applaud Robinhood for that. However, I have a deep concern that if we hyper-fractionalize and securitize everything without educational gates or protection, we are failing our civic and professional duties. The common enemy here is not institutional traders or hedge funds or stodgy traditionalists (insert your favorite “them”) but rather caricaturing or gamifying a noble profession.
Lack of liquidity is not the problem nor the common enemy. The true culprit is lack of balance in the public square and the popular press. A long-term investor should take advantage of the full risk premia available in the public and private markets, knowing they both come with risks and baggage. These are not opposing forces for which we need to take sides, but complementary sleeves in a portfolio. Nuance is the adult form of dogma.