As we’ve seen in previous articles, liquidity is ‘good’ only if your need for it isn’t shared by most other market participants at the same time. If everyone else wants to liquidate at the same time you do, liquidity can be a very bad thing. But if liquidity isn’t always good, how did we get to this point where nearly everyone believes the most prudent strategy is always to stay liquid? The answer is that we’ve been conditioned to favour liquidity, thanks to a bunch of systematised biases and the result has been a widespread case of what I call liquidity bias.
For starters, consider the concept of T+2. Set by the SEC, T+2 is the requirement that stock-market trades settle – and that you get your money out – two business days after trade date T. (The rule has changed over time from T+7, moving most recently to T+2 in September 2017.) The point of requiring trades to settle in two business days is to keep markets moving swiftly and to reduce the likelihood of default. Since liquidity is the ease with which you can buy and sell the assets you want in the quantity you want, liquidity is effectively mandated by T+2 for most broker-dealer security transactions.
“Wall Street is like a shark that has to swim to breathe and liquidity is what keeps its heart pumping”
The notion that you should be able to get your money out in a couple of days has become a kind of creed for investors of pretty much every stripe and it’s the accepted guideline for institutional investors. Thus, T+2 is one important source of liquidity bias – but it isn’t the only one.
Liquidity is essential to the basic mechanics of the financial industry. Brokerage commissions are generated on the basis of liquidity: a trader makes money when something is bought or sold, not when it’s held. Wall Street is like a shark that has to swim to breathe and liquidity is what keeps its heart pumping.
The industry’s basic need for liquidity is then magnified and reinforced in countless ways. Individual investors rely on advisors and institutional investors typically rely on consultants who recommend investment strategies and portfolio composition. Often the entire content of an institutional investor’s investment policy, which dictates what they can and cannot do, and the maximum allocation to various strategies, is guided by a consultant. Such consultants are, in a sense, the gatekeepers who provide entry into financial markets. And these consultants, as well as the analysts they employ, predominantly come from a background in liquid securities. Maybe they cut their teeth at a trading desk or they analysed stocks and bonds. Whatever their training, they probably had direct experience with liquid assets and little or no direct experience with illiquid ones. That means they see investment opportunity in terms of liquid securities, often without ever looking elsewhere.
These gatekeepers rely on data to make recommendations to their clients and this is another circumstance that reinforces liquidity bias. The key input advisors and analysts use to scrutinise and ultimately recommend any given strategy begins with a benchmark – the S&P 500, say, or Barclays Global Bond Index. These indices are meant to reflect the risk, return and volatility, and therefore the attractiveness, of any given investment. Typical analysis of a prospective strategy involves combining multiple indices into a series of hypothetical portfolios and gauging the assessed risk and likely return. Such analysis is relatively easy to conduct – thanks to the overwhelming availability of data on liquid markets, which are free or at least very cheap, and are updated at high frequency. Data on liquid markets is, essentially, liquid. And all this free-flowing data creates a sense of security (even if that security is something of an illusion), which reinforces liquidity bias.
“Liquidity bias isn’t just a behavioural bias, like anchoring or herding”
This pervasive bias has gone on to shape the entire world of finance through the lens of liquidity. All of the analytical approaches to portfolio construction – including portfolios of illiquid assets – borrow from and mimic the rules of liquid investing, because those are the ones that every CFA knows. The prevailing definition of diversification, which is based on the notion of an efficient frontier, comes from the world of liquid securities (as we’ll see, such concepts don’t necessarily apply very well to the illiquid world, in which assets are idiosyncratic.) In this way, liquidity bias isn’t just a behavioural bias, like anchoring or herding. It also affects how we think about risk and about the assets themselves.
This bias is further compounded by the fact that the vast industry of advisors and analysts who serve investors of every stripe tend to be hired by chief investment officers who, nearly always, come from a background of liquid securities. This means that pretty much everyone at the table, from the top to the bottom, speaks the same language: the language of liquidity.
Liquidity bias comes from all these sources, and it is continually magnified and compounded by the fact that everyone has the same orientation: toward liquid securities and away from any other sort of investment. But that means there is no one around to even to ask the question: what if we’re missing something?
