A Different Liquidity Trap

Liquidity has its dangers. The evidence is fairly clear that humans (and that category includes most investors) tend to make economic decisions that are not in their best interest. Liquidity, as it turns out, can enable this irrational behavior.

Let me back up. Behavioral finance is a young science that uses psychology to understand irrational thinking. A well-known experiment in the field gives a good illustration of the phenomenon. Imagine you could save $7 on a $25 pen by traveling 15 minutes away to a discount store. When asked, most people say they would be willing to do that. But they would not be willing to travel 15 minutes to the same discount store to save $7 on a $488 suit.

“What’s going on here?” asks Dan Ariely in his bestseller, Predictably Irrational. Saving $7 should mean the same to the consumer regardless of the item being purchased. The problem, he says, is relativity. Wrongly, most of us see a $7 savings on a $25 pen as somehow worth more than a $7 savings on the $488 suit. Yet, the return on investment of the time spent is the same, having nothing to do with what is being purchased.

It’s not just social scientists who are poring over evidence of our irrational behavior. Dalbar, the Boston firm that evaluates the financial services industry, has been studying money flows in and out of mutual funds for 30 years, and concludes that investors can be their own worst enemy. They tend to make bad decisions at critical points, in both up and down markets. The worst case was October 2008 when equity investors lost 24.21% while the S&P 500 Index lost 16.80%. The second biggest underperformance gap took place in March 2000, when the S&P surged 9.78% but investors took home only 3.72%.

Dalbar’s studies show a substantial spread between returns of funds and the returns of the investors in those funds, primarily related to timing of investments.  Philip Maymin of New York University and Gregg Fisher of the investment management firm Gerstein Fisher, wrote a more academic piece a few years back that reached similar conclusions. Their title says it all: “Past Performance is Indicative of Future Beliefs.”

Which brings me back to the subject of liquidity. The ability to convert any asset into cash immediately and easily sounds like a perfect goal for investors. In 2008, the opposite happened as liquidity decreased for every asset except cash and short-term Treasury bills. The experience was not easily forgotten. In fact, behavioral finance tells us that investors remember losses more vividly than gains, even if their gains are greater. Investors reasonably concluded that step one in avoiding similar losses required staying liquid.

It’s no surprise that liquid alternative mutual funds experienced a 22% annual growth in assets (excluding commodity funds) between 2010 and 2014, versus 12% for mutual fund industry overall.  Investors were also looking for potentially higher, risk-adjusted returns, of course, but that goal had to include liquidity.

As the above referenced studies suggest, though, the liquidity “trap” can come at a cost, behaviorally speaking. The ease with which the average mutual fund investor has been able to buy and sell securities does not always turn out to be an advantage.

Does that mean investors should protect themselves from themselves by allocating assets to illiquid investments?  It’s a question more will be asking as private equity, considered one of the least liquid of investment alternatives, makes its way to the retail market.

Traditionally, private equity has been available to institutional investors or high net worth individuals—accredited investors–who could meet the high minimums and who could afford to lock up a portion of their assets for years. Private equity mutual funds now coming to market (full disclosure: our firm, Altegris, offers one) give a broader group of investors access with characteristics similar to mutual funds.  But, importantly, they do not offer daily liquidity. Thus managers of these private equity funds can ignore the market’s demand for instant performance and untimely withdrawals.  They can focus intensely on investments that generally take more time and potentially more effort to work.

Of course, private equity funds haven’t marketed themselves as a safeguard against irrational behavior. It’s their track record that has attracted university endowments, foundations, pension funds and wealthy investors. To wit, in the 25 years through September 2015, the Cambridge U.S. Private Equity index returned 13.4% annually compared with 9.9% for the Standard & Poor’s 500 index, according to Cambridge Associates.

We have just passed the seven-year anniversary of the bull market, making this the third longest rally in history.  When the rally ends, behavioral finance studies suggest many investors, trapped by the ability to sell, will sell at the bottom and fail to get back in as the market recovers. We have already seen that in the increased volatility experienced over the last 12 months. Illiquidity might prevent you from doing just that.

This requires a very close look at what one’s liquidity requirements really are, which, of course, depends on one’s investment goals. That 3.5% illiquidity premium, as measured by the performance of the Cambridge Associates Index vs. the S&P 500, can compound into some large numbers for a child’s education or a different kind of retirement if it is maintained.

Of course, past performance is no guarantee of future results. This applies to both the liquid and illiquid markets. The odds are that we are in for a five to ten-year period of a “Warren Buffet market,” with lower GDP results, lower equity returns and greater dispersion. As Buffett recently observed, investors should be on the lookout any time the market value exceeds the value of GDP.

With a potentially lower return from the traditional markets, meeting an investor’s financial goals today does require a fresh look at allocations and some real discussions about the liquidity trap.

 

A version of this article was originally published on ThinkAdvisor here: http://www.thinkadvisor.com/2016/05/25/a-different-liquidity-trap

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