What is liquidity and why is it important?
One of the most important considerations for anyone investing in financial markets is the ability to access their money should the need arise. The ease at which this is possible is defined by the liquidity of the underlying asset, be it stocks, bonds, commodities, or real assets.
So, what is liquidity?
Simply put, liquidity refers to how quickly you can convert an asset into cash while maintaining its value. An asset that can exchange hands quickly can be described as liquid. One that takes longer to sell is considered less liquid—or illiquid.
A helpful way of thinking about liquidity is to consider the ease with which a transaction can be completed. We can see the effect of this in our day-to-day lives: Selling a bike on an online auction website is generally quicker and easier than selling a car. Selling a house will likely take longer still, as transactions become more complex and costly.
In stock markets, company shares sit across the liquidity spectrum. For a stock to be considered liquid, its shares must be able to be bought and sold quickly, and with minimal impact to the stock’s price. The shares of multibillion-dollar companies traded on major stock exchanges tend to be highly liquid. These are known as large-cap stocks and are traded in high volumes on any given day. Shares in Apple, for example, were traded on the NASDAQ more than 40 million times on August 2 alone.¹
Smaller companies—or small-cap stocks—are typically listed on smaller stock exchanges. They’re usually less liquid, which therefore implies greater liquidity risk. And because they’re not traded as frequently, any sudden spike in demand can create significant market volatility.
Volume and bid/ask spread
While there are no hard rules to determine whether an asset is liquid or illiquid, a useful way to determine the liquidity of an individual stock is to analyze its bid/ask spread and volume. This essentially boils down to supply and demand, with the bid referring to the highest price an investor is willing to pay for a stock and the ask representing the lowest price at which an investor is willing to sell for. Because these two prices must meet in order for a transaction to occur, consistently large bid/ask spreads imply a low trading volume for the stock, while consistently small bid/ask spreads imply high volume.
For example, a bid of $9 and an ask of $10 results in a bid/ask spread of $1. The bid/ask spread can also be given as a percentage of the lowest sell price or ask price. In the example above, for example, the bid/ask spread in percentage terms would be calculated as $1 divided by $10 (the bid/ask spread divided by the lowest ask price) to yield a bid/ask spread of 10% ($1 / $10 x 100). This is a fairly large spread—the spread on a more liquid stock is often a difference of cents—and a transaction is unlikely to take place.
The illiquidity premium
Because there’s less risk when investing in liquid securities rather than illiquid ones, illiquid assets tend to have higher expected returns (a risk premium) as compensation for their incremental risks and higher costs of trading. Larger, long-term investors such as pension plans and insurance companies are therefore able to use the associated risks to their advantage and diversify their portfolios with illiquid assets such as real estate, farmland, and infrastructure that not only suit their long-term investment horizons, but also offer the potential of additional returns. This is often described as the illiquidity premium.
Mutual funds and ETFs
When considering mutual funds, liquidity risk takes on a slightly different form. If the underlying assets are illiquid, a fund may not be able to meet redemption requests without significantly diluting the interests of any remaining investors. This can be a particular issue in times of market volatility, when many investors may wish to withdraw their money from the fund at the same time. Mutual funds and exchange-traded funds (ETFs) are designed in a way that enable investors to redeem their investment daily, which make them highly liquid, but the liquidity of the fund’s holdings is a vital component in this agreement.
Earlier this year, one of the United Kingdom’s best-known fund managers froze redemptions on his $4.6 billion equity fund after ongoing poor performance led to increasing outflows. The fund was invested heavily in illiquid and unlisted stocks, despite it being marketed to retail investors who were told they could take their money out at any point.²
Thankfully, rules recently introduced by the Securities and Exchange Commission (SEC) seek to prevent the same issues affecting U.S. investors by insisting fund managers of mutual funds and ETFs provide greater transparency around their holdings.
As part of these rules, the SEC now requires managers to regularly review their liquidity risk procedures, limit illiquid holdings to 15% of net assets, and classify their fund’s holdings into four liquidity categories: highly liquid investments, moderately liquid investments, less liquid investments, and illiquid investments. The classifications are based on the number of days in which the fund reasonably expects the investment would be convertible to cash (or sold or disposed of) in current market conditions without significantly changing the market value of the investment.³
Do your homework
An investor’s ability to buy and sell assets is central to their confidence and ability in the marketplace. There are no hard-and-fast rules on whether a stock is liquid or illiquid, but as we’ve shown here, there are several important measurements that can be used to get a good idea.
For investors unsure of going it alone, opting for a mutual fund can be a sensible alternative. With firm guidelines in place to prevent liquidity becoming an issue, these funds are able to safeguard access to your money when it’s needed.
1 NASDAQ, as of August 2, 2019. 2 “Neil Woodford’s flagship fund frozen for another four months,” Reuters, July 29, 2019. 3 Final Rule: Investment Company Liquidity Disclosure, Securities and Exchange Commission, June 28, 2018.
Diversification does not guarantee a profit or eliminate the risk of a loss. Investing involves risks, including the potential loss of principal. See a fund's prospectus for more details.
The views and opinions on this site are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security.