In a recent comment (see "Waltzing through the blogospher," November 28, 2009) Steve Campisi wrote about the need to measure liquidity risk, citing the difficulties that the Yale Endowment fund had. It just so happens that this month's Institutional Investor's cover story deals with the huge drop in assets major colleges have seen in their endowments, effective the fiscal year ending this past June 30. The drops have been quite staggering, with the average loss being roughly 20 percent.I'm intrigued by the notion of liquidity risk, but I can see huge challenges with it, too. How does one properly assess this risk, especially when the variables that can impact it can be quite significant. It was probably a lot easier selling your Dubai World bonds a few weeks ago than it is today, right? During a flight to quality liquidity dries up. If you don't have to sell an asset that is down, you can perhaps afford to wait around to see if it recovers its value. But, there are times when you must sell, thus you encounter liquidity risk and lower prices. Long-Term Capital Management WAS able to recover the value of just about all of their assets...the problem was they couldn't afford to hang around and had to be bailed out. Perhaps stress testing your portfolio would be one way to determine what your risk is.
More details will help, and we hope to see this topic explored in greater detail.
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The comments posted on this blog about the "problems" inherent in identifying, measuring and evaluating risk are surprising in what they may reveal about the performance analyst's viewpoint on risk. First, it seems odd that the majority of the information posted is typically about measuring returns according to standard procedures - while any discussion of risk has the feel of delving into a deep mystery that borders on the unfathomable. In reality, it's not really that hard to "get one's arms" around risk.
ReplyDeleteThe first challenge may be discomfort with the ideas that: a) risk may not come from a single source, b) that each type of risk may not have a single interpretation, and c) that risk may not be best measured by a standard calculation - in fact its measurement may not necessarily be a number, but instead could be a simple comment. For example: "Liquidity risk is LOW because we have 4 years of cash flow invested in highly liquid Treasury bonds."
The key perspective needed is the understanding that the investment process is first and foremost a RISK MANAGEMENT process; it is NOT necessarily a return enhancement process. Rather, the investment process first concerns itself with meeting a client's financial goals, and the initial responsibility is to establish an appropriate portfolio strategy. So, the first question to ask is: "How much risk is appropriate, given the client's tolerance for risk?" The answer results in the efficient allocation of capital, and this capital allocation is essentially the creation of a basket of risks, each with a promised return. So, return is the result of risk.
We may than try to enhance the market return of the portfolio with a) tactical shifts of capital and b) active management of the individual investments in each asset category. It's important to note that we begin with risk management and then try to increase return. Risk first, return second. Any active management must be evaluated in the context of risk. To do that we must identify the types of risk and get a sense of how much return we have earned relative to the additional risk(s) taken.
This is true for both individual products and especially for entire client portfolios.
So, what about liquidity risk? It's not really difficult to define or to measure. One simple method is to evaluate how much of the portfolio could be sold within a stated period without a significant price concession. For example, about 5 years ago I allocated a certain portion of a client's portfolio to short term bonds. This was a precaution against the perils of a 2008 scenario where all risky assets had depreciated. We determined that 1/2 of this bond portfolio could be sold within a couple of days and the remainder could be sold within a week. That was enough of a "risk analysis" for the client's situation.
But we must be careful not to make the process too simple. For example, some investors define liquidity simply in terms of access to their money. I think that is a mistake: investors need access to a stable amount without the uncertainty of the ups and downs of the market. So, is a large cap equity mutual fund "liquid" just because the fund company must redeem your shares at NAV? Of course not; this would probably involve selling your shares at a deep discount, thereby guaranteeing that you never join in the subsequent market recovery. Yet many investors considered most of their portfolio "liquid" simply because they could redeem their investments in a day. This proved to be a costly mistake, especially for the large endowments.
So, do we need a "standard calculation" for liquidity risk? Of course not. Could we evaluate the liquidity risk of our portfolios? Of course we can. Maybe it's simpler than we think.