Of the £200bn in savings accumulated by UK households during the pandemic, the vast majority is sitting in instant access savings accounts. This is perhaps not surprising in a time of crisis, when one of the triggers for saving – as well as the lack of opportunity to spend – is uncertainty about the future.
In more normal times too, however, people show a marked reluctance to lock their money up for extended periods and are willing to miss out on better returns to ensure they can get their hands on their cash if they need to.
The same is true of investors. By their nature, many people saving for retirement are long-term investors but most will have their money in funds offering daily liquidity. Again, this makes sense – many of the asset classes that make up a well-diversified portfolio are readily available in daily liquid funds, so there is no need to lock money away for longer. As the FCA’s 2021/22 Business Plan reminds us, however, there can be a premium available for those with longer investment horizons, which few are currently exploiting.
Savers who remember higher interest rates may often look for higher rates, which has led to the manufacture and sale of harmful illiquid interest-paying investments as cash alternatives. Illiquidity without patience – and complexity without advice and expertise – causes scandals such as mini-bond mis-selling.
Long-term view
Nevertheless, the regulator has stated it wants asset managers to “enable investment in less liquid assets for those with a long-term investment view who can cope with the risk of these investments”. Broader access to assets such as infrastructure and private equity could potentially improve portfolio diversification and boost returns for long-term investors.
In currently available structures, there is already a choice as to how investors can access less liquid asset classes – that is, through an individual advised portfolio, a discretionary managed portfolio or a collective investment scheme. These already give the investor quite different experiences and outcomes when it comes to the illiquid investment within. In addition to these approaches, the regulator is now looking at a new type of fund structure to accommodate less liquid investments and the consultation has recently ended.
Of course, liquidity is also a risk to be managed – and the regulator’s business plan reflects this balancing act. In the 2021/22 year, the FCA also wants to ensure asset managers “manage liquidity in funds to avoid unnecessary risks to investors and market integrity”.
This comes after most of the UK’s open-ended property funds were gated in the market turmoil of March 2020. In August last year, the regulator consulted on approaches to managing liquidity in funds for which there is a mismatch between the dealing period of the fund and the time required to sell the underlying assets. The decision on whether such funds should be required to introduce a mandatory notice period is expected soon.
Relative issue
Even in supposedly more liquid asset classes, liquidity can still become a problem. During periods of financial tightening, institutional and retail investors tend to behave in the same way, with a flight to safety and liquidity. And in any diversified portfolio, some parts will be less liquid than others – emerging market equities, for example, are likely to be less liquid than their developed market peers.
Typically, the problem of liquidity for the well-advised investor is dealt with through diversification. If the client has an investment horizon sufficient to take on some liquidity risk, this is balanced elsewhere in the portfolio through exposure to more liquid assets.
Portfolios are constructed based on expected correlations between asset classes, to manage overall portfolio risk and maximise potential return for that risk over the course of market cycles. Liquidity risk is also often managed by carving out a proportion of the client’s assets into cash – for example, cash expenses for the next six to 12 months.
In practice, however, these approaches have their limitations. Bear markets often bring about changes in the correlations between individual assets, as well as between asset classes, meaning the assumptions that underpin portfolio construction can fall down. Holding significant sums in cash is also suboptimal in terms of time in the market and can be particularly damaging in certain market conditions.
What’s the alternative
So, what’s the alternative? How can we help clients to understand the level of liquidity they require and manage liquidity risk across the overall portfolio? First, we can take into account illiquidity risk in cashflow planning, running cashflow without access to illiquid parts of the portfolio for a significant period.
Second, we can ensure we are using sophisticated correlation matrices that provide detailed analysis of the relationships between different parts of the portfolio – including in periods of market stress. Third, if the client is in decumulation, we can manage risk more tightly and more frequently, on a monthly rather than a quarterly or annual basis.
Finally, as ever, it is about good communication. At portfolio review time, it is important to talk to the client about potential illiquidity in the portfolio, taking into account both changes in market conditions and in the client’s own circumstances to ensure any choices are still appropriate.
By understanding the client’s needs, plans and level of sophistication; making an investment and cashflow plan that reflects those needs; and keeping the communication channels open, advisers can help their clients strike the right liquidity balance.
Ben Goss is CEO of Dynamic Planner
