Quell Your Worries With Liquidity
WeĂ˘â‚¬â„˘ve all heard the saying, Ă˘â‚¬Ĺ“cash is king,Ă˘â‚¬Âť but in our investment world the word cash should be replaced with the word liquidity. Yes, for us, liquidity is king.
Why am I even talking about cash and liquidity in this up market? After all, in this balmy and spring-like March, the market is doing very nicely indeed. Although the S&P 500 was down 1.6% in the first days of the month, it bounced back magnificently, and now the index is up 2% for the month and almost 11% for the year. The financial sector, as represented by the Financial Select Sector SPDR (XLF), gave us quite a ride this week — and, if you were long financials, it was a beautiful thing.
Further, many technical indicators are apparently pointing upward (I donĂ˘â‚¬â„˘t follow these — I just read the headlines). Although technical analysis is not my prime focus, I can say that our Rockledge Sector Scoring and Allocation Methodology, which is based on the fundamental analysis, does point to a mildly bullish market in the medium term of the next three months.
Everything seems to look good, so why am I worried? What is that nagging feeling?
To answer that question, letĂ˘â‚¬â„˘s back up a bit — to 2008. For investors, this was an important and memorable year for many reasons. Obviously it was unforgettable because of the large and painful market drop and the corresponding recession. But, as bad as that was by itself, several important factors made it not just painful, but very, very scary for investors. The most prominent and the talked-about factor was the significant increase in cross-asset correlations, which limited our ability to use safe heavens (except cash, of course) and basically gave us no place run or hide. The other factor was liquidity or, rather, lack thereof.
The lesson I learned from the increased correlations was diversification. As readers have heard from me here many times, the one and only answer to high cross-asset correlation is allocating to alternative strategies. A general sort of diversification — letĂ˘â‚¬â„˘s say, into many stocks — is meaningless. The true benefit of diversification lies in the use of alternative asset classes that are non-correlated.
This is the core and the foundation of the Ă˘â‚¬Ĺ“endowment investment modelĂ˘â‚¬Âť at such institutions as Yale and Harvard. If you look at the latest endowment surveys, the funds at these universities allocate more than 20% to alternative strategies that are non-correlated to broad market indices. With this, they are profiting from lower overall portfolio volatility and higher risk-adjusted returns. These institutions, unlike most of us, benefit from access and ability to invest in hedge funds and other providers of non-correlated strategies.
However, IĂ˘â‚¬â„˘ve recently had a very interesting discussion with the head of a large and successful billion-dollars-plus family office here in New York. He has been a long proponent of diversification and using hedge funds to access alternative strategies and achieving non-correlated returns — yet he actually implied that we, as retail investors, might now be in a better position now than he. We were taken aback at first, but it all makes sense, and the reason is this: liquidity.
Allow me to explain. For those who are unfamiliar, investing in hedge funds means putting your money into partnerships — and these are as hard to exit as they are to enter. Investing in a hedge fund typically requires that you become a limited partner of this fund, with all the attendant financial and legal hurdles — and getting your money back is similarly addled with strict and specific procedures. First, you are typically required not to withdraw your funds for a year. Then, once you satisfy your lock-up period, you can only withdraw in two ways: several times a year (as when you sign up for a health insurance with your employer) and/or typically with a 60-day notice.
Just imagine the market falling further and further, during which time you have to calmly type a withdrawal notice, print it and sign it. Then you must fax it to your hedge fund (if you still have a fax machine, that is) and ask them politely to send you money back in 60 days, all while you are watching CNBC flashing red. It would make anyone queasy.
But wait, thereĂ˘â‚¬â„˘s more. Many of these funds have incorporated gating terms into their agreements, which limit how much total money can be withdrawn from the fund per month, or per any individual investor. In theory, this is to prevent a Ă˘â‚¬Ĺ“runĂ˘â‚¬Âť on the fund, but in practice you are stuck in front of a closed door.
All that said, I am not saying you shouldnĂ˘â‚¬â„˘t allocate to hedge funds — not at all. Quite the opposite, in fact: Most hedge funds have excellent track records and provide outsized returns. They typically have superior portfolio managers, and that is exactly why you might be willing to sacrifice a short-term lack of liquidity for longer term alternative non-correlated returns. So, certainly if you have access to a good fund, IĂ˘â‚¬â„˘d encourage you to consider it. The key word here is Ă˘â‚¬Ĺ“access,Ă˘â‚¬Âť because a typical retail investor wonĂ˘â‚¬â„˘t have that.
The good news is that there are more and more retail ETFs — meaning, vehicles with real-time liquidity — that allow us to access alternative and non-correlated strategies to achieve similar objectives as sophisticated investors do. (See my article last week for an example or email me for the list.) In this way, all of the above-mentioned issues are heavily mitigated. Yes, the ETFs might drop while you are placing a market order in a down market, but I am sure you would feel better waiting a few seconds to get your money back, as opposed to 60 days.
At the time of publication, Gurvich and Rockledge clients were long XLF.