Post-Brexit: The liquidity factor

Financial markets were buoyant by the quick post-Brexit stock market recovery with the FTSE market trading well above the high for the year and the S&P index closing above its all-time high.

To their credit, the Bank of England sprang into immediate action; boosting banks' lending capacity by lowering capital requirements and making commitments to cut interest rates. These actions along with the rhetoric and easing measures by other major central bankers including the US Fed, the ECB and BOJ, in our view, attempted to calm the world's financial markets.

Amidst the exuberance created by central bankers, something else was brewing in products with inherent liquidity risk. A number of fund managers began to suspend trading on their real estate funds to avert carnage as redemption requests began to pile up and to avoid a collapse because of the liquidity crunch.

Calling for a trading halt is not a trivial matter and fund managers typically only do so as a necessary measure for prudent risk management.

When too many investors stampede for the exit, fund managers have difficulties liquidating the assets at reasonable prices within a short time. Panic sales of large volumes of assets will only lead to a steep drop in prices; that is, if buyers can even be found in such times of uncertainty.

The same situation could happen to other investment instruments such as bond funds, REITs, certain hedge funds and boutique funds, albeit to a lesser extent. Investors may not be aware of this potential for a liquidity crunch on their holdings. Liquidating large commercial properties often held by property funds are even more difficult and will take much more time.

The pause in trading gives time for the dust to settle and for fund managers to make rational decisions amidst the turmoil. It allows time to assess the market before liquidating assets to achieve the best returns. This serves to protect the interests of both fund managers and investors.

Fund managers typically hold a certain percentage of the funds holdings in cash which enables them to meet regular redemption activities. However, an excessive cash holding in the fund means less money being put to work which limits the potential returns of the fund. Fund managers need to determine the ideal liquidity threshold to maximise returns on the funds.

Does this mean that products with higher liquidity risks, such as property funds, are inferior and should be avoided?

No, not at all! Your adviser should be able to educate you on the nature of the products and weigh potential returns against the inherent risk of each product type. Financial adviser representatives play a critical role in recommending products that match your risk profiles, investments objectives and time horizons. 


Should you get out at the first opportunity once trading resumes?

Probably not, as excessive selling activities would cause the value of the assets to crash. You don't need to be excessively concerned about trading halts as it is an established risk management practice in financial markets around the world.  Even regulatory authorities call for trading halts to prevent large volumes of irrational selling in times of extreme fear.

This is also known as a 'circuit breaker' or trading curb which may be activated as necessary or when predetermined thresholds are exceeded. 


How should you deal with risk?

Since the investment process is a journey to meet investment and financial goals, it has to start with sound investment advice. It pays to engage the services of competent financial adviser representatives to be a part of the investment journey.

Financial adviser representatives work with you to identify the most appropriate asset allocations that match the risk profiles, investment objectives and time horizons to meet your individual needs. This may involve diversification into different asset classes, sectors, and/or regions.  It also involves professional advice on the various risks involved such as liquidity risk, sectoral risk and currency risks.

Taking the example of property funds, they can be an attractive component within a balanced portfolio if you are a long term investor. This is because they are good vehicles for diversification of assets due to their relatively low correlation with other asset classes, such as equities and bonds.

If you have a long term investment time horizon and have knowledge about the nature of property funds, you would be better prepared to deal with trading halts or delays in meeting redemption requests. It is important that you read the product literatures as it may contain fund information and /or warnings to the effect that you "may not be able to cash in immediately on requests because property in the funds can’t easily be converted to cash".

The biggest task ahead for the fund managers is to manage the process of resumption of trading after the trading pause. To some, it could be a monumental and nerve-wrecking event akin to a space shuttle's re-entry into the atmosphere. Well, not quite as hazardous, although it is not to be taken lightly.

It is not in the interest of fund managers to prolong trading suspensions. Preparatory work for trading resumption involves much more than gearing up liquidity levels and deciding on the best time to resume trading. Communication with the investors is the key since no one wants to be kept in the dark. 

Here are 5 things you might expect from your financial adviser representative prior to resuming trading:

  • You should be kept informed of what has happened during the suspension
  • You should be reminded of your longer term investment objectives
  • You should receive updates on market conditions
  • You should get advice on the reasons why you should consider staying invested
  • You should have your fears allayed by speaking with your financial adviser representative about your investment portfolio

These measures will go a long way in helping to achieve a smoother transition and minimising the risk of a rush to sell off when trading resumes. All this clearly shows that it is important for you to know and understand what you are buying. Caveat emptor!

Back to Brexit, let us remind ourselves that the UK has yet to invoke Article 50 of the Lisbon Treaty to officially start the exit process.

Neither the UK nor the European Union are in a hurry to do so but the market has thus far already given us a flavour of what could possibly lie ahead. While headwinds and uncertainty remain and no one can predict exactly how things will play out, not all is lost.

The weakened pound has almost immediately generated a wave of new business opportunities. Holiday makers from across the Atlantis and around the world have started to book trips to the UK.

Exports are expected to benefit from increased demand as a result of lower prices. Favourable exchange rates and weakened property prices will capture the attention of foreign investors. These are business opportunities that will help generate jobs and boost the economy, although it has to be made clear that the recent euphoric stock market performances are by no means indicators that the UK is out of the woods. The transition out of EU is expected to be complicated and tedious. It calls for strong leadership, excellent diplomacy, strong negotiation skills and perseverance. For a change, the rescue would be out of the hands of the Bank of England.

On this dawn of a new era, it's over to you, Mdm Theresa May.

This article is accurate as at 10 Oct 2016.

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