As I mentioned in my Windows 10-plagued post yesterday, the SEC is considering new procedural and disclosure rules for ETFs and mutual funds about the liquidity of their positions. The most controversial, as well as, to my mind, the most reasonable, is the idea of allowing funds to assess a premium to net asset value during times of unusually high purchases and apply a discount when redemptions are running high.
Liquidity itself, on the other hand, is not as straightforward a concept as it appears on the surface. That’s not a reason for having no disclosure. But it raises the question of how extensive the disclosure should be.
The definition the SEC appears to be using is how many days it would take for a given fund to sell its entire position in a certain security without having an impact on the security price. Let’s refine that a bit by saying that having no impact would mean that the stock moves in line with its market over the selling period (as opposed to just doesn’t go down).
Let’s take Exxon (XOM) as an example. It has 4.2 billion shares outstanding and has been recently trading 17+ million shares daily.
For you and me, selling is a piece of cake. Our 100 or 200 shares is a miniscule portion of the daily trading volume. Also, no one on Wall Street knows–or cares–what we’re doing.
Suppose, on the other hand, that we own 1% of the company, or 42 million shares, which amounts to three days’ total trading volume. What happens then?
Subjectivity and skill/deception come into play.
How much of the daily trading volume can we be before a broker notices that we’re doing unusual selling? (Once that happens, he/she looks up our position size on a trading machine (mutual fund positions are disclosed quarterly in public filings at the SEC) and assumes we’re selling the whole thing. The trader then calls his own proprietary trading desk, and all the traders at other firms that he/she’s friendly with. Then the price moves sharply against us.)
In my working career, I mostly dealt with positions in the $50 – $100 million range, although some of my stocks have been more illiquid than that position size would suggest. I always thought that I could be 25% – 30% of daily volume without moving the price. In the XOM example, that would mean my position would take 9 -12 days to sell and would be classified, according to the SEC proposal, as sort of liquid. A larger or perhaps more cautious manager might think the percentage of daily volume should be capped at 10%. In this case, the same position would take 30 trading days(six calendar weeks) to unload and would be highly illiquid.
The norm in the US is to separate trading sharply from portfolio management. I’ve been lucky to have worked mostly with very talented traders, who could conceal their presence in the market. I can remember one trader, however, that I inherited at a new firm who was almost inconceivably “loud.” Using him, every stock was illiquid (luckily for me a hapless rival headhunted him away after months of ugly trading results).
Organization size, not just portfolio size, also comes into play.
Suppose I’m alone as a manager at my firm in having a 1% position in XOM. That’s one situation. On the other hand, I might be one of five managers with similar-sized portfolios, each with a 1% position. If we all decide to sell at the same time–perhaps influenced by internal research or by the most senior PM–the firm’s liquidity position in XOM is far different. The stock is now very, very illiquid. With conservative daily volume limits, it could take half a year to unload and ostensibly mega-cap liquid stock.
This is a whole other story, one that I don’t know particularly well. However, corporate bonds, especially low quality bonds, can be extremely hard to sell.
It will be interesting to see what the SEC comes up with.