Mutual Funds Day 8: Liquidity
Every asset has a value. The value depends on not the seller, but the buyer. If you wish to sell your house for 1 Crore, but the highest a buyer is willing to give you is 0.75 Crore — then the value of the house is 0.75 Crore.
When everything is going well, the same house may sell for 1.25 Crore (Above the fair value). Whereas in bad times, the buyers will demand a lower price (Below the fair value).
The ability to sell an asset near its fair value is called Liquidity. When the demand of buyers and sellers is very high, the asset will be priced fairly and there will not be any slippages.
“If you have wealth without liquidity, you’re still in bondage. If you have capital without currency, you’re still in bondage. Liquidity equals freedom.” ― Hendrith Vanlon Smith Jr
The concept of Liquidity applies to Mutual Funds also. The more famous a fund is, the more people would prefer to buy/sell. When more people buy/sell, the more famous the fund will become. So it is a perpetual spiral. When the number of transactions is higher and the AMC handles huge volumes (known as AUM), the liquidity tends to be higher.
When you buy/sell a mutual fund, liquidity is one of the main factors you need to take into consideration. You can check the AUMs, and buy/sell order book to get a fair idea. The reason is that you might be redeeming the fund for a financial goal or emergency and you would want to get a fair price for your assets.
During the redemption request, you will be stuck with a liquidity issue if no one is ready to buy from you. Most likely you will end up selling your assets below the fair value. In case you have a very big holding, the slippages themselves will cost you many year’s returns.
A fund or asset with lower liquidity is a friend of a smart buyer. What he needs to do is Bid for a specific price and wait. If the seller has an urgency to sell, most likely the buyer will get the assets at prices way lower than fair value. These transactions are called fire sales.
As a seller, you would always pray such a situation never happens. There is nothing more depressing than seeing your assets getting sold off at rock-bottom prices. Most likely you will end up regretting the decision all your life.
If you read the 2nd chapter, you would already know the importance of an emergency fund. Ideally, the savings fund or emergency fund is kept in the most liquid asset class so that liquidating them will have the lowest slippages.
In case of a financial emergency, you should consult your financial advisor on which fund you should redeem first. 9 out of 10 times, the FA will ask you to redeem the one with the highest liquidity. In case you are redeeming a non-liquid fund, then request you to place a limit order i.e. set a pre-defined sell value rather than a market order.
The mindsets of greed and fear are indispensable in financial markets. During times of extreme fear, people get into panic mode and sell off assets at whatever valuations the markets are quoting. Be smart, do not fall into traps.
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