Liquidity in investments

Investments that can be bought and sold easily are considered to be liquid. Investments that are difficult to buy or sell are considered illiquid. Liquidity is one of many important objectives of investing. We can actually look at liquidity in several different ways, and for purposes of this article I’ve broken it down to four general discussion items, as follows: Basic Rules of Settlement, Liquid for a Cost, Exceptions to Liquidity, and Ratio of Liquid to Illiquid.

Basic Rules of Settlement

When buying and selling different investments, there are specific rules with respect to transaction dates and liquidity. Two dates are often used to describe transactions, trade date and settlement date. Trade date is fairly straight forward to understand. It is normally the day your purchase or sell is first executed. If you spoke to an advisor after cut off times (i.e. market hours) and your advisor entered the order for the next market day then trade date would be the next market day. Settlement is a little more difficult to understand and changes with different investments. The following is a chart with the most common investments and the respective settlement dates:

Common Investments

Settlement Date = Trade Date + (below)

Money Market Mutual Funds

1 business day

High Interest Savings Accounts

1 business day

Short Term Bonds (3 years or less)

2 business days

Long Term Bonds (3 years plus)

3 business days

Mutual Funds

3 business days

Canadian and US Equities

3 business days

European and Foreign Equities

Depends on market

To illustrate trade date and settlement date we will use a typical week with no public holidays. Michelle purchases a stock named ABC Company on Monday – this is the trade date. Settlement as per the above schedule for equities is the trade date plus three business days – settlement is on Thursday. What this means is that Michelle does not have to deposit money into her investment account until Thursday, even though the investment was purchased on Monday. If Michelle already had money in a high interest savings account then her advisor could sell a portion of this investment on Wednesday to cover the purchase. The opposite happens when an investment is sold. Let’s assume that a few months go by and Michelle needs some money and sells ABC Company on Monday – this is the trade date. Although we did the trade on Monday, the settlement date is Thursday. We would not be able to transfer funds to Michelle until the settlement on Thursday. We explain settlement to new clients to ensure they give us a few days notice if they require funds.

Liquid for a Cost

At any time you should have the right to make a change in your investments without it costing you a fortune. Having flexibility with investments ensures you never feel like you are backed into a corner with no options. We recommend asking the liquidity question prior to making any investment decisions – what will it cost me tomorrow if I need to sell. Everyone should know the total cost to liquidate an entire portfolio. When I have sat down with people wanting a second opinion the first thing I look at is the types of investments they have and what it would cost to make any necessary changes. I will use Wendy who came in for a second opinion as an example. Wendy was holding a basket of proprietary mutual funds that were originally sold to her more than two years ago on a deferred sales charge (DSC) basis. I explained that with proprietary mutual funds they can not be transferred in-kind (as is). Her only option was to sell the mutual funds, and transfer the net cash after redemption charges, if she wanted to make a change with her investments. In explaining DSC mutual funds to Wendy, she was shocked to know it would cost her four per cent (or $23,200) of her $580,000 investment account to make a change even though she has owned these investments for more than two years. Immediately Wendy felt she was backed into a corner. I explained to Wendy that if she had sold these mutual funds soon after she purchased them two years ago then the cost would have been $37,700. Although Wendy had liquidity, it was liquidity for a cost – she had no idea. In my opinion, every investor should avoid being backed into a corner with excessive liquidity costs.

Exceptions to Liquidity

Not every investment will be easily converted to cash. Your principal residence is one investment that is not easily converted to cash. Many assets that people buy either have restrictions on when they can be sold or take significantly longer than the settlement dates for common investments noted above. Examples of investments that are not easily liquidated include: infrastructure assets, private real estate investments, antiques, art work, private companies, hedge funds, flow-through investments, venture capital funds, etc.. Some investments have in the fine print that they reserve the right to suspend redemptions under certain circumstances. It can be very frustrating for people who have invested in illiquid investments and would like their money back. Prior to purchasing any investment you should determine if it is liquid, illiquid, or has the possibility of becoming illiquid. If it is illiquid you should be prepared to hold it until key dates are reached or a liquidity event occurs.

Ratio of Liquid to Illiquid

A good exercise for all individuals is to list all of your investments and categorize them in the liquid or illiquid category. In my opinion, everyone should have some liquid investments, including cash as an emergency reserve, or investments to either obtain income, growth, or a combination of both. There is no set rule on what ratio of liquid to illiquid investments people should have. As a general guideline, younger individuals may have more illiquid investments, especially if they have real estate with debt or the higher risk tolerance to invest in illiquid investments. Another general guideline is that as people age, or if they have a lower risk tolerance, the ratio may favour liquid investments.