When the tide goes out…
9 July 2020
At the time of writing this article, it appears New Zealand, as a country, is on top of the direct health risks associated with COVID-19. However, it is still at the beginning of trying to effectively manage the negative economic ramifications from a ‘go hard, go early’ lockdown approach to managing the pandemic.
Past economic and market shocks have produced periods of market volatility for investors, but it’s the permanent financial losses that some investors incur in an economic downturn that cause the real damage to household wealth. Many of these permanent financial losses can be attributed to the lack of investment liquidity and investment transparency.
Investment liquidity I broadly define as the relative ability to exit an investment at any point in the economic cycle and without any undue spreads, discounts, exit fees, brokerage etc. Realised returns which are in the bank should feel more valuable than paper profits.
Investment transparency in my opinion is having sufficient and timely information to be able to make an informed decision on a specific investment.
New Zealand underwent economic deregulation in the 1980s. Since this time we’ve experienced five major economic downturns. There are certain types of investment instruments that have shown greater weakness during these downturns, and in fact multiple downcycles. A number of these have gone into liquidation with low payouts back to their investors.
The first key to getting a better sense of relatively higher liquidity or transparency risk is to engage an independent financial adviser. I’m not a lawyer, so when it comes to the small type in a legal contract, I’m going to get legal advice and not enter into a situation with 80% understanding. A product disclosure statement is long and we may not pay enough attention to general risk statements when we probably should.
For example, a risk statement in a recent $100m+ capital raising for an unlisted property company noted the below:
‘As part of this offer, xxxxxxxx does not intend to quote the shares on a licensed market in New Zealand and there is no other established market for trading them. This means that you may not be able to sell your shares.’
With no clear exit option for the investor there appears to be higher liquidity risk in such a company versus a listed property company.
Secondly, general human nature accounts for many of our actions. We are often attracted by the possibility of higher returns and may have an overly optimistic outlook when investing. Many product disclosure statements will aim to appeal to these instincts by highlighting the positive rather than the negative aspects of the offer.
At this early point in the COVID-19 economic downturn, the sharp decline in financial markets and in our economy has already created a new list of investment casualties that will cause permanent wealth loss to their investors. Local instances to date include:
A New Zealand based hedge fund in liquidation;
Several new property syndicates on offer have been pulled from the market;
One finance company in liquidation.
It’s highly likely that this list will lengthen as the full economic downturn plays out on the private sector. We have yet to experience the full effect of the pandemic and it may take a considerable period of time before some investments move from financial stress into financial failure.
As the speed at which the downturn was factored into listed companies on the share market was rapid, investors have had both relatively good levels of information and liquidity through which to act. This is in contrast to many unlisted investment vehicles, where public information flow and exit options for their investors have been lacking.
The next question is what investment advisers and investors should do to mitigate exposure to liquidity and transparency risks. And if they’re already in such an investment what can they do to protect themselves?
Firstly, before investing in illiquid or less transparent investments, investors and their advisers should be confident of achieving a higher return for the extra risks. They should also look for clear signs of structural durability in the investment so that they are confident it can substantially survive the worst recession.
Secondly, the allocation to these investments should be on the basis that no liquidity will be required before the expected lifetime of the investment and if a loss occurs it won’t derail the investor’s financial goals. It’s safer to limit the proportion of the investor’s total portfolio in such investments, depending on their situation and risk appetite.
If you feel confident that you have ticked these boxes, then your level of exposure and investments shouldn’t worry you too much. However, it could be worthwhile to request further information on any transparency gaps to limit the risk of negative surprises. If you do feel overexposed, you can request the investment manager for a plan to create fair liquidity options for all investors.
At Findex we aim to have either all or the vast bulk of client investments in liquid assets. This means portfolios are easier to adjust based on changes in the client or market situation. Where illiquidity is taken on, there needs to be a clearly understood offsetting value proposition and alignment with a client’s risk profile.
If you have any further questions relating to this article, please speak with your adviser or contact the Findex team.
This article first appeared in NZ Asset Magazine on 21 May 2020.
Findex NZ Limited, trading as Findex
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