© James Steidl/Dreamstime

The writer is senior portfolio manager at Capstone Investment Advisors

Broad market liquidity — the ease with which investors can buy or sell a security without affecting its price — has been in a downward spiral for more than 10 years.

Look, for example, at what has happened to trading in futures contracts on the S&P 500 index — typically the world’s most liquid equity index futures. Over the past decade their liquidity, as measured by market depth, has collapsed by around 90 per cent. This pattern is repeated across asset classes and regions.

Depth is broadly a measure of the market’s ability to absorb flows without meaningful price impact in the underlying security. More specifically, it denotes the number of shares or contracts available on the bid or offer on a security at any point in time.

The decline in liquidity coincides with a huge increase in the number and magnitude of “volatility shocks” — defined as daily moves of more than 5 percentage points in the Vix Index which measures markets’ expectations of volatility. Between 1994 and 2007, there were nine. In the years since the 2008-09 financial crisis, there were 62.

More significantly, market liquidity has started to behave like sand — the tighter you try to grip it, the faster it slips through your fingers. Just when demand for liquidity is greatest, especially during periods of stress, it has tended to drain away. So not only is liquidity low, it has also become fragile and unreliable.

There are many reasons for these sudden droughts. The past decade has seen a proliferation of computer-driven, quantitative strategies driven by rules or market signals. The huge shift of assets into systematic and passive vehicles has reduced the scope for active managers to step in during periods of stress and provide liquidity. Instead, these systematic and passive strategies are constrained by their algorithms.

Tighter banking regulation has compounded the problem, radically reducing the capacity for large broker-dealers to assume risk. As a result, the investing world has lost access to some of the liquidity once provided by these banks.

Another key issue is that the market makers’ role has been largely taken over by bots running high-speed algorithms. Empirical observations suggest that these bots typically respond to any increase in the volatility of the underlying asset by progressively withdrawing liquidity.

There may well be additional reasons, but it is undeniable that we are now in a different and much less liquid market regime than the one in which many investors grew up.

Should they care? The short answer is yes and the reason is volatility — the flipside of the liquidity coin. Low liquidity means that the market now struggles to transfer risk efficiently from one participant to another. When an investor sells an asset, their sale can result in a price fall that triggers limits on trading positions known as ‘stop-losses’, forcing further sales. Lower liquidity, therefore, tends to amplify moves and exacerbate volatility.

But increased volatility resulting from lower liquidity is seen not only in asset prices. Price spreads that were once stable, for example between the Nasdaq 100 and Russell 2000 Indices for US shares, have become much more volatile in recent years. Relative moves between these two have increased materially over the past two years, highlighting the impact that low liquidity can have on current market trends.

What does this imply for markets? It means that more bubbles are likely, following those we have recently witnessed in cryptocurrencies, penny stocks, certain large caps and special purpose acquisition companies, as price moves are amplified by poor and fragile liquidity. Equally, it suggests that during periods of market stress, low liquidity is likely to create self-fulfilling panics that will exacerbate drawdowns.

To navigate this landscape successfully, investors must first recognise these liquidity risks. Second, they must understand that in this new environment, investor positioning — whether speculative, passive or systematic — and technical factors are more important in determining short-term moves in asset prices than market fundamentals.

Above all, given that liquidity and volatility are two sides of the same coin, it is more important than ever to understand and manage portfolio volatility.

For investors who want to play defence to avoid making tough or bad decisions during potentially brief periods of turbulence, hedging volatility with financial instruments is critical. For investors who want to play offence, more frequent bursts of volatility provide opportunities for returns during stress episodes.

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