Making money off illiquidity: Two Strategies

At first sight, illiquidity is bad news for investors, since it gives rise to transactions costs, which, in turn, can lay waste to investment strategies. In a post from a few months ago, I examined how transactions costs can explain why so many strategies that look good on paper don't deliver their promised upside.

However, in this post, I want to take the "glass half full", optimistic view of the phenomenon. Illiquidity or potential illiquidity is not all bad news for investors. After all, to beat the market, you have to have an edge over other investors and here are two competitive advantages that can be created out of illiquidity.

a. Illiquidity arbitrage: Not all investors value liquidity equally. To the extent that you need or care about liquidity less than the typical investor in the market, you should be able to exploit this difference to make money. How? Wait for a period of illiquidity (either on the entire market or on an individual stock), where asset prices are marked down by typical investors, who observe the illiquidity and price it in. Then, step in and offer to buy assets. You will get these assets at a bargain price (from your perspective) but at a fair price (from the perspective of the median market participant). Wait for the illiquidity to ease and then sell the asset. This may very well be the biggest weapon that an old-time value investor brings to the market. In fact, Warren Buffet did exactly this type of bargain hunting during the banking crisis of 2008, taking large positions in Goldman Sachs and GE, during their most illiquid days. (I know... I know.. technically, this strategy is not arbitrage, since it is not riskless.. )

"This is easy. I too can be a liquidity arbitrageur", you may say, but it is easier said than done. There are two factors that are at least partially under your control. The first is the use of financial leverage in your investment strategy. Borrowing money to fund investments may increase your expected upside, if things go well, but it also increases your need for liquidity.  The second  is a combination of patience and a strong stomach. Buying during periods of illiquidity will expose you to down side risk, at least in the short term, and you have to be able to ride it out. But the desire for liquidity is also a function of  factors that are not  in your control. First, if your income stream is stable, predictable and in excess of your spending needs (Do you have tenure?) and you have have less need for liquidity. Second, it is subject to what I will loosely term "acts of God". A sudden illness, accident or unforeseen event (Did you invest with Bernie Madoff?) may quickly eliminate whatever buffer you thought you had. Third, if you manage other people's money, it is their need for liquidity that will drive your decisions, not your own. It is one significant advantage that you and I have on the most skilled portfolio manager.

b. Illiquidity timing: Both the level of illiquidity and the price demanded for it change over time in the market. An investor who can forecast changes in illiquidity well can profit off these changes. But how does forecasting liquidity translate into a payoff? You have to be able to shift into liquid assets, before the market becomes illiquid, and into illiquid assets, ahead of periods of liquidity. With the former action, you cut your losses and with the latter, you gain as the illiquid asset regain their value. This is particularly true, if you use financial leverage and invest in illiquid assets, as many hedge funds do. In fact, one study argues that liquidity timing may be one of the biggest competitive advantages in the hedge fund business.

How do you get to be a good liquidity timer? First, you have to track not just the standard investment measures - multiples and fundamentals - but also liquidity measures - trading volume, short selling and bid-ask spreads. In fact, those technical indicators that fundamentalists view with such contempt, such as trading volume and short sales, may be useful in detecting shifts in liquidity. Second, you have to be clear about how exposed an individual asset is to market shifts in liquidity - a liquidity beta, so to speak. In my extended paper on liquidity (linked below), I describe ways in which you may be able to estimate this beta.

For more on liquidity betas and the potential for making money off illiquidity, you may want to look at this paper that I just posted on liquidity and its effects on financial theory and practice:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408