The Globe and Mail, Report on Business
Published March 6, 2010

With very few exceptions, the investment managers who did poorly when markets were melting down bounced back with a solid return last year. What didn't work in 2008 worked well in 2009.

That wasn't the case, however, for one of Canada's highest profile investors, the Caisse de dépôt et placement du Québec. When its 2009 results came out, they were abysmal. The 10-per-cent return not only lagged other balanced portfolios by a large margin, but it also came on the heels of an equally abysmal 2008, when it was down 25 per cent.

Was it the Caisse's equities that caused the problems? No, the results were excellent.

Was it real estate? Nope.

The fund had some problem areas, but the major issue was an often overlooked risk: liquidity. When the Caisse needed cash to take advantage of weak markets, it wasn't there. Indeed, its managers were forced to sell stocks at low prices to meet its own cash flow requirements.

Liquidity, or the ability to quickly convert securities into cash at reasonable prices, is the least understood and, as the past two years revealed, most underestimated risk that investors take. The mismanagement of cash flows and liquidity was a defining feature of the recent market crisis. Sophisticated risk-management models assumed that liquidity would be available as needed, whether to rebalance a portfolio, roll over short-term liabilities or fund cash needs. Those were bad assumptions. As a recent Economist magazine essay explained, “What makes liquidity so important is its binary quality: One moment it is there in abundance, the next it is gone.”

As an aside, when someone tells me the market is going up or down based on liquidity factors (“hedge funds are awash with cash”), I stop listening and take my leave. The tap controlling capital flows can be turned on or off in a heartbeat. That was clearly illustrated during the credit crisis of 2008 (when the tap was turned off) and the subsequent corporate bond rally in 2009 (on). It is totally unpredictable.

The Caisse was the highest-profile Canadian institution to have liquidity problems, but it had lots of company. Other institutions like Harvard University suffered when illiquid investments sucked cash from their portfolios at a time when it was needed elsewhere. Some individual investors had the same challenges.

After being totally focused on capital ratios (debt compared to equity), risk managers and regulators are now looking more closely at liquidity measures. They want to know where the cash will come from if disaster strikes and, importantly, what commitments the institutions have made to others.

Individual investors who are drawing an income from their portfolio need to do the same. Over the last year and a half, the most challenging work we've been doing at Steadyhand has been coaxing investors out of cash and back to their long-term asset mix. But after the big returns of the past year, it has become increasingly important to refocus our income-dependent clients on liquidity issues.

I say that because it's tough to convince someone to sell a stock or fund that's up more than 20 per cent in the past year and put the money into a bank account, money market fund or GIC guaranteeing a return of zero to 1 per cent. Unfortunately, the price for liquidity is steep right now (just as the converse is true: investors should expect a significantly higher return from an illiquid investment).

But in good markets or bad, investors need to know where their next paycheque is coming from. If prices for stocks, corporate bonds and real estate were to become temporarily depressed, is the investor's savings account big enough to prevent any distressed selling? Is the investment income (interest and dividends) sustainable through a tough market? In other words, is the portfolio positioned to let the long-term assets ride it out?

In this year's letter to Berkshire Hathaway shareholders, Warren Buffett reinforced the point: “When the financial system went into cardiac arrest in September, 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant...We pay a steep price to maintain our premier financial strength. The $20-billion-plus (U.S.) of cash-equivalent assets that we customarily hold is earning a pittance at present. But we sleep well.”

Whether the cash is used to buy stocks, as Mr. Buffett did, fund short-term needs or just provide a cushion for easy sleeping, having some money earning next to nothing can be a good thing.