Following on from The next crisis in the Bond market..., ETFs, liquidity profile and valuation issues, Bond fund distance, liquidity and trading, Bond liquidity, collective investments and fairness I want to describe a specific type of risk. I call it liquidation risk.
Firstly, let's describe the corset theory of weight loss.
A corset can reduce the size of a waist, but it cannot reduce the weight of the wearer, the weight is merely redistributed. By packaging up illiquid assets into a vehicle that produces a continuously priced asset there is an illusion of liquidity. But the illiquidity is still there, just with one degree of indirection.
As such a unitised fund may be priced at 101.15/101.05 but this does not reflect what happens when there is a market disruption that causes a rush for the exit as unit holders try and offload their units.
How can an investor really manage a portfolio of assets where for each asset a NAV is calculated but the NAV is based upon "good times" pricing models? What happens when the good times stop?
My modest proposal is that every unitised fund should not just be priced at bid and ask but also a liquidation price calculated and published. So 101.15/101.05 and then perhaps 85 as a liquidation price. The benefit of this approach is that unit holders can than see a simple measure of liquidation risk, the difference between the bid price and the liquidation price expressed as a percentage of the bid price.
The methodology for calculation of the liquidation price should be subjected to peer review, perhaps under the auspices of Global Investment Performance Standards.
The liquidation price then allows the market to value this type of risk effectively.