CHG Issue #160: The Price of Liquidity

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We’ve mentioned before that volatility is the price of liquidity and today we are going to dive into what that means in practice. Last week we saw a notable pickup in volatility with the VIX closing the week 16h as we are witnessing what appears to be a factor trade unwinding in the market.

According Kenneth French's data library the size factor has been the worst performing factor of the three research factors and the second worst of the five research factors over the past twelve months. Absent the post-COVID outperformance the size factor has been a consistent underperformer which has attracted a lot of flows into large caps, especially large cap tech, and when those flows reverse you get the classic squeeze through the door in the crowded theater type of flows like what we have seen in the Russell over the past two weeks.

We can learn a lot about the value of liquidity when we see flows like this.? It is typical to see short covering, gaps, and a stretched out market when a market moves out of balance and that is exactly what we have seen in the Russell futures over the past few trading sessions. When sizeable traders see their stops triggered the price of liquidity sky rockets as the market quickly moves to find prices that can satisfy the new flows.

The options market provides a higher resolution picture of how these flows are being accommodated over the price and time dimensions. We find that the options market is pricing this move differently than it has other, recent short covering rallies. The short squeeze in GME was met with expanding call skew, but in this case the short squeeze in the Russell has been met with expanding put skew. This makes the put spreads cheaper and currently the market is offering over 5-to-1 odds that IWM (the Russell 2000 ETF) closes between $210 and $180 on December 20th which would be back in the prior range. Therefore, the market is confident that this upside breakout will be accepted and the market will close above $200 by the end of the year.

Observing how these flows are being priced by the market also provides us a different angle on the broader topic of liquidity and how that relates to the recent popularity of alternative assets. Just like large caps have been outperforming small caps, alternatives have been outperforming traditional investment options and have seen huge inflows over recent years. During the ZIRP-era we witnessed huge flows into real estate and other fixed income like asset classes that could provide a yield pickup relative to treasury bonds. These flows were put into long-term vehicles that locked up investor capital for up to ten-years.

As demand continued to grow and competition increased among managers we saw managers increasingly offer vehicles with more flexible liquidity provisions. Now we are seeing a desire for the "ETF-ization" of alternatives (see BlackRock's acquisition of Preqin) which comes from the desire to capitalize on the high demand for alternatives and take market share by offering lower fees and a more liquid investment vehicle.

?The challenge with this approach is that the investment vehicle cannot change the underlying volatility of the assets it holds. Only in extreme cases where the vehicle owns all the available assets is this not true, but even in that case the intrinsic volatility of the asset cannot be changed and the vehicle merely suppresses the true nature of the asset. Volatility is the price of liquidity but liquidity is purely driven by market technicals whereas volatility is related to both the intrinsic nature of the asset and the market in which it trades. What we are witnessing today is a suppression in the price of liquidity to meet investor demand across asset classes that eventually leads to things like what we just saw in the Russell 2000. This is really just an overcomplicated version of lending long and borrowing short which caused the S&L crisis and countless other financial crises throughout history.

We know how this ends because we are seeing it play out today with example of the Blackstone and Starwood’s private REIT vehicles. Did they overpay when rates were at 2%, probably; do they own high-quality assets, definitely. The problem is they made a strategic mistake when they decided to fudge the pricing of their NAV (probably to defend their fees) because it lowered the price of liquidity for the retail investors in their funds. Say what you will about the so-called dumb money, but they are smart enough to take the liquidity when it’s being underpriced. By making their funds appear less volatile than the public markets they encouraged their investors to redeem when fundamental volatility increased.

This provides a framing through which we can distinguish intrinsic volatility from extrinsic volatility. The high-quality assets in the Blackstone and Starwood REITs are not the problem, higher interest rates and investor perceptions are the problem. They shouldn’t be faulted for buying what they did, but they can be faulted for not hedging for higher rates, especially when the curve was flat. When rates increased the odds changed for CRE, but due to the structure of the market the flows can’t move through as quickly as they can in the public equity market. This is why public REITs and CMBS underperformed so much in 2022 and 2023, it was the only thing people could sell. Now imagine if we put everything into ETF wrappers that people can bid up and sell down based on fear and greed. If we are going to make these asset classes more liquid there will be more volatility and higher correlation which impairs the main attraction of these assets.

Illiquidity comes with lower extrinsic volatility and can be a good thing during credit crises because it prevents investors from paying the "stupid tax." For example, today banks have cut back dramatically on CRE lending because their regulators have told them to despite it being one of the most attractive lending environments in recent history. But guess who is lending: Private Debt funds, because they have 10-year locked up capital and less regulators to answer to which allows them to capitalize on higher rates and lower valuations. The banks' capital comes from deposits that can come and go on a whim. As banks have lent less and PE firms take their place it makes the economy less sensitive to things like short-rates, the yield curve, and credit crises. However, if we move everything into liquid vehicles it risks removing that cushion making the overall economy more sensitive to the whims of investors.

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