Holly Black: Welcome to Morningstar. I'm Holly Black, with me is Tom Whitelaw. He's Director of Equity Strategies at Morningstar. Hello.

Tom Whitelaw: Hi. Thanks for having me, Holly.

Black: So, Tom, you've been doing some research into liquidity. I'm going to start with a really obvious question. What is liquidity in investing?

Whitelaw: Yeah. So, it's the ability to sell something in the desired quantity without impacting the price and that price impact is key as anything is liquid as long as you're not bothered about the price that you get. And it's why we talk about discount risk, that is, how likely is it I will have to take a discount on the market value of my investments if I want to sell them.

Black: So, how do you assess that discount risk?

Whitelaw: It's not easy because it's a fluid concept. So, one-minute liquidity is plentiful, and then the next, it's not. So, we look to build up a picture of the fund from all of its individual stocks, and we look at the liquidity of those stocks across a number of ways. So, we look at here and now how liquid is it today and then, also, how liquid has it been at the worst-case scenarios? We look at it on a couple of levels. We look at it on a pro rata style sell-down, which is, selling everything and keeping the portfolio structure exactly the same. So, if I've got 5% BP, 3% Vodafone, when I finish selling, I've got 5% BP, 3% Vodafone and also a waterfall sell-down, which is more like a fire sale sell-down. So, in that scenario, maybe BP and Vodafone are most liquid I end up with zero percent in there and we weight it towards the pro rata because that's what we think is more typical. And the final thing we look at is company ownership, so how big a chunk of individual companies am I owning because if you're owning 5%, 10%, 15%, 20% of individual companies, it's much, much harder to sell those weights.

Black: So, that's all good as an analyst for you. But if I am an individual investor, I buy and hold for the long term, do I still need to worry about liquidity?

Whitelaw: Well, I guess the very worst case scenario you can have of owning in a liquid fund is if it receives redemptions that overwhelm it and the strategy ends up having to gate or close down for a period of time, which means that during that period you can't get your cash back. Thankfully, those instances are rare, and often the impact of running too much money and having a liquid portfolio are more hidden.

So, it could be that your fund has to pay more to trade, so the market impact costs are higher because you're a bigger fish in that pond. Or if that's not happening, it could also be because the strategy or the underlying strategy of the fund is changing and there's some style drift in there. So, the manager is actually not trading how they want to. They're kind of maybe holding onto the more illiquid names because they know they can't sell them and selling the more liquid names or vice versa if they get a huge inflow, they can't buy some of those less liquid names that maybe have driven some returns in the past. So, again, that will kind of eat into your future expected return.

Black: So, I was going to ask you for a recent example. I feel we can't discuss liquidity without mentioning Woodford Equity Income.

Whitelaw: Yeah. I mean, that's one of the instances that led to a lot of developments in our model because it was something that we were well aware of, because it kind of just flagged up all the stages that we have. So, on a pro rata level, like it was off the charts, like there was just such an illiquid tale of stocks and holdings within that fund that it was by far the least liquid. From a waterfall standpoint, even in a like a fire sale scenario, it had very little liquidity at the top that it could actually access.

So, when it did get a big redemption, it couldn't even meet that redemption without having to dig into that really, really illiquid stuff at the bottom. And then, just from an ownership perspective, they owned kind of almost 20% of a ridiculous amount of companies, which meant that when they came to sell, the market knew they were trying to sell, the market knew they were in a jam. So, the prices that they were being offered to sell those stocks were way, way lower than what the market value would be or had been, and that's what led to some of the huge dislocations in performance you saw with that strategy.

Black: So, how do I avoid that sort of scenario as an investor, how do I assess liquidity?

Whitelaw: Yeah. I mean, read our research. I know that sounds glib, but it's very difficult to find out the liquidity position of a fund at an individual level because each manager does their own analysis. And when we were building this model, we looked at all the regulatory guidance out there and it's very, very broad and it really allows funds to put their fund in as good a light as they want. So, going back to the Woodford scenario, we were talking to Woodford, talking to his risk and compliance teams. They were saying they were fine. They were running their own assessments, which were all in the boundaries of what the regulators say. And they were saying they were fine.

We didn't think that they were, and that's why we developed this – we developed our own model so that we could run it across every strategy and be able to identify the funds that look problematic. And if a fund looks problematic, then our analysts will do a much deeper dive into what's actually going on there and what might be causing it. And then, that ultimately affects the final rating that we give the fund, and you'll also be able to see commentary on that in the reports that we write.

Black: Tom, thank you so much for your time. For Morningstar, I'm Holly Black.