Nervousness over liquidity — which popular opinion would place in the fixed-income market — is building in the equity markets.
The presence of new market participants, herding in certain stocks, the continued move toward passive investment and worries about paying off bond redemptions are bubbling away in the background, sources said.
“There are certainly market/industry structural changes that are increasing fragility and liquidity tension,” said Kristian West, global head of equity trading at J.P. Morgan Asset Management, in London.
“I'm not concerned per se because we are long-term investors and any short-term volatility should work its way out over time,” said one pension fund executive, who asked not to be named. “However, I am concerned about the implications of (exchange-traded funds and high-frequency traders) on individual stocks and sectors. Days when the Dow (Jones industrial average) opens down 500 or 1,000 points suggests that there are some unintended consequences from (algorithmic) and computer-driven trading strategies,” he said.
ETFs have driven liquidity toward the end of the day, said Mr. West, which “makes intraday liquidity more fragile and fleeting, and changes the participants one interacts with.”
“Sum this all up and there are real liquidity tensions. The U.S. market was trading 10 billion shares a day in 2010; and year-to-date average is 7 billion,” said Mr. West.
As for high-frequency traders, which long have been discussed by money management and pension fund executives for their potential to harm returns, Mr. West said: “HFT market-making isn't really market-making in the traditional sense — (it is) fine for retail flow but very fragile, fractious, momentum-enhancing and difficult to interact with for institutional investors.” He said on-screen liquidity was cut by as much as 90% in the runup to the Federal Open Market Committee's Dec. 16 rate increase announcement. “This has the potential to increase market volatility, "real' spreads and short-term execution costs.”
And a change in institutional investor behavior has had an impact, too, with a move toward passive and more quantitative approaches to trading. Money managers have tended to trade less to reduce frictional costs and performance drag, which has resulted in less liquidity, said sources.
“In general, concerns around liquidity are very warranted,” said Wouter Sturkenboom, London-based senior investment strategist at Russell Investments. “We are not yet seeing massive issues with trading equities. But market breadth is dropping, which has been happening for a couple of years. That indicates that underneath the surface, liquidity in the equity markets is in decline. We probably won't notice that until we get a shock, and investors try to trade out of” certain stocks.