When selecting investhments, pay attention to potential return, risk and how easily you can exit it, experts tell Sanjay Kumar Singh.
Recently the Bombay Stock Exchange and the National Stock Exchange issued lists of 283 and 16 stocks, respectively, advising investors to exercise extra caution when investing in them owing to lack of liquidity.
Liquidity risk implies that the investor may either not be able to sell an investment when s/he wishes to, or may be forced to sell it at a discounted price.
If the larger part of your portfolio is locked up in illiquid instruments, it can pose a serious problem.
On the equity side, small-cap stocks tend to have low liquidity as institutional investors like FIIs steer clear of them.
It is retail investors who primarily invest in them and they buy mostly on momentum.
When the markets are going up, as is the case now (the S&P BSE small-cap index is up 32.61 per cent over the past year), incremental money flows into these stocks.
But as soon as the markets correct, liquidity tends to dry up.
One way to circumvent liquidity risk is to invest via the mutual fund route since a fund house is bound to redeem your investments.
Investing via this route is also advisable as less information is available on these stocks.
"Fund managers have greater access to research and data and they are also on the job day in and day out. They are better placed to invest in the right businesses within the small- and micro-cap space and hence cushion the liquidity risk in these stocks," says Vinit Sambre, senior vice-president and fund manager, DSP BlackRock Mutual Fund.
Liquidity risk also tends to be high in real estate, especially in weak markets.
"As soon as the real estate market begins to correct, buyers turn into fence sitters, hoping to catch the bottom," says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor.
The size of investment can also create liquidity-related challenges: Selling a larger parcel of land is usually more difficult.
"Investors, especially retirees, shouldn't have a large component of their wealth tied up in realty, leaving them asset rich but cash poor," says Raghaw.
Also, invest in this asset class only if you will not need money anytime soon.
"You must have an investment horizon of 10 years or more to invest in real estate," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Lower-rated corporate bonds also carry liquidity risk.
Most financial advisors advise their clients to avoid corporate bonds rated below AA+.
"If you do wish to invest in lower-rated paper for the extra return, do so via the fund route, where you can rely on the fund manager's expertise to take that extra risk," says Manoj Nagpal, chief executive officer, Outlook Asia Capital.
At the same time, he advises that investment in such paper (or funds investing in them) should not exceed 20 per cent of your fixed income corpus.
Taking the fund route shouldn't, however, be regarded as a guarantee of complete liquidity, as was seen in the JP Morgan AMC case (after the downgrade in ratings of Amtek Auto's debt), when the fund house had restricted redemptions to a limited amount.
Exchange traded funds (ETFs) too suffer from liquidity issues.
If you invest in them, go for the more popular categories, like those based on the Nifty, banking, etc where volumes are higher.
Those having a smaller corpus and those belonging to newer categories may have liquidity issues, resulting in a larger spread between the NAV (net asset value) and the market price.
"To avoid liquidity risk in ETFs, take the index fund route. However, the latter has a higher expense ratio," says Raghaw.
Before investing in an illiquid instrument, check your portfolio to see that its composition is not skewed towards illiquid assets already, suggests Dhawan.