If your mutual fund holds securities that are less frequently traded and, therefore, less liquid, then you could be incurring higher trading costs that show up in your fund’s NAV, if not in your brokerage statement. Not only that, your fund also needs to maintain enough liquidity to ensure that it can efficiently and quickly process shareholder redemption requests. These liquidity concerns can directly impact the risk-adjusted returns expected by investors from such funds.

In case you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.

Liquidity risk within mutual funds is caused by a lack of ready cash to properly handle shareholder transactions. Funds have to stand ready at all times to process redemption requests as they come in, and should have either cash on hand or securities readily able to be converted to cash. In many cases, the securities a fund owns are frequently traded and easily able to trade whenever needed at minimal cost. Other times, funds can hold risky or thinly traded securities that can pose a threat to a fund’s ability to raise cash without incurring a heavy cost.

The Investment Company Act of 1940 address two key concerns relating to liquidity risk. It stipulates that mutual funds have up to seven days to distribute sale proceeds to shareholders (although most do it the next business day). It also allows funds to only hold a maximum of 15% of fund assets in illiquid securities.

To learn more about the SEC’s new liquidity rules, click here.

Funds are able to keep a steady reserve of cash using a few different methods.

• Maintaining a cash position – Many funds keep a small portion of cash as part of the fund’s asset allocation. This cash is often used to fund daily transaction activity.

• Balancing buying and selling – Investors make continuous purchase and redemption requests. Funds manage new money coming in to offset redemption requests going out.

• Maturing bonds – As bond holdings in the fund mature, they get redeemed for cash.

• Reinvested dividends – All dividend and interest payments received go into the fund’s net asset pool.

Learn about how swing pricing is used in mutual funds by clicking here.

While liquidity risk can be an issue for any fund, it particularly poses a risk to funds that invest in riskier or less frequently traded securities. Junk bonds, for example, can go south quickly if investors prefer safer assets. From mid-2015 through to the beginning of 2016, junk bonds plummeted in value, causing investors to race for the exits. In the extreme case of the Third Avenue Focused Credit Fund (TFCIX), it had to sell bonds at far below market value prices to meet redemption requests, and eventually decided to freeze redemptions altogether before shuttering the fund completely in December 2015.

Other asset classes, such as emerging markets equities, real estate and commodities, can experience similar issues if the supply and demand balance changes quickly.

To learn more about how a mutual fund’s NAV is calculated, click here.

While not often explicit, liquidity risk can cause significant damage in the wrong situation. Here are a few things to keep in mind when understanding liquidity risk.

• Look for wide bid-ask spreads – If you want a quick and easy gauge of a fund’s liquidity risk, look at the bid-ask spread. A wider range indicates buyers need to pay a higher price and/or sellers need to accept a lower sale price. Either one can negatively impact an investment’s total return.

• Fluctuations in NAV – Since liquidity pressure makes an investment inherently more risky, be prepared to experience greater NAV changes.

• Potential for significant losses – As evidenced by the Third Avenue example, a severe liquidity crunch can result in massive losses in unusual cases. A severe imbalance of buyers and sellers could lead to wide disconnects between a security’s value and the value it’s trading for.

In most cases, liquidity risk is not a major concern, as there are many buyers and sellers transacting throughout the day. Sectors that present greater risk, such as junk bonds and emerging markets, tend to exhibit greater liquidity risk as well. The impacts of liquidity can present themselves in a hurry, and often with little to no warning, so investments in these areas warrant a greater degree of attention.

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