I am increasingly hearing of people investing into positions in the markets because they think that the price of a share is cheap due to a decline in the price. The price is not cheap, it is low for a reason.

Worse, when these investors enter the market and buy the shares they think they have made a great decision when they see prices immediately rise. But prices in such situations usually rise because the shares are illiquid and the buying just pushes up the price artificially.

To understand this we first have to define liquidity, which in this case is how quickly one can buy or sell shares without affecting the price. This alone is not specific enough, because there is a difference between selling one share and selling a million shares. This brings us to the concept of average daily trading value (ADTV), or the total value of the shares of a particular stock traded every day averaged over some period. If we look at the trading size as a percentage of value traded we can get a better picture if trading a certain size in a single day is liquid or not.

So, for example, if the trading size is 1 per cent of ADTV then it is usually safe to assume that it is liquid. However, if the trading size is, for example, 20% of ADTV, then doing it all in one day without affecting price is difficult. Looking at the Dubai Financial Market (DFM), as an example, in the second quarter the value traded for Emaar Properties was AED 3,227,999,534 which gives, using an estimate of 64 trading days, an approximate ADTV of, AED 437,493. This would indicate that buying AED 1 million shares of Emaar Properties, representing about 2% of ADTV, in the open market on a single day should not impact the price. On the other hand, the same calculation on Shuaa Capital gives an approximate ADTV of AED 2,452,726 indicating that an equivalent size trade to Emaar of AED 1 million Shuaa shares in a single day would constitute about 40% of ADTV and would likely affect the market price.

This means that for the investor who buys a relatively illiquid stock and sees a price rise, it is most probably a phantom profit as once the investor tries to sell the price appreciation will reverse or worse.

This is completely unfair if this is being done by an asset manager who is charging a fixed fee on assets under management (AUM). Let’s say the manager buys AED 100 million of an illiquid AED 0.50 share in a block-trade from a distressed seller. This won’t move the market. But if the manager then buys AED 1 million of the shares in the open market then he can easily move the price to AED 1 per share, increasing the position to AED 151 million with a profit of at least AED 50 million on paper.

If the manager is charging a 1% management fee, then doing so on the inflated valuation of AED 151 million is equivalent to charging 1.5% on the actual value of AED 100 million. Of course these outsize returns can be made bigger by pushing the price further.

Worst of all, when the manager tries to exit, if he can’t find another investor to sell to in a block-trade, then unloading all those shares will obliterate the stock price. The asset manager would make outsize fees on inflated valuations and then walk away free.

Some will argue that the performance fees that asset managers usually charge would help to align their interests with their investors. But remember, performance fees are contingent and charged to profit whereas management fees are guaranteed and charged to the assets.

The idea of announced values being much higher than actual values is not new.

For this reason it is imperative that investors demand from their asset managers certain liquidity guidelines, or at the least apply management fees retroactively after exit. The risk is ending up with a highly illiquid portfolio that looks good on paper but you only find out the truth when you try and sell into the market.

This article was originally published in The National.