Managing Liquidity Risk for Institutional Investors

Transcription

1 Managing Liquidity Risk for Institutional Investors Key Takeaways Less-liquid investments have the potential to offer institutional investors some significant benefits Liabilities influence how much liquidity risk can be taken Communicate liquidity needs with investment advisor/manager Aim for sufficient liquidity, not excessive liquidity In 215, Jonathan Jacob, Senior Vice-President, Portfolio Risk Solutions, conducted a series of seminars across Canada discussing ways institutional investors can benefit from carefully considering their ability to take liquidity risk. This paper summarizes his comments. Pension funds have to pay out benefits, foundations have spending requirements, and all institutional investors face the occasional need to rebalance their asset mixes. Some investors enter into hedging contracts that may require funding, and others commit funds to real estate or infrastructure funds that make capital calls from time to time. All of these activities require cash. Liquidity risk refers to the risk that an investor is unable to raise necessary cash within the time frame required to meet such payments. Traditionally, institutional investors have mitigated this risk by holding the bulk of their assets in relatively liquid form publicly traded stocks, bonds and money market instruments securities that can be sold for cash in a relatively short time frame. However, many institutions do not face the need to liquidate the bulk of their assets for a very long time, if ever. Furthermore, there are several less-liquid investment classes that offer profound benefits to investors. These facts suggest that institutional investors could examine their actual need for liquidity, come to an understanding of their ability to take a measured degree of liquidity risk, and allocate part of their assets to less-liquid investments in order to gain the benefits they provide. We consider these points in more detail below. Benefits from Less-Liquid Investments Before discussing how to evaluate one s capacity for taking liquidity risk, it makes sense to look at the potential benefits of doing so. We start in the public equity markets. PUBLICLY-TRADED STOCKS Liquidity can be thought of as a trade-off between the amount of time an investor can take to sell a security and the price the investor wants to obtain for it. If the investor needs to sell shares in a hurry, they may have to settle for a less attractive price. Conversely, if an investor wants to sell shares without an adverse price impact, it may take more time to do so. Prepared by: Jonathan Jacob, CFA, FSA, FCIA Senior Vice-President Portfolio Risk Solutions

2 We examined this trade-off by considering how long it would take to liquidate a 3 million portfolio of Canadian stocks without adverse price effects (with assumed 5% participation rate), based on their three-month average trading volumes. For a portfolio of large cap stocks, we found that about 8% of the portfolio could be sold in one day, with the remainder of the portfolio being sold within a week. However, for small cap stocks, the picture was quite different (see Figure 1). Figure 1: Required Time to Liquidate Small Cap vs. Large Cap Portfolios Figure 2: U.S. Stock Returns by Liquidity and Size Annualized Return (%) 2 Low Liquidity High Liquidity 4-1d 1-7d 7-1d 1-3d 3-18d Small Medium Large Size S&P/TSX 6 Note: Annualized returns, Source: Ibbotson, Kim: Liquidity as an Investment Style: 215 Update. S&P/TSX SmallCap % 2% 4% 6% 8% 1% Note: Three-month average volume 5% participation rate for 3 million portfolio on Apr 2, 215. Source: Bloomberg. In our study, we found we could sell approximately 6% of the small cap portfolio within a week, but the remaining 4% could take as long as six months to sell completely. Given the less-liquid nature of small cap stocks, why invest in them? An updated study by Ibbotson and Kim covering the period demonstrated the existence of a significant performance enhancement from investing in less-liquid stocks, and showed that the enhancement was greatest for small cap stocks (Figure 2). PRIVATE REAL ESTATE An example of a less-liquid asset class is privately-owned commercial real estate. The process involved in selling an office building or a logistics and distribution centre can take months. Yet commercial real estate offers some compelling benefits to pension funds and other investors that need regular income. First of all, analysis of IPD annual return data shows that Canadian commercial real estate has historically generated a very reliable stream of income (Figure 3). Figure 3: Canadian Commercial Real Estate Sources of Return Capital Return Income Return Stable income Source: Investment Property Databank Ltd. As at Dec 31, Ibbotson, Kim: Liquidity as an Investment Style: 215 Update. Page 2

3 This reliable income stream helps the investor meet cash needs, directly offsetting the lower liquidity of the real estate itself. Second, over a longer time period, real estate has generated total returns rivalling those of equities (Figure 4). Figure 4: Canadian Equities, REIT and Real Estate Returns Returns (indexed to 1) Canadian Equities REITs Real Estate Sources: Investment Property Databank Ltd., S&P/TSX Capped REIT Index, S&P/TSX Composite Index, Bloomberg. Third, compared to traditional asset classes, alternatives tend to have lower volatility and lower correlation to other asset classes. For example, while direct real estate and REITs have similar long-term returns, the volatility of commercial real estate is clearly far lower than that of the REITs (Figure 4 note the period 27-1 for a demonstration of this fact). Infrastructure investments are similarly characterized by reliable long-term income streams, lower volatility and capital appreciation beneficial to many institutional investors. Assessing Capacity for Less Liquid Assets Active members constitute an initial source of liquidity to the pension fund as they and/or their employer are making contributions to the plan to fund their ongoing benefit accruals. Eventually, an active member will retire and start removing liquidity from the pension fund in the form of monthly pension payments (Figure 5). Figure 5: Pension Fund Liabilities for an Active Member Contributions Benefit Payments Total Accrued Assets A deferred member is not a source of liquidity, but will also not be draining liquidity from the plan until retirement (Figure 6). Figure 6: Pension Fund Liabilities for a Deferred Member Benefit Payments Total Accrued Assets In the preceding paragraphs, we showed there are many benefits to investing in less-liquid assets. How can an institutional investor square doing so with its need for liquidity? Let s consider in detail the case of a defined benefit pension plan. CONTRIBUTORS TO / DETRACTORS FROM PENSION FUND LIQUIDITY The members of a defined benefit plan fall into three main categories: active members accruing benefits, deferred vested members awaiting benefits but no longer accruing any, and retired members receiving benefits. Page 3

4 Finally, a retired member is a detractor from liquidity (Figure 7). Figure 7: Pension Fund Liabilities for a Retired Member Benefit Payments Total Accrued Assets For any given plan, we can aggregate all three classes of members to come up with a view of the plan s overall liquidity state over time. Figure 8: Pension Fund Liabilities for Aggregate Plan Members The second inflection point (B) occurs when benefit payments exceed both contributions and investment earnings. From this point, the plan s assets actually start to decline. Before the first inflection point, the plan essentially has little or no liquidity risk, and can comfortably invest in less-liquid investments. However, with an eye to the future, it s important to ensure that there will be sufficient liquid assets and/or income-generating assets available by the first inflection point. In addition, the plan should prudently maintain at least some buffer of liquidity in case of unforeseen liquidity needs or liquidity needs that are not due to the benefit structure of the plan (payments to cover hedges, fees, capital calls, etc.). Once the second inflection point is reached, the plan requires significant liquidity and arguably any less-liquid investments should be restricted to those that can generate reliable income. Conceptually, we can summarize this state of affairs as shown in Figure 9. Figure 9: Aggregate Projected Cash Flows and Overall Plan Liability Risk A B Inflection Point Retiree Payments Deferred Payments Active Payments Active Contributions Accrued Assets Net Cashflow Retiree Payments Active Payments Net Cash Flows Deferred Payments Active Contributions In the sample plan illustrated in Figure 8, we can see there are two key inflection points from the perspective of liquidity risk: The first inflection point (A) occurs when net cash flows cease being positive; in other words, when benefit payments first exceed contributions. From this point on, the growth in the plan s assets slows considerably. Overall Plan Liability Risk Highest need for liquidity Lowest need for liquidity Page 4

5 Having framed the plan s ability to invest in less-liquid assets, we can turn to the process of constructing an appropriate portfolio. Portfolio Construction with Less-Liquid Assets The traditional way to assemble a portfolio is to run the allowable asset classes (specifically, their returns, volatilities and correlations with each other) through an optimization calculation that constructs the asset mix that maximizes the return for each level of volatility. The curve showing the optimal return for each volatility level is the so-called efficient frontier shown in Figure 1. Figure 1: Efficient Frontier With No Constraints Expected Return (%) No Constraints Portfolio Risk (%) In this example, we show that for a chosen volatility or risk level of 6% per annum, the optimal portfolio would be expected to return about 8% per annum. We have labelled the efficient frontier curve No Constraints because we constructed it to include many liquid and less-liquid asset classes and did not place arbitrary limits on the allocation to any asset class. In practice, an unconstrained approach to building optimal portfolios is not feasible: the combined return/volatility/ correlation characteristics of less-liquid asset classes result in asset mixes that investment committees are unlikely to be able to stomach, as the mixes may not be prudent from other perspectives. Figure 11: Unconstrained Asset Mix % of Asset Mix Mortgages High Yield U.S. Equity I&G* U.S. Equity Core Infrastructure Canadian Small Cap Portfolio Risk (%) Note: * U.S. Equity Income & Growth For example, as demonstrated in Figure 11, the asset mix corresponding to our chosen volatility level of 6% per annum would consist largely of infrastructure (about 8%), along with modest helpings of high yield bonds and Canadian small cap stocks. Not a real-world asset mix! One way to deal with this is to place an arbitrary limit on the allocation to alternative investments, say 1%, 2% or 3%. The effect of doing so on the efficient frontier is shown in Figure 12. We also included the ultimate constraint of no alternatives for comparison. Figure 12: Efficient Frontier with Alternative Asset Constraints Expected Return (%) Portfolio Risk (%) No Constraints Alternatives (3%) Alternatives (2%) Alternatives (1%) No Alternatives Page 5

6 The plan sponsor has a trade-off to make between the constrained allocation to alternatives and the resulting return for any given level of risk. Before making a final decision based solely on the efficient frontier, the plan sponsor should also stress-test their intention - the issue of liquidity risk also plays a role in this decision. Specifically, let s suppose the investment committee agrees that a 2% allocation to alternatives makes sense for their plan large enough to move the efficient frontier to a more appealing risk-reward position, yet small enough that the use of less-liquid alternatives is not a concern given the plan s current and future expected liquidity needs. The committee members should then ask themselves what impact a bear market in their liquid investments (with little to no impact on alternative assets) would have on their allocations, and how comfortable they are with the result. Figure 13 shows the impact that a bear market in the liquid non-alternative asset classes could have on the plan s allocation to alternatives. Figure 13: Stress-Testing To See How Asset Mix Could Change -1% -25% -4% inflection points in its liquidity profile that we discussed earlier. For example, an investment committee that set a 2% cap on alternatives may be comfortable with a temporary increase to 25% during a time of market stress, but not with higher amounts. One reason the committee may be comfortable with some amount of alternatives in excess of its stated cap is the fact we noted before: the income stream from the alternatives helps to offset their lower liquidity. In this case, the committee may wish to establish a policy for managing liquidity risk as the less-liquid allocation moves up towards 25%. Ideally, the plan s investment managers would be fully informed of this policy and could be ready to help the plan reduce its alternatives exposure in an orderly manner. Conclusion In this paper, we have shown that there are benefits to be earned by investing in less-liquid assets. We have also examined how an institutional investor can determine its ability to deal with liquidity risk over time, and have outlined an approach for deciding how much of a portfolio to allocate to less-liquid investments. Specifically, we ve examined how an investor s liabilities or obligations impact its ability to invest in less-liquid assets. As those liabilities shift over time, the investor should monitor its liquidity needs regularly, and communicate with its investment managers concerning them. 2% 22% 25% 29% Base Case Test 1 Test 2 Test 3 In closing, we would emphasize that an investor should ensure it has sufficient liquidity, not excessive liquidity. As Roger Ibbotson concluded in his research, Don t pay for liquidity you do not need. Non-Alternatives Alternatives For example, we can see that if the non-alternatives fall 25% in value (certainly within the recent experience of many plans), the alternatives will then make up 25% of the plan s remaining assets, distinctly above the constraint of 2% the committee imposed at the beginning. How comfortable is the committee with this result? The answer to this question will depend on several factors, including not only the committee members own views, but also the time remaining before the plan reaches the We invite you to watch a webinar recording of Managing Liquidity Risk for Institutional Investors. Use the link to watch the recording (33 minutes), following a brief registration. or Scan QR Code to gain direct access to our website Page 6

7 About the Author Jonathan Jacob is Senior Vice-President of the Portfolio Risk Solutions group at Greystone Managed Investments Inc., and is a member of the Greystone Asset Strategy Team. Jonathan s group evaluates portfolio risk and provides consultative advice in the construction of multi-asset portfolios. Jonathan is also responsible for providing risk-based investment solutions to clients and their advisors. Disclosures This document is for informational purposes only. It is not meant as investment advice and is not an offer, solicitation or recommendation to purchase or sell any security. There is no assurance that any predictions or projections will actually occur. Past performance is not necessarily indicative of future results. Commentary reflects the opinions of Greystone Managed Investments Inc. as of the date of the document. This document was developed from sources believed to be reliable, but is not guaranteed to be accurate or complete. Greystone Managed Investments Inc. All rights reserved. Page 7

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