Mark Aarons, Head of Portfolio Risk and Solutions for VFMC

Mark Aarons, Head of Portfolio Risk and Solutions for VFMC

Hedging with Hindsight

A Look at Unlisted Assets and Liquidity Risk

What if you could design your hedging strategy with 20/20 hindsight? We asked VFMC’s Mark Aarons how to best address this question.

Nobody knew the coronavirus was going to turn 2020 into the year the world went into a tailspin, with Australia most likely experiencing its biggest contraction since the Great Depression.

But what if you did? What hedge would you put in place to protect your portfolio from the downturn?

We asked Mark Aarons, Head of Portfolio Risk and Solutions for Victorian Funds Management Corporation (VFMC), the Victorian government’s funds management arm.

Aarons, who is also Adjunct Associate Professor at the Centre for Quantitative Finance and Investment Strategies at Monash University in Melbourne, has studied hedging for investment managers extensively and also has led VFMC’s ongoing project to better measure risk in the portfolio.

“Wouldn’t a crystal ball be wonderful?” Aarons says as he ponders the question.

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If you are looking at your liquid assets and you knew this was coming, you wouldn’t hedge if you didn’t have any mandate constraints.

“It depends on which assets in the portfolio you are looking at. If you are looking at your liquid assets and you knew this was coming, you wouldn’t hedge if you didn’t have any mandate constraints.

“You would just sell the risky assets before the sell-off started and possibly go short while you’re at it to really make money.”

But the story is different for unlisted assets.

“If you want to hedge market movements on your illiquid assets, then you need to be able to measure and attribute that risk to start with. How much risk do we have in it and where does that risk come from?” Aarons says.

“That then enables you to do a whole lot of other useful things, such as sizing your allocations, so that you can actually do risk allocation, rather than just asset allocation.

“Unless you’ve done that work, I really don’t know how you could even attempt to hedge the drawdown in your unlisted assets. It would be in the realm of a wild guess.”

VFMC’s Risk Project

VFMC has been working on a portfolio analytics project, named the Investment Risk Uplift Project, for a little over a year now. The aim of the project is to understand the risk at a total portfolio level. This requires strong data and risk modelling capabilities to succeed. It is also complemented by a significant data and analytics project at VFMC.

“What we are trying to do is come up with an accurate way to measure risk across the whole portfolio and in each part of the portfolio via a bottom-up approach,” Aarons says.

“The whole industry has really been challenged by measuring the risk from unlisted assets in particular, and for us at VFMC that is mainly infrastructure, hedge funds, property and private credit. We don’t have much private equity.”

VFMC doesn’t hedge its illiquid assets, but it is something the fund might want to do in the future in certain market conditions. But first it tries to get a more complete picture of risk in these asset classes.

“All of the unlisted assets have components of the different macro risk factors: there is equity risk, interest rate risk, inflation risk, commodity risk. And there is foreign exchange risk as well, which we manage on a total portfolio basis,” Aarons notes.

“How much of each of these risks is there? What is the duration of your rate risk or your inflation risk? If you can get a handle on that, then that will inform your overall risk allocation. Then at least you won’t have any unintended exposures or blind spots.

“In those four asset classes, we’re investing considerable effort to measure and understand the risk. I wouldn’t want to suggest that we’ve got a perfect picture, and there’s lots of work still to do, but to the great credit of VFMC, we’ve been resourced to go on that journey.”

Liquidity

The perfect storm caused by falling equity markets, increased unemployment and the federal government’s decision to allow those in need early access to their super has created high demands on funds’ liquidity.

Aarons argues that although most funds are in a relatively comfortable liquidity position, perhaps it is time to put a more rigorous framework around the management of liquidity at an industry level, not unlike the rules that have been put in place for banks under the Basel III regulations.

“If you look at banks, they have liquidity coverage ratios, which were introduced after the GFC (Global Financial Crisis). This looks at all sources of inflows and outflows in a stress event; it is rather detailed and comprehensive. It is not clear to me that all funds have that same clear and detailed picture of the components of their liquidity risk,” he says.

Again, it is important funds seek to gain a view of their liquidity position at the total portfolio level because sources and drains on liquidity are spread around the portfolio. Different functions within the investment teams might work on different components. For example, one team might deal with term deposit maturities, while another team looks after foreign exchange forward maturities and others manage capital calls.

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“From my previous roles in banking, I saw that banks were really forced to upgrade their risk and capital management generally – and their liquidity management specifically under the APRA Prudential Standard APS 210. I’m wondering if the buy-side could benefit from going through an analogous exercise?

Cash might also be ‘trapped’ in pockets of a portfolio due to mandate structures. These all need to be tied together to give a total portfolio view, Aarons says.

“From my previous roles in banking, I saw that banks were really forced to upgrade their risk and capital management generally – and their liquidity management specifically under the APRA Prudential Standard APS 210. I’m wondering if the buy side could benefit from going through an analogous exercise,” he says.

“Metrics such as cash flow at risk or a liquidity coverage ratio are really useful. It forces one to look at liquidity risk from a total portfolio perspective. It will need to be different because funds are not banks, but I’m wondering if something of that scale needs to be done. That would enhance the portfolio management overall, especially since unlisted assets are such important components of modern portfolios.

“There’s been some off-the-mark criticisms of unlisted assets in the press recently. To me that misses the point. In principle, unlisted assets are fine, but the portfolio management around them may need to be better adapted. Well-crafted regulation could help.”

Time Buckets

In a previous interview, Aarons made the argument for spreading out liquidity risk by using different time buckets for the maturities of foreign exchange forwards and he says this is still one of the first things funds might want to consider in their approach to liquidity.

“Liquidity risk is often caused by timing mismatches. Whether it’s a mismatch between FX hedge duration and the sell-down time of illiquid assets, or the mismatch between the valuation frequency of illiquid assets and the frequency which members’ can switch investment options, timing mismatches can cause problems,” he says.

A related way that funds can manage their liquidity is to look at their collateral arrangements.

“From a currency hedging perspective you could consider not posting cash collateral if you don’t have to,” Aarons says.

“It gives you more control over the timing of cash outflows. The regulations in Australia, under Prudential Standard CPS 226, allow you to not collateralise physically settled FX forwards at all. There are many possible variations – no collateralisation, one-sided collateralisation, two-way non-cash collateralisation.

“I wonder why some funds do cash collateralise, because if you don’t post cash collateral, it helps a great deal from a liquidity point of view. It allows one to spread out liquidity risk into the future in the manner you choose.

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I wonder why some funds do cash collateralise, because if you don’t post cash collateral it helps a great deal from a liquidity point of view. It allows one to spread-out liquidity risk into the future in the manner you choose.

“Now, the different collateralisation options can increase the cost, but there are things you can do there as well. One might also ask, what is the cost of not managing liquidity risk well? Selling liquid risk assets at a low price to cover a liquidity shortfall can be very costly, even if it only happens infrequently.

“If there’s no collateralisation, one might then say: ‘Well, I’m worried about counterparty risk now,’ and, sure, that is a valid concern, but at least you can spread that counterparty risk over more and more counterparties. You can diversify your counterparty risk.

“You can’t diversify your liquidity risk, but you can spread it out through time.

“We did this recently at VFMC by spreading our FX forward maturities much further into the future and it reduced our outflows very significantly, given the drop in the Australian dollar. Our Dealing and Implementation teams did a great job of getting these trades done efficiently before the sell-off.

“I won’t get into the specifics of the positions in our portfolio. But it is fair to say that it saved us a very large sum in outflows in near-term time buckets by pushing the potential outflows into the future. And that gives us time to manage it. It also gives the Australian dollar time to bounce back, so you might not even have to pay out.

“I have heard some unfortunate stories recently of funds who kept their FX forwards fully collateralised or uncollateralised but with short-dated maturities – just like MTAA did in 2008/09. Whilst funds might have ample liquidity overall to settle their FX forwards, it does potentially mean selling liquid assets at depressed prices to fund it.

“That’s so unnecessary and means that their members are taking a NAV (net asset value) hit for no good reason.”