Liquidity sleeves that mimic a fund’s strategic asset allocation with ETFs could help asset owners navigate bouts of volatility, such as seen during the months of March and April this year, iShares says.
Many pension funds in Australia conduct stress tests on a regular basis, in which they calculate the impact of sharp falls in equity markets, member switching and fluctuations in exchange rates on the portfolio.
But often it is not the fall in asset prices that causes issues for institutional investors during a crisis; it is the lack of liquidity that follows as fear spreads across markets.
When the full extent of the coronavirus pandemic became clear in March this year, liquidity dried up quickly, making any response difficult to execute.
A strategy that could lessen the burden on funds in such situations is implementing a so-called ‘liquidity sleeve’, a portfolio of exchange traded funds (ETFs) that mimics the strategic asset allocation of the overall portfolio.
Scott Williamson, Head of iShares’ Asset Owner Client Group at BlackRock, says ETFs have proven to remain liquid during unexpected stress events such as the one markets experienced in March and April of this year.
“In each stress event or bout of volatility that we have mapped over the last 10 years, you will find ETFs increase in volume and liquidity,” Williamson says in an interview with [i3] Insights.
“When the stress events hit, and whether it is the high yield or the long bond that is in trouble, every time the ETF is there to provide liquidity. We actually see liquidity jump in stress events, not go south for the winter,” he says.
The Origins
Williamson was instrumental in the development of the liquidity sleeve concept, which started many years ago during a phone call with a high-profile US West Coast endowment fund.
“I was on the call and they said: ‘Couldn’t we mirror our policy with these ETFs that you guys are talking about?’. It was still early days and institutions were just starting to figure out what an exchange traded fund was,” Williamson says.
“We said: ‘Yes, of course you could’, and all the benefits were starting to develop in our heads. So I walked over to a member of the team and said: ‘What if we created a portfolio of ETFs that would mirror the asset allocation of a typical institution?’
“That individual said to me: ‘You could use the Pension & Investments Top 200 pension fund survey and the Greenwich Associates Endowments Survey, which have the average asset allocations of those investor types.
“From there we created liquid policy portfolios (LPP) and that was the first incarnation of our liquidity strategy,” he says.
The benefits are not just limited to greater liquidity. There are also benefits stemming from lower trading costs, as bid/ask spreads for ETFs tend to be tighter than for the underlying assets, while shorter settlement times also result in lower value-at-risk ratios.
“This approach has all the benefits of ETFs, which are that instead of T minus 1 or T minus 2 or weekly liquidity, we had daily liquidity, trade date notification and T +1 cash settlement, all the while that when you trade in these liquid vehicles you are doing so at fractions of the transaction cost of trading the underlying market themselves,” Williamson says.
This [liquid policy portfolio] approach has all the benefits of ETFs, which are that instead of T minus 1 or T minus 2 or weekly liquidity, we had daily liquidity, trade date notification and T +1 cash settlement, all the while that when you trade in these liquid vehicles you are doing so at fractions of the transaction cost of trading the underlying market themselves
The concept developed quickly from a standard commingled fund approach to a customised implementation, since few institutions hold exactly the average asset allocation.
“We built this first LPP on the published allocations of the pension funds surveyed and this was to be the source of liquidity for cash flows, capital calls, distributions, contributions, whatever it may be,” Williamson says.
“From there, when you got into conversations with clients, they would simply say: ‘Oh, I like this, but that is not exactly me. My allocation is this, not that’.
“So then we started looking at custom solutions and now we are taking an actual client’s policy statement, their literal strategic asset allocation, and building a custom liquid policy portfolio for them,” he says.
Leave Your Active Manager Alone
The concept of a liquidity sleeve also helps in keeping active managers on track and allowing them to stay fully invested if so desired.
“You didn’t hire an active manager to provide liquidity to you. You hire an active manager to do one thing and that is to drive alpha, to drive excess return, in the portfolio,” Williamson says.
“If you have a stable of active managers and you need to source liquidity and you start to constantly tap active managers for liquidity, then that changes the philosophy of the implementation of that active manager.
“They start to recognise: ‘Wow, I need to be somewhat liquid here, because I’m getting constantly hit for liquidity by this client’.
I came into the picture thinking: ‘You can reduce your cash drag. You can reduce risk from the notification period. You can reduce transaction costs’. But they said to us: ‘No, for us it is about not disrupting active managers'
This idea, again, came from conversations with asset owners. Williamson recalls an engagement with a client from the southeast of the United States, which didn’t have trading costs or settlement times in mind as the key benefits.
“One of the most interesting client engagements that I had was a very large southeastern United States pension fund, with whom we worked for years on a custom liquidity solution.
“And at one point they were ready to take it to their board, so they wrote up the features and benefits of this solution the way they were looking at it. I came into the picture thinking: ‘You can reduce your cash drag. You can reduce risk from the notification period. You can reduce transaction costs’.
“But they said to us: ‘No, for us it is about not disrupting active managers’.
Single Asset Classes
Building a liquidity sleeve that mimics the total portfolio was the starting point of the concept. But as this idea became more established in the US, it has found its application in single asset classes too.
One recent example was an asset owner, who sought access to the high yield market in the midst of the pandemic turmoil, Williamson says
“I was in a conversation with an East Coast pension fund and this was a single asset class conversation where we were talking about high yield. High yield is characterised by bouts of illiquidity, because it is just not the most liquid asset class of all.
“And when you get into periods of volatility, as we experienced in March and April, these are markets that completely shut down. They are closed for business.
“What this pension fund said to me: ‘We are thinking about this much more from a risk management lens. We’ve got the bond market where we can traditionally go, but when the bond market seizes up and it does so frequently in these bouts of volatility, we would like to have a second venue for market access and liquidity’.
“And so they are looking at it from a risk standpoint, in terms of making sure that they can access the market to either put risk on or take risk off.”
It also helps in maintaining the integrity of carefully constructed credit portfolios. Often bond portfolio managers spend a long time researching individual securities and assessing their contribution to the overall portfolio.
What if you had, in your high yield portfolio, a sleeve of high yield ETFs, so when the CIO comes to you and says he needs US$50 million you don’t have to touch those great bonds that you spent so much time pulling together?
But unlike equities, corporate bonds are not necessarily widely available, Williamson says, and so you want to leave these bonds alone as much as possible.
“Fixed income managers spend an enormous amount of time researching individual CUSIPS (the Committee on Uniform Securities Identification Procedures number) to put in the portfolio to generate alpha,” Williamson says.
“Imagine this bond manager has researched certain bonds and the CIO comes in and says: ‘I need US$50 million in liquidity’. You’ve spent all this time orchestrating this perfect set of bonds, but now if you sell this bond, then you may never get it back.
“So we said to that portfolio manager: ‘What if you had, in your high yield portfolio, a sleeve of high yield ETFs, so when the CIO comes to you and says he needs US$50 million you don’t have to touch those great bonds that you spent so much time pulling together.
“You just sell your ETFs,” he says.
Unlisted Assets
A more recent area of development has been liquidity sleeves that mimic private market exposures, including private equity, private credit and hedge funds. These areas are tricky to replicate as valuations are often done only quarterly, while some fund structures might lock up an asset owner’s money for several years at a time.
Allocating a small portion of the private markets portfolio to a liquid sleeve could take pressure off these assets in times of market stress.
Williamson says the team already had the building blocks in place to develop this approach from when they first looked at mimicking the overall allocation of pension funds.
“When we created that first LPP, we had to regress and model for the hedge fund allocation, using the HFRI Conservative Index. So we realised that since we had dollars running against the LPP for eight years, we actually had an eight year track record,” he says.
Many pension funds are also looking to increase their allocation to private equity, but in this asset class they are subjected to the number of deals the private equity manager does.
To help asset owners get an exposure quickly, iShares developed a liquidity sleeve that gives exposure to the private equity sector.
“With private equity, we are utilising the Cambridge Private Equity Index and what we are doing is effectively breaking that down and regressing it into its factor exposures so we understand what is inherent in that index.
“We also recognised that a private equity implementation is a very illiquid implementation, which might mark to market only once a quarter. So we used quantitative techniques to smooth out that quarterly mark into something more real time, akin to public equities.
“Finally, we took a database of mergers and acquisitions activity and we looked at a number of events where public companies were taken private by public equity firms over a period of ten years.
“We then assembled that group of 120 separate events and we looked at their aggregated factor exposures the day before the M&A announcement.
“Because on the day of you can imagine you have a big momentum-type of spike, in terms of factor exposure. But the day before…, we tried to find a common denominator, a similarity between the type of companies that were being acquired by private equity firms and taken private.
“So the combination of those three approaches: the regression of the Cambridge Index, the smoothing quantitative techniques we used and the M&A considerations developed into a single exposure for our private equity fund.”
But where total portfolio liquidity sleeves have become an established practice in the US, these single, unlisted asset class sleeves are only now starting to become more widespread, Williamson says.
“This concept of private equity and hedge funds, that is really just starting to build steam now,” he says.
This article is paid for by BlackRock. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.