The churning tides of portfolio liquidity: How to avoid being left high and dry
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By: Adam Berger, CFA, Multi-Asset Strategist
When it comes to liquidity, market events gave asset owners plenty to think about in 2022. The UK pension crisis, in particular, offered a number of lessons: Market liquidity can seize up quickly, as it did after an unexpected fiscal policy decision by the UK government. And strategies intended to reduce specific portfolio risks (in the case of UK pensions, the extensive use of interest-rate derivatives to hedge liability risk) can potentially increase liquidity risk.
While this particular crisis was driven by a number of circumstances that were specific to the UK pension market , I think it was a good reminder of the need for asset owners of every type to think about liquidity risk across a portfolio and to plan for some degree of uncertainty. To help, I’d like to propose a framework for assessing portfolio liquidity based on the intended uses and sources of liquidity.
Why now?
In addition to the lessons learned from the UK pension crisis, there are a number of reasons to take a fresh look at liquidity.
First, as I discussed recently , we may be at the beginning of a more volatile time for economies and markets broadly, following what was a remarkably stable period after the global financial crisis (GFC). And if we are headed into more volatile waters, then investors may face greater liquidity risk than they have in some time — if also more opportunity to be a liquidity provider after a decade in which central banks filled that role.
Second, asset owners are especially conscious of their illiquid allocations right now. Public market declines in 2022 left many with an overweight to private market assets in their equity portfolios — the “denominator effect,” a topic I address in more detail here .
And third, it’s important to keep an eye on portfolio liquidity as an input into risk management, as it does not automatically factor into many common risk-management processes (e.g., VaR models).
Defining the framework
Liquidity risk should be evaluated separately from other portfolio risks, and I think the process can be fairly simple and straightforward, with a focus on the uses and sources of liquidity. The uses might include:
Beneficiary payments — To put it another way, this is the purpose for which the asset owner’s pool of assets exists (payments to retirees from a pension, to a university from an endowment, etc.). From a liquidity management standpoint, the good news is that these payments are generally predictable (although there can be exceptions).
Capital calls — This includes commitments to private assets or other investments where the manager can call capital from the asset owner to take advantage of opportunities as they arise.
Margin calls on levered assets — Asset owners who use leverage to increase returns, to gain exposure in a capital-efficient way (e.g., using fixed income futures to gain duration exposure, as in the UK), or even to take risk off the table (e.g., currency hedging) must be prepared for the liquidity impact if the market moves against them and their counterparties demand additional collateral.
Portfolio rebalancing — For asset owners who, in the wake of a big market move, want to sell assets that did well and buy assets that did poorly, liquidity will be key.
New investment ideas — This might include funding ideas on an ongoing basis opportunistically.
Turning to the sources of liquidity, I’ve attempted a high-level (and admittedly subjective) ranking of them, from most to least liquid, in Figure 1 . On a case-by-case basis, this list could certainly vary (e.g., some hedge funds might be more or less liquid), but I think this is a reasonable starting point. Some asset owners’ lists would also include additional leverage being used in their portfolio (e.g., drawing down a line of credit).
Figure 1
Testing liquidity in normal and stress conditions
To demonstrate the “uses and sources” liquidity framework, I created a simple illustrative portfolio and modeled a “normal environment” marked by regular/predictable uses of liquidity and reasonable/low-cost sources of liquidity. Then I conducted a series of stress tests with various degrees of stress in the uses of liquidity, the sources of liquidity, and in both at the same time.
1. Traditional portfolio and basic liquidity analysis
As shown in
Figure 2
, this illustrative $1 billion portfolio includes allocations to a variety of public equity, fixed income, and alternative assets. I sorted the assets based on the liquidity rankings in
Figure 1
and then factored in a “haircut” based on my assumptions about how much of each allocation might be liquid enough to be available when needed without an unusually high transaction or market-impact cost (second column).
My assumptions were fairly conservative and based on market experience. In core fixed income, for example, we saw in both the post-GFC and post-COVID eras that liquidity is not always plentiful in the investment-grade bond market. Within equities, I gave a little more credit to the US market and a little less to emerging markets. And I assumed no immediate liquidity for private real estate and private equity. My hedge fund assumption of 20% liquidity may be on the less conservative/more optimistic side, but of course every asset owner will want to assign their own assumptions in conducting such an analysis based on the liquidity terms of the strategies/vehicles in which they invest. The bottom line: This $1 billion portfolio has about $528 million of liquidity.
I also made some assumptions about the “uses” of the portfolio’s liquidity (bottom table in Figure 2 ). I assumed a benefits spending rate of 5% or $50 million and capital calls of 1.5% annually or $15 million (using simple assumptions of a 10-year fund life with 10% of the private equity allocation being called in any given year; in practice, more sophisticated modeling would typically be used to model these calls). That $65 million would easily be covered by the portfolio’s assumed liquidity and, in fact, by the core fixed income allocation alone.
Figure 2
2. Liquidity-use stress test
In
Figure 3
, I assumed the asset owner faces additional one-off spending needs amounting to $50 million (e.g., a pension might need to pay lump-sum benefits for early retirements) and faster capital calls amounting to an additional $15 million. This brings the liquidity needed to...
