Anticipating the credit
crunch, some institutional investors readied their portfolios for an imminent bear
market, while the majority stuck to strategic weights backed by long-term
return assumptions. But who among either group thought that liquidity, the ultimate
facilitator of portfolios, would become so thin that their strategies would become
compromised for lack of it? In the grip of a fierce market that has wiped out
returns from most asset classes and torn the local currency down from its
near-greenback-parity high, superannuation funds are managing liquidity
pressures that will seemingly not abate for some time.

Paying benefits; rebalancing;
meeting member demands for cash; funding expensive currency hedges, capital
calls and other operations are among the gamut of severe liquidity challenges
being negotiated by the industry. Originating with the collapse of structured
credit markets, gut-wrenching writedowns and a mass deleveraging process
shuddered through global financial markets, destroying billions in invested capital.
Today’s liquidity stresses are the most severe in the history of superannuation
to date.

They became particularly acute when Lehman Brothers, a counterparty of
many trades held by managers worldwide, failed. Allocations across the globe
were wound up and sent to the sheltered harbour of the

US Treasury
bond market, and the Australian dollar depreciated sharply. The wealth
destruction caused by this bear market has been fast and brutal, and its shocks
have diminished funds’ access to the essence of their existence: liquidity. While
the capability of retirement savings funds to pay benefits remains intact, their
ability to implement predetermined investment strategies has, in some cases, been
undermined.

As a general rule, the extent of a fund’s liquidity stress depends
on how heavily it has allocated to unlisted assets, which now account for
greater shares of portfolios since listed markets have cascaded. Now that funds
with more unlisted assets are, for the most part, less liquid, there is a
broader awareness that liquidity can “evaporate more sharply in areas where people
don’t expect it to, and stay away for longer than what was expected,” say Celia
Dallas and John-Austin Saviano, of
US
consultancy Cambridge Associates.

Previous bear markets have sent indexes on
doubledigit annual declines, but this financial crisis has also dealt blows of
market illiquidity and multiple asset class falls to superannuation funds. The
most exacting liquidity challenge to date for funds has been the rapid
deterioration in value of the Australian dollar, which in some cases required forced-selling
of assets to maintain currency hedges for global listed and unlisted
investments.

For Lochiel Crafter, chief executive officer of the $18 billion
Australian Reward Investment

Alliance
(ARIA), the currency fall became “the biggest dislocation that I’ve seen in my
investment career”. Combined with listed market declines and an increase in the
movement of ARIA members to more conservative investment options, the “currency
crunch” has resulted in the fund honing its liquidity management processes so
it can counteract an array of market scenarios. Just as well. The prudential watchdog, the Australian Prudential Regulatory Authority (APRA),
is concerned about super funds’ management of liquidity in the current
environment.

Investment & Technology understands that APRA is visiting
funds, requesting that they perform a series of stresstests and demanding that funds
supply plans detailing how they would cope with 50 per cent, or even 100 per
cent, liquidation. How would a fund find the cash, and how long would it take
to provide it? An outright run on a fund by all members or total aversion of
investment risk seems a remote possibility, but APRA’s exercises see super funds’
liquidity management capabilities tested to their absolute limits.

In this
cash-starved market, funds’ management of available liquidity should be optimal.
To date, APRA has generally been satisfied with its findings. In a statement
addressing the liquidity tests, the regulator said that “while liquidity
stresstesting could be enhanced in some cases, initial findings are that, in
general, funds are alert to liquidity risks and are dealing with current market
stresses proportionately”. Crafter defines liquidity management as a balance between
a need for long-term investment returns and shortterm demands for cash, in
order to accommodate members’ investment choices and to keep the fund
operating.

At present, negative returns, currency hedging costs and responding to
members’ investment decisions are the main influences on ARIA’s liquidity
management processes. “Money’s been tight, but we’re not stressed in any way,”
Crafter says, adding that the strategic integrity of the portfolio remains
intact. “We’ve shifted to have a higher focus on short-term liquidity, but
still have a fiveto- 10-year view of investment returns. We still have an unlisted
assets program, and we still have a 25 per cent limit on how large it can be.” The
main objective of liquidity management is clear. “We need to know how we will generate
liquidity across the entire fund structure: where we can get it from, and how quickly
we can get it,” he says.

Its daily processes are the “money-in, money-out” management
of cashflows, and weekly and three-month forecasts of liquidity obligations, such
as benefit payments and investment activity. But cashflow sensitivity analyses and
changes in the Australian currency are the primary concerns at present. Interestingly,
ARIA’s forecasts have not prompted it to set aside dedicated cash reserves for
liquidity needs. “We forecast liquidity, and keep an appropriate level of cash
in place,” Crafter assures. He says the focus on liquidity management is part of
a broader appreciation of risk management within the fund: “The worst things
for us are surprises.

Our view is to manage a portfolio to minimise surprises.”
The most unwanted surprises for investors are the bad events they don’t
foresee. Scenarios can be played out, and action plans stress-tested, but a
severe equity market decline, currency swing or the collapse of a significant
counterparty is always unwelcome, rarely foretold, and usually catches funds
unawares. “We don’t know what comes next,” says Troy Rieck, managing director
of capital markets at Queensland Investment Corporation (QIC), in reference to
the prospects of future liquidity pressures. “If equities fall another 50 per cent,
we’d have a very interesting world.” In an instance of fortuitous timing, QIC
began building its current risk infrastructure, which prizes liquidity, three years
ago.

The decision to do so was not made in expectation of the global crisis,
but in recognition that the past few decades have produced “incredibly benign”
market risks if viewed in a more far-reaching historical context, Rieck says. “Twelve
months ago, the biggest problem for funds was finding homes for cash. Now they
have been hit by a big risk event, after risk has been underpriced and
under-resourced. We’re starting to see what under-resourcing the risk
management functions of funds can result in,” he says. “Peak-to-trough
drawdowns of 50 per cent or more are quite common; it’s not unusual to see a
large collapse in listed markets.

A lot of people haven’t thought: ‘what if that
happens? What would my fund look like?’” While they are usually conceptually
straightforward, liquidity management frameworks are typically difficult to
execute well. According to Heather Myers, director of endowment strategy with Russell
Investments, “it is virtually impossible to build a portfolio that approaches guaranteed
liquidity no matter what happens”. Central to liquidity frameworks are frequent,
cautious forecasts and full knowledge of cashflows.

Next come the simulations
of episodes of liquidity stress triggered by various events: market crashes,
long-duration bond defaults, and swings in foreign exchange rates, among
others. In devising potential scenarios, funds should not be restricted to
models but explore a wide range of nightmarish circumstances to test the
resilience of their fund, and how effective their liquidity techniques are. “How
much cash would the fund need if the [foreign] exchange [rate] fell 25 per cent
in the next three months?” Rieck asks. “Answering this gives you a set of
numbers in your head so you know what could happen in extreme circumstances.”

The
financial crisis has provided QIC’s new risk management structure with a baptism
of fire. At any point, the manager can summon $10 billion in cash to invest or
meet an urgent obligation. (“It just rolls off the tongue, doesn’t it?” Rieck
says gloatingly, referring to the size of the cashpile.) But if equity markets
fell another 50 per cent, life would become hideous for the manager. “But,
until we run out of every dollar, the fund is liquid,” Rieck says. “It’s been
12 to 18 months of hell and hard work.

We don’t know what’s coming next, but we
want the widest set of options available to fund for whatever comes down the pipeline.”
Even with expansive scenario analyses, few institutions anticipated the extent
of the decline in equity markets and the precipitous fall of the Australian dollar.
Illustrating this, AMP Capital Investors’ $1 billion global bond fund was
forced to liquidate up to 30 per cent of its assets to meet an escalating currency
hedge, it is understood.

Funds with large hedging programs for international
listed and unlisted investments may not have been fully aware of the
implications for their offshore portfolios if the currency sharply devalued, says
Ray King, founder of Sovereign Investment Research. “They were let down by
traditional consultants in that area,” he says. Another impending risk is the demographic
compositions of funds with large numbers of members nearing retirement. There
is a continuing tendency among Australians to take a large proportion of their
benefit as a lump sum upon retirement.

In 2006, 67 per cent of benefit payments
across the industry were lump sums, figures from Mercer Investment Consulting
show. Also, due to the taxation of benefits passed on to non-dependents upon the
death of a retiree, members may feel compelled to take their money out while
they are alive, and expect their accounts to be available upon request. And if
retirees continue to pull the bulk of their assets from super funds relatively
quickly, institutions that have experienced steady asset growth and membership
over the years may face slowing growth or even some downturn during the next 10
to 20 years as the number of retirees increases, Mercer finds.

The pressure to
keep the majority of larger accounts continuously liquid should increase as

Australia’s
population continues to grey. According to the Australian Bureau of Statistics,
the number of people in

Australia
aged 65 years or more is projected to increase from 12.9 per cent in 2004 to
26.9 per cent in 2050, after taking into account the arrival of 100,000
immigrants each year. The next immediate liquidity event expected to affect
many Australian super funds, however, is a spate of capital calls from
alternatives managers wanting to draw-down commitments.

This has already
heavily impacted

US
pension and endowment funds. The consequences for these investors have been
forced drifts from strategic investment targets as they search portfolios for
liquidity to meet their obligations. Some have even incurred penalty fees as
they redeem investments from hedge funds that have imposed gating provisions,
Dallas of

Cambridge
Associates says. Super funds with substantial illiquid investment programs,
particularly in private equity, are expected to face a somewhat similar
increase in capital calls.

King of Sovereign Investment Research questions
whether funds with alternatives programs have accurately projected what their
illiquidity exposures will be in years to come. QIC’s Rieck believes these
programs will “act like a thirsty sponge and drain liquidity from portfolios”
in the next two years, rather than the typical timeframe of five years, as
managers see attractive buying opportunities in the unlisted universe, since
valuations of such assets are expected to decline. “It’s not clear where funds
are going to get money from,” Rieck says. “We’ve seen funds with large
outstanding commitments, and managers are calling for capital.

They think they’ve
found that once-in-a-lifetime asset. And funds have to provide – it’s a
contractual commitment.” To some, however, the threat is overblown. Neither
ARIA nor any clients of Frontier Investment Consulting have reported unusually
sudden calls from unlisted asset managers for committed capital. Crafter of
ARIA says one distressed debt manager has drawn down its commitment faster than
usual, but that private equity managers have been quiet. In the private equity
market, deal-flow has slowed because credit remains expensive, and calls for
capital from these managers has not been identified as a risk in ARIA’s
cashflow forecasts.

The multi-manager business of Colonial

First
State
(CFS) can discard this scenario. It does not run any illiquid investment
programs – not because it is sceptical of the return or diversification benefits,
but to ensure it can accommodate member choice. “You can’t lock yourself into
long-term illiquid timeframes when underlying investors can withdraw their
cash,” says Scott Tully, head of First Choice Investments at CFS.

The major
risk faced by the manager is the movements of members. “We recognise that our
liquidity risk arises from investors wanting their money back,” Tully says. The
allure of cash to CFS clients has been strong. In its first few months of
existence, its new cash product, FirstRate Saver, has pulled in more than $500
million. Frontier Investment Consulting also observes that the “modest trend” of
member movement to conservative options has gathered pace in recent months,
says Kristian Fok, deputy managing director with the consultancy.

These
movements have affected the rebalancing activities of funds, but have also
precipitated another gradual change in their liquidity profiles. Since the last
major downturn, the asset bases of super funds have grown relative to their
cashflows, Fok says. Larger member accounts now far outweigh the size of the
contributions that feed them. “Assets can no longer be offset by cashflows,”
Fok says.

As a result, member contributions relative to riskier holdings such
as equities and alternatives will probably shrink in the near-to-medium term,
due to the growing number of members choosing more conservative options and the
small volume of contributions compared to total assets. Voluntary contributions
are also predicted to diminish somewhat as the domestic recession puts more members
out of work.

These are further dimensions of liquidity management that funds
are dealing with. Facing up to these risks, super funds need to broaden their
thinking about investment strategies and the liquidity that enables them, since
investment assumptions, based on historical cash flows, have now changed for
the foreseeable future. “You don’t want to be managing for liquidity only for
now, but also in the future,” Fok says. As a pertinent starting point, currency
hedging should be moved out of asset classes and carried out at the fund level,
Rieck says: “You need to do these things in one place. Then there will be no
people offsetting [hedging] trades, or trading with different brokers at
different times.” Liquidity
management also involves saving money wherever possible and deploying it
effectively.

QIC began amassing its $10 billion hoard in the last two years of
the bull market, “when we could, not when we had to,” Rieck says. Institutions
can strengthen cash reserves by taking distributions from alternatives managers
in cash and not as re-invested capital with the manager, by not leaving excess cash
with futures dealers and custodians, and by engaging in securities lending and “repo
finance” with bond managers. “None of this is new,” Rieck says. “We think of
ourselves as a treasury division in a multinational corporation, because the
tasks are similar to corporate finance. It involves jobs like finding out the
costs of capital, funding trades, and hedging tax exposures.”

The manager also
began separating capital from investment exposure by using derivatives to keep
strategies in place, while unleashing capital and putting it to work elsewhere.
“Cash isn’t the same as liquidity. [The aim is] not to assess which liquid
funds we have available, but to think of every asset, and how long it would
take to sell it. To provide the assurance that you can lay your hands on the
money when you need to.” This separation of capital from investment positions
can be achieved by using exchangetraded derivatives.

However, the collateral
required to place these bets can be large, sometimes as much as 10 per cent of
the synthetic exposure, and involve counterparty risk. “But move it to the
over-the-counter world, and the pricing can be attractive,” Rieck says. “Our
job as investors isn’t to eliminate risk. It’s to smartly and efficiently trade
off some risks against others.” But buying options often adds leverage and
counterparty risks to the portfolio. “It’s cheap to get in the market with an option.


But you have to back it up with sufficient cash, otherwise you’re leveraging
the portfolio,” Fok says. And since leverage essentially amplifies investment
risk, incurring losses through such exposures is extremely risky and can result
in the losses exceeding the collateral behind the positions. “If you have
exposure to a leveraged asset that decreases in value you have to post margin
to cover it,” says Dallas of

Cambridge
Associates. But if it works, you have freed some cash for use elsewhere.

Assessing
the networks of counterparties in service provider relationships can also pinpoint
threats to a fund’s liquidity profile. Checking up on the futures clearers used
by custodians, and the brokers used by managers, and judging whether any
providers face capital pressures or are exposed to a weak counterparty, can
help detect potential threats to cashflows or the liquidity of investments.

Fok
says that managers with liquidity problems can sometimes influence member investment
options. “Some retail platforms have been impacted [by] over-reliance on one or
two managers, whose funds have frozen,” he says. “If you’re going to have 50
investment managers, 12 asset classes and investment options, you better find a
way to coordinate those activities, otherwise you don’t know the risks that you
have.” Ultimately, comprehensive analysis of liquidity risks, and effective
actions taken to counteract them, should prevent funds from being
forced-sellers of assets in declining markets. “If you’re a forced-seller, you’re
going to get screwed,” Rieck says.

It also provides the means to swoop on
assets volunteered by forcedsellers. “We didn’t build our risk framework because
we thought that the investment world would be coming to an end – we are
terrified that insufficient risk management would force us to change investment
policy mid-stream,” Rieck says. “We wanted to be in a position that if
something bad happened, we could take advantage of it and buy a once-in-a-generation
asset in a capitalstarved world.” Frontier now advises clients to ensure that,
in the future, they can access ongoing liquidity for operational as well as
opportunistic reasons – to “appropriately” increase the levels of investment
risk in their portfolios.

Until interest rates in

Australia fell, super funds were
invested in cash to earn a positive return while other asset classes suffered. “But
that’s not the case anymore,” Fok says. “Now it is about achieving the
flexibility to take advantage of opportunities.” “Before, we thought that in
the long-run, cash was a drag,” Fok adds. Now, it is drawn on to support
operations as funds lay plans to have access to sources of liquidity other than
cash and equities. They have come to recognise that asset classes often
outperform and incur losses at different times.

In a paper issued in October
2008, Liquidity
Considerations in Today’s Environment, Dallas and Saviano of Cambridge Associates
recommend that clients review all their hedge fund holdings and aim to minimise
lock-ups where possible – even if this results in higher fees – so that, if necessary,
these investments can serve as potential sources of liquidity in the next few
years, since hedge funds have generally outperformed listed markets.

Institutions
should also take advantage of bear market rallies to sell assets at higher
prices in order to better fund rebalancing activities. “Until credit markets
stabilise and the earnings cycle bottoms out, it is likely that rallies in risk
assets will prove ephemeral, making more aggressive rebalancing an important
strategy for both raising cash and locking in gains,” the consultants write.

To
arrive at innovative liquidity management techniques in the future, super funds
would benefit from the input of people involved in various areas of fund
operations. Executives, investment committee members, asset consultants and
administrators are all privy to different pieces of information about
liquidity. While administrators work out benefit payments, investment personnel
know the fund’s allocations and day-to-day market conditions, as well as
longer-term trends. “It would be worthwhile to combine these pieces of
information together,” Fok says, both now, and in the future. 

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