By Simon Mumme
“There is a group of members that are reacting to what is happening in the rear-view mirror: when markets go up, they invest in equities; when equities go down, they invest in cash”
Access Capital Advisers, which oversees $12 billion in assets, has drawn on tough lessons from the financial crisis to consult its client superannuation funds about managing liquidity risk.
The consultant and asset manager is advising clients about mitigating the risk of being unable to fulfil essential services to members, such as paying benefits to retirees, sustaining fund investment strategies or enabling members to change their investments.
Access knows how a lack of liquidity can hurt funds. Before the financial crisis, it led clients into large private equity and infrastructure investments, and the consequential demands on fund cash flows and distortion of portfolios exacerbated the impact of the 2008 market rout.
For example, the $6 billion MTAA Super, a longstanding client of Access, lost $500 million after it was unable to buy currency forward contacts to hedge its international assets as the Australian dollar fell by $0.34 to $0.62 within eight weeks.
Westscheme, which was an Access client before it became part of the $42 billion AustralianSuper, closed the so-called “Target Return Portfolio” that held most of the fund’s illiquid assets, in June 2010. MTAA Super did the same six months later.
“That was a very testing environment that threw up a lot of issues that funds and ourselves would not have thought of in advance,” says Alexander Austin, chief executive officer of Access. “Our clients managed it by selling equities and managing asset allocation on a weekly and monthly basis throughout the crisis.”
This spurred Access to develop better ways of managing liquidity risk. It now forecasts how a broad range of market scenarios can affect the various cash flows of funds. It will seek new clients for the service, which is led by head of risk Justin Webb, in 2012.
In a November 2011 working paper: Risk and return of illiquid investments, the Australian Prudential Regulation Authority (APRA) says that the unlisted investments made by industry funds helped them generated higher risk-adjusted returns than retail funds between September 2004 and June 2010.
This indicates that unlisted assets can provide an “illiquidity premium” that boosts investment performance, APRA notes. But the experiences of Access and its clients during the financial crisis show that funds seeking this premium should carefully manage liquidity risk.
Members on the move
The incoming and outgoing cash flows of a fund broadly determine its level of liquidity. These flows include member contributions, investment income, hedging cash flows, commitments of capital to illiquid assets, expected pension payments and the movement of members between investment options.
Market collapses disrupt all of these cash flows. Falling asset prices curb investment income and can force funds to sell assets at a loss to rebalance portfolios. This can be compromised by the tendency of members to simultaneously seek more conservative investment strategies, withdrawing the capital needed for riskier investments, potentially leading to further forced-selling. Members can also be treated inequitably if assets in a liquid investment option are sold to enable others to switch out of an illiquid option. Outside of the fund, rising unemployment reduces contributions.
“Financial market outcomes can have a huge impact on funds; member behaviour can exacerbate it,” says Austin. “There is usually a group of members that react to what is happening in the rear-view mirror: when markets go up, they invest in equities; when equities go down, they invest in cash.
“We’re going through market volatility right now. Members are going to be much more sensitive to it than they were in 2007.”
Funds must adapt as members react to the performance of markets, Austin says. For this reason, Access and the administrators of its clients analyse past member behaviour and judge how many are likely to switch into conservative strategies during market shocks.
“Funds should form a view of what are the potential effects of member activity if markets fall and make sure their asset allocation is appropriate for a range of outcomes,” Austin says.
“You can’t make markets go up, but you can make changes to help withstand further market moves.”
APRA is watching
The severity of potential equity and currency market shocks, plus members’ reactions to them, should be factored in to regular liquidity “stress tests” set by funds, Austin says.
The prudential regulator agrees. In 2010, APRA found that 94 per cent of funds do not conduct formal stress tests to analyse how the liquidity of their total portfolios and individual investment options would be impacted by adverse financial market and economic conditions.
Super funds manage long-term investment strategies but must also operate within short-term constraints, such as liquidity. APRA wants trustees to manage liquidity risk in a “holistic” way that gauges current levels of liquidity and how susceptible their funds are to running out of liquidity in normal and stressed environments, writes Craig Roodt, credit risk specialist at APRA, in the August 2011 issue of the magazine inFinance.
“Survival is, in fact, a low standard. Often not a lot needs to change for the result to be very different, and liquidity events, by their nature, can occur rapidly,” Roodt writes.
APRA wants all funds and their investment options to be liquid at all times.
“It is meaningless to talk about being liquid ‘at a fund level’ if some options are unable to meet their obligations,” Roodt writes.