The challenge of managing portfolios which allocate to illiquid assets remains ongoing. It is far from a set-and-forget problem.
The early release of super program and the impact of the Your Future, Your Super (YFYS) reforms are both examples of policy announcements which have (or will have) flow-on liquidity impacts. This is an important and complex area which requires ongoing review.
The Conexus Institute and CFA Societies Australia have collaborated on a research project exploring these liquidity challenges. The output is a range of resources (models, papers, presentations, and videos), which will soon be made available on an open-source basis to enable funds to tailor the analysis to account for their fund’s unique situation.
Exposure to illiquid assets needs to be fund-specific
One of the strongest reflections amongst the research group was that the allocation to illiquid assets by a super fund needs to be informed by the fund’s net-inflow characteristics, not just present inflows, but prospective inflows.
Funds face highly different situations with respect to net inflows – more than half of funds are in net outflows. Our research demonstrates that a fund with positive inflow can maintain shape and quality in a stress event far better than a fund in outflow.
Funds in outflow need to consider whether they should have a lower allocation to illiquid assets compared with peers experiencing inflow. Funds using peer group allocations to inform their allocation to unlisted assets should re-consider that practice.
Though not a formal part of this research, all funds will need to consider their future net inflow position as YFYS takes effect. There will be both interim impacts (the two-to-three-year impact of performance test failures and associated member activity) and medium-term impacts (stapling) to consider.
Liquidity management: more than just solvency
Most work on liquidity management focuses on the first-order issue of solvency. While undoubtedly important, this area tends to be more explicitly managed and is subject to greater regulatory oversight.
There are a range of second-order issues which are also important but may be less formally managed. We explore three second-order issues:
- Portfolio quality: the loss of portfolio ‘shape’, potentially reducing portfolio quality, when funds find themselves required to raise funds in a stress event.
- Pricing inequities: unit price inequities which may occur due to ‘stale’ pricing of illiquid assets in funds which offer frequent liquidity.
- Liquidity management costs: the costs of raising liquidity or restoring portfolio shape, some of which may be borne by all members.
The models developed explore each of these issues in the context of single sector options (such as a property option which invests into unlisted property) and multi-sector options (like a balanced fund).
We do not set prescriptive standards on these issues. Rather, all the standards are inputs into the models, allowing trustees to consider, then explore the consequences of, their own internal standards.
Revisiting single sector options
There remains a relatively small amount, by number and assets, of single-sector options which invest into illiquid assets. These are often supported by a ‘banker option’ arrangement (whereby the large multi-sector (commonly balanced) option implicitly guarantees liquidity to single sector options) embedded into the operating structure of the fund.
While such an arrangement results in minimal insolvency risk, other issues remain, particularly the risk of member inequities due to ‘stale’ pricing. There are many possible treatments including consideration of redemption frequency, valuation frequency, investment mandate (e.g. the allocation to illiquid assets) and the possible use of liquid proxies (to trigger the need to consider an out-of-cycle revaluation). The models provide flexibility to explore all these issues.
YFYS will have a huge impact on individual super funds, for some positive and for others negative. Investment governance needs to be best practice to ensure the avoidable adverse impacts are minimised.
This research is freely available to provide funds with a baseline standard. As part of the release of this research, all super funds and asset consultants are invited to attend complimentary workshops.
It was a pleasure working with CFA Society members Stefano Cavaglia and Reece Zachariah on this project. The Advocacy Council of CFA Societies Australia provided valuable review and feedback.
Invitation to complimentary workshop
All super funds and asset consultants are welcome to attend complimentary workshops on 8 or 9 September to explore this research. If you didn’t receive an invite but would like to attend, please email [email protected]