Illiquid assets tend to offer better returns but many pension funds do not take advantage of them. Luisa Porritt explores how trustees can get access to these market opportunities
Investors around the world have been eyeing stock markets of late and wondering what they need to do to protect their investments. Major indices, including the S&P 500 and FTSE 100, have been swinging sharply as concerns grew about the depth of oil price drops and the impact of slower growth in China on the rest of the world.
Bond markets are making investors nervous too, as they try to gauge the timing of interest rate moves after years of historically low rates, and the effect these will have on their portfolios.
For pension funds, it is understandable to look at the changing situation and want to react. But while challenging day-to-day market conditions should make schemes think about the make-up of their portfolios, a hasty response could be damaging. And schemes might miss out on specific opportunities that falling markets create.
A principal concern for many investors is shrinking liquidity in normally liquid markets: that is, the ability to buy and sell at a reasonable price. This is not the same as having the ability to sell at all, which both fund managers and consultants say is not a restraint – although some assets may be harder to offload quickly than others.
According to Laurent Crosnier, chief investment officer of Amundi in London, “there is always liquidity: it’s a question of the price of that liquidity”.
David Will, senior investment consultant at JLT Employee Benefits, says liquidity is “the ability to trade without moving markets, at an explicit transaction cost at any time”. Though not fundamentally illiquid, analysts say certain markets, such as corporate bonds and other credit markets, are less liquid than they used to be.
Schemes can afford some exposure to traditionally illiquid assets”
However, as long-term investors, pension funds can typically afford to ride out daily market movements, so long as they can still meet their primary obligation to pay out benefits to their members.
This means that where appropriate, schemes can afford some exposure to traditionally illiquid assets and step in when usually liquid markets become less so.
“To an extent, it’s about the right balance between recognising when something has been sold off because of liquidity rather than as a result of a fundamental credit concern,” says Rupert Brindley, managing director of global pension solutions at J.P. Morgan Asset Management (JPMAM).
He says an example of this is US corporate debt: concerns about retail investor redemptions have driven a shift into government bonds and credit default swaps, but pension funds may find this asset class offers a good opportunity to meet their cash-flow requirements.
Fears generated by actions taken during the 2008-09 financial crisis, such as hedge funds becoming illiquid due to gating, may have led to a conflation between illiquidity and failure, says Sorca Kelly-Scholte, head of pension solutions and advisory for Europe, the Middle East and Africa (EMEA), also at JPMAM. But the illiquid nature of an asset does not mean it will fail, she adds, and such thinking could be making pension funds hesitant to buy assets that could generate decent cash flows.
Scheme v market liquidity
How much liquidity pension funds need varies. A scheme close to maturity would generally be unwise to consider investing in a long-term infrastructure asset.
Some mature schemes can consider adding illiquid strategies to their portfolio, however, as they still have a number of years remaining to invest and pay out increasing benefits before winding up.
Other commentators warn such actions might make pension schemes less attractive for a buyout by an insurance company.
But, according to Kelly-Scholte, the extent of UK defined benefit scheme liabilities means demand for buyouts is unlikely to be met, partly because large deals take a long time to process, while the price of buy-ins and buyouts is beyond what most pension funds with substantial deficits can afford.
Of paramount importance is for trustees to understand the profile of a scheme’s membership and the implications for cash flow”
The ability to forecast is key; this means asset-liability risk can be taken purposely with some sacrifice of liquidity to the overall benefit of the portfolio.
Of paramount importance is for trustees to understand the profile of a scheme’s membership and the implications for cash flow, then marry that with liquidity needs, says Matthew Phillips, head of wealth management at Thomas Miller Investment.
But schemes positioned to handle less liquidity do not necessarily take advantage, says Joe McDonnell, head of Morgan Stanley Investment Management’s (MSIM) alternative investment partners’ portfolio solutions group in EMEA.
This is despite DB schemes being positioned to perform better in theory than an otherwise comparable strategy by capitalising on the risk premia generated by illiquid assets.
For defined contribution, conditions are very different as the risk profile of the scheme is determined by individual member preferences, although in practice the majority of DC investments are held in a default fund, which is relatively liquid and diversified in character.
“Most schemes invest entirely in pooled funds, a fair proportion of which are daily priced and dealt,” says Will. “This means they can sell assets, and quickly, if the need arises.”
Freedom and choice might reduce liquidity
Liquidity considerations for schemes have grown more complex following the introduction of the UK government’s ‘freedom and choice’ legislation. Members of DC schemes who are able to take their entire pot as cash, in one go or several tranches, require investments that are priced and dealt daily.
DB members seeking to take advantage of the freedoms may elect to transfer out, potentially resulting in a larger capital outflow for a scheme if several members decide to withdraw at once, though this is mitigated by the fact most schemes run more liquidity than they require.
To manage this risk, schemes can examine how many of their members are approaching the age of 55, and may be thinking about withdrawal.
The size of the scheme is also relevant. The cash flow profile of schemes with a larger number of members will not be as ‘lumpy’, whereas smaller schemes with one or two members owed large benefits may find they need to realign a large amount of money at short notice.
Finding liquidity in less liquid markets
Schemes need to think about how they would respond in the event of a capital call, says Chris Redmond, global head of credit at Willis Towers Watson, adding that those with less operational sophistication need a bigger buffer in place.
Where equities have been regarded as a contingent source of liquidity, it is important for schemes to take into account falling markets.
This adds impetus to the requirement to monitor assets and their liquidity closely. “The difference between now and pre-crisis is that the ability to transact – and at size – has reduced,” says Redmond.
This is largely due to the reduced role of the banks in market-making activity, which has been driven by regulatory requirements forcing them to hold more capital.
Over the course of 2015, problems emerged in some markets that are typically fairly liquid, including high-yield bonds, US Treasuries and German Bunds, while equities also saw significant one-day moves. Managers have also reported reduced liquidity conditions in equity markets of late, says Phil Edwards, European director of strategic research for Mercer’s investments business.
It is important for schemes to take into account falling markets”
In this context pension funds find themselves in a degree of conflict as to what their strategy should be, according to Andrew Wilson, chief executive of Goldman Sachs Asset Management International for EMEA.
Since their funding levels will have further deteriorated, there is an instinct to act cautiously, but volatile conditions could be the right time for pension funds to acknowledge their long-term role and increase exposure to risky assets.
Payson Swaffield, chief income investment officer at Eaton Vance based in Boston, says short-duration, high-quality, investment-grade bonds present the lowest risk of losing their principal and of being subject to price volatility, having held their value through recent difficulties.
Those holding exchange-traded funds exposed to credit markets may have daily liquidity but find their investments are not tradable daily. This is because selling by retail investors tends to spark a greater sell-off, causing prices to fall further and outflows to increase, in turn tightening liquidity conditions.
Volatility has been accompanied by larger moves in markets. This is important for UK DB schemes to take into consideration as they make use of leverage, and are thereby required to post collateral, raising a question as to where they will source liquidity from.
According to Matti Leppälä, chief executive of PensionsEurope, it has become difficult for larger funds in both the UK and the Netherlands to hedge, as trades have become smaller, while it is also harder for them to find the high-quality products they need as a result of the European Central Bank buying up government bonds.
But Redmond at Willis Towers Watson says: “Most pension funds are in a good place; they are not that leveraged, they have a large amount of liquid assets, they can sell physical equities and take out futures to free up cash.”
Most pension funds are in a good place”
Most commentators agree pension funds are in an enviable position to take advantage of a degree of illiquidity premia. Partners Group, a private markets investment manager, is seeking to open up private markets to DC investors via funds offering daily valuations, even though the underlying investments typically have a four- to six-year holding period.
One such fund is already being marketed in the US and two more are due to be launched in the UK and Australia. A spokesman for the firm says it aims to provide liquidity by investing in the more liquid segment of private debt, holding a minority of assets in listed private equity and infrastructure, and a small portion of cash.
However, for some less liquid investments purporting to offer monthly or quarterly liquidity, there can be a mismatch between this claim and the nature of a fund’s underlying assets.
Some schemes invest in pooled property funds, which may carry a redemption period of a year or two. Many hold private debt, having stepped in to fulfil the reduced lending activities of banks since the crisis.
Size may be more of a issue for investors seeking to move large pools of assets, says Edwards at Mercer. This strengthens the case for buy-and-maintain strategies, which have proven popular in recent years, as they only need to react to significant events.