We have all been trained to regard return volatility as the main measure of portfolio risk. Relying on well-established multi-factor risk models, VaR models, credit default models and their own hard-earned experience, most institutional fund chief investment officers (CIOs) have a good understanding of their portfolio’s ex ante return volatility.
Often assisting the CIO is a senior manager – a chief risk officer (CRO) – dedicated to measuring and monitoring the portfolio’s volatility as market conditions change and as new asset types are added to the portfolio. The risk officer is also responsible for alerting the CIO whenever portfolio risk guidelines are violated. Some funds consider the CRO’s function so important for good risk control and fund governance that the risk officer may report directly to the fund’s CEO, not the CIO.
Controlling ex ante volatility risk is an effective way, although not guaranteed, to avoid large unexpected negative returns – either negative absolute returns or negative returns versus a benchmark, which are certainly key CIO concerns.
Michelle Teng
Yet, for long-term institutional investors such as pension funds, sovereign wealth funds and defined contribution plans, volatility risk is rarely life-threatening. Volatility comes and goes. For example, large equity market “volatility spikes” and the concomitant market declines occur roughly every three to four years, and usually subside with asset returns reverting to long-term trends within two to three quarters. Importantly, volatility events generally do not require that a CIO immediately raise cash.
Although volatility events may lead the CRO to raise ex ante portfolio volatility estimates, the CIO can usually, if required to return to a risk target, rebalance risk exposures over time and minimize the cost of any rebalancing using liquid derivatives. In the face of volatility spikes, the CIO’s worry is not about raising cash, but being able to ride out the event and avoid a costly rapid portfolio de-risking that requires selling risky assets, usually after the market has already declined.
Consequences of a Cash Spike
However, there are events that can threaten a fund’s survival – a sudden need to raise cash. A CIO unable to meet their cash obligations is faced immediately with an unavoidable and usually distasteful task: portfolio assets must be sold, and willing buyers must be found.
While asset volatility could lead to a cash spike, other causes of cash spikes may arise from other areas within or outside the fund. The challenge for the CIO is the integration and management of the fund’s overall liquidity risk.
Unlike volatility risk, liquidity risk forces the CIO to make unattractive and costly portfolio decisions. Given the potential greater severity of liquidity risk versus volatility risk, the key question for a CIO is whether the organization has the skills and clearly defined responsibility to manage the fund’s liquidity risk.
What makes fund liquidity management distinct from a typical CRO’s portfolio or asset risk orientation?
First, it is the need to integrate all aspects of a fund’s liquidity demands and sources: top-down asset allocation, bottom-up private market deal-making activities, and internal and external operations.
Second, it is the need for a long horizon in a world brimming with large and growing portfolio allocations to illiquid private assets.
Long Horizon Perspective
To integrate all liquidity demands and sources across the entire fund, liquidity management needs a long horizon perspective, much longer than is typically required for many asset volatility risk scenarios. Given the possibility of government policy changes, a fund needs to monitor the liquidity consequences of large external liquidity demands.
For example, on the one hand, some government groups are exhorting plans to bolster retirement outcomes and support national economic growth by embracing illiquid private assets. At the same time, other government groups are proposing to give pension owners more “pension freedom.”
Both sets of policies would work to exacerbate fund liquidity risk. These policies should naturally pop up on the radar of the liquidity management team.
CIOs have learned the hard way of the unanticipated consequences of well-intentioned government policies. For example, U.K. regulators aspiring to minimize funds’ funding volatility encouraged them to invest in liability-driven investing (LDI) strategies that use leverage to extend asset duration to better match liability duration. However, only a few funds thought through the liquidity implications – massive cash variation margin calls and forced selling of assets – of a gilt sell-off as occurred in September 2022, ironically instigated by the government itself.
Performance-Enhancing Opportunity
Just as a robust traditional risk function monitors and keeps at hand a list of potential effective hedges against market movements, a best-in-class liquidity management function should identify, evaluate and keep at-the-ready possible external liquidity facilities. A comprehensive cost-benefit analysis would help the CIO determine whether a particular liquidity facility, and what size, might be useful.
A strong liquidity management function would also quantify the sensitivity of the fund’s liquidity risk in alternative situations – just like what a CRO does for different adverse market scenarios. For example, how would the portfolio’s performance and liquidity risk change with a 10-percentage-point higher allocation to private equity? Crucially, a portfolio’s liquidity risk does not necessarily increase linearly with allocations to illiquid private assets.
Importantly, high-quality liquidity management can enhance portfolio performance beyond just helping the portfolio avoid a liquidity event. Oddly enough, it is not uncommon to find that some funds currently have more liquidity than they need. A liquidity management team should be able to identify this hidden cost, measure how much excess liquidity they may have, and have a plan on how to put it to work.
Given the importance of liquidity management, why do we not observe many funds with a dedicated liquidity management team, or perhaps even a designated chief liquidity officer? While a new and separate chief liquidity management function may generate cumbersome organizational overlaps and internal confusions within a fund, the long-term benefits are likely worth any added effort and stress.
Michelle Teng is co-head of the private assets research program within the Institutional Advisory Solutions (IAS) group at PGIM.