Perhaps one of the greatest lessons of the 2007-08 period for institutional investors was about liquidity. Equity markets dropped precipitously and credit spreads widened, while liquidity in safe-haven assets dried up and other instruments became impossible to trade. At the same time, hedge funds were gated and institutional investors faced capital calls on private equity at unwelcome moments. They received a hard lesson about the way liquidity characteristics of assets can change. Some learned to value liquidity in ways they had not done before.
Eight years on, and the structure and financing of the economy has changed dramatically, while markets have powered ahead. Bank lending has decreased and ultra-low, even negative, interest rates, coupled with quantitative easing (QE), have channelled savings towards asset managers. But has the institutional investment world fully taken account of how liquidity can evaporate at times when it is most needed?
Pascal Blanqué is CIO and head of institutional business at Amundi and the author of Essays in Positive Investment Management, published in 2014. The recent appointee to the 300 Club of leading investment professionals contends that liquidity is a dimension clearly missing from the thinking of investors. And their thinking should evolve to take greater account of it.
Investors and regulators are in the early stages of a learning curve on liquidity, Blanqué says. “I am struck to see how poorly described the various aspects of liquidity are. Just ask 10 or 20 investors what is liquid or illiquid. Do they manage it on a multi-temporal basis? Do they have a liquidity bucket? This will be an area of pressure more and more from end-clients. Regulators have spent the past 10 years focusing on banks, but now they must turn to asset managers to understand the immediate challenges. And asset managers must assist in this process.”
Furthermore, classic distinctions between liquidity and illiquidity are misleading. And as investors increasingly adopt illiquid assets, Blanqué also warns against a “fake equality” between listed and unlisted vehicles.
Blanqué also contends that liquidity is a missing ingredient in modern portfolio theory (MPT). “Liquidity is forgotten in the efficient frontier for the simple reason that MPT implies you can arbitrage across all assets at any time, which is not the case in reality,” he says. “Institutions like pension funds should spend some time analysing their their liabilities by liquidity duration using liquidity buckets, so quality becomes a powerful structural tool or framework for the allocation of the pension fund or institution, taking a multi-temporal, multi-horizon and ideally multi-scenario type of approach. Liquidity should be seen like that, but rarely is.”
Second, he continues, “MPT is fascinated by annualised returns, investment horizon and the path towards the objective. This is what we learn at school. This is not a criticism; this is a fact. All of us in the industry talk about annualised returns. But if you think about an institution with a long-term horizon, by definition, this multi-temporal horizon implies a liquidity structure. And on a multi-temporal basis the various assets or segments will give different levels of liquidity.”
Blanqué says risk factor frameworks are a good basis to allocate capital. Again, liquidity is a key ingredient absent from most investors’ analysis. “Think of the portfolio in terms of liquidity buckets,” he says. This is another way to look at it, in terms of construction, specifically when you add the second flawed aspect of MPT.
On top of that, the fact that the industry is benchmarked – and cap-weight benchmarked, at that – means investors are collectively exposed to what Blanqué terms the “mechanical, unintended dynamics of bubble formation”. He explains: “This has been documented recently by the IMF, saying basically that there are bubbles not because investors are irrational but because they are trapped in mechanic, unintended positions.
“This opens the space for smart beta strategies, such as low volatility or mean variance. The beauty of this process is that these strategies underperform cap-weighted approaches in a rising, linear and frothy market. But when approaching bumpy territory they have value because they provide an asymmetrical distribution of returns.”
Herding is yet another issue that Blanqué raises: “We have not seen such crowded spaces in terms of trades for many decades. To an extent this is not a surprise because the asset allocator in chief is central banks today, so we are QE led.”
Blanqué points to what he terms a “paradox of tranquility” in markets, with abundant liquidity and rising asset prices. But liquidity risks lie under the surface of these otherwise calm markets: “Liquidity risk is not priced because you don’t have liquidity premia on these [currently liquid] assets. That is one of the inefficiencies today.”
The recent market turmoil, says the CIO, assuming it is properly managed, should be a wake-up call for the early signs of complacency following two years of double-digit returns: “We all know those returns cannot be extrapolated. This is a reminder as well that the volatility regime is about to change. We have been living under anaesthesia, on steroids, thanks to QE.”
Blanqué also points to the importance of foreign currency exposure management. “This is the first time in two decades, in my view, that currency policies of investors are critical because the first impact of what is going on the monetary policy front is in the FX market,” he says. “This started first with the decline of the yen and then the euro against the dollar. Investors are part of the great competitive devaluation game.
“The best way to lose money in a marginal-basis-point world is to get the foreign exchange wrong. You can struggle for three quarters to earn 2bps on bonds and lose 5% on the Swiss franc in six hours. Focusing on hedging policies on the defensive side or on currency as a performance engine on the positive side are critical as well, and this is not an area where most institutional investors are comfortable and well prepared.”
Blanqué is convinced that institutional investors will increasingly adopt policies to deal with liquidity issues. With the rise of alternative credit, valuation risk and liquidity, challenges have shifted from banks to the buy-side. Assets must have “proper liquidity policies including stress-testing and ALM of mandates, valuation policies, pricing policies and relationships with counterparties,” he says. All this should take place under the scrutiny of the regulators.
“My point is that we should not deny there has been a structural change in the market, and that our common interest on the buy-side is to be as timely as possible in the cycle of regulation,” Blanqué explains. “What I refer to as the ‘liquidity budget’ will eventually become legal concept. It will be calibrated on the basis of stress tests on the liability side, so the portfolio is not distorted.” A key question is whether institutional investors are adding to or detracting from stability. What should be the incentives and regulations to ensure they play a stabilisation role?
Investors, of course, face uncertainty, which simply means they do not know ex ante about all outcomes. “Outcomes are asymmetrically distributed, and some have a probability that is high enough to be taken seriously,” concludes Blanqué. “This is why it is important to incorporate liquidity in the risk concept and to move forward on that. There is no Holy Grail for sure, but we should spend more time and resources on these issues.”