Liquidity is never far from the minds of institutional asset owners but the importance of having a comprehensive liquidity plan came into sharp relief during the pandemic-induced spike in market volatility earlier this year.
When stock prices plummeted in February and March, the asset allocation of many institutional portfolios fell out of synch with policy benchmarks, with asset owners finding themselves significantly underweight equity and overweight fixed income. That would have been the perfect time to rebalance, but an investor holding, for example, a portfolio of 60% stocks and 40% bonds, would have likely faced liquidity constraints because of a heavy increase in selling as volatility surged.
Beyond times of stress, institutional investors such as pension funds, endowments and foundations, face steady liquidity pressures as they work to manage obligations to meet capital calls and benefit payments in addition to regular portfolio rebalancing.
Meeting liquidity needs can be challenging in any environment. While traditional strategies such as keeping the entire portfolio invested internally or with third-party managers or keeping a portion of the asset allocation in cash to meet near-term needs have stood the test of time, institutional investors today can also use exchange-traded funds (ETFs) to do so in an efficient and cost-effective manner.
Misplaced fear
The question of liquidity often is raised during high-volatility periods when concerns about a decline in market liquidity, particularly in corporate bonds, typically emerge. However, amid the market turbulence, fixed income ETFs have demonstrated that they are now integral to efficient fixed income markets. In their biggest test to date during the fixed income liquidity crisis in March 2020, fixed income ETFs provided critical liquidity, price transparency and lower transaction costs than were available in individual bonds.
According to a report by Robin Marshall, director, fixed income research at FTSE Russell, the COVID-19-related selloff in corporate bonds in the first quarter of this year raised concern over the liquidity of fixed income ETFs. In addition, widening discounts between corporate bond ETF prices and the net asset value (NAV) of the funds during that period were also cited as a concern.
But Marshall pointed out that ETF NAVs use estimated prices that are struck once a day while ETFs trade throughout the day at constantly changing market prices, which is what can cause wide dislocations between the price and NAV, especially in illiquid markets.
“This makes ETF pricing timelier than NAV calculations,” Marshall said in the report. “There is little evidence the liquidity infrastructure around ETFs…failed during the March/April 2020 period.”
That is an important point because institutional asset owners can use ETFs to deliver a target asset allocation that’s aligned with an institutional client benchmark while still having access to liquidity.
To do so, investors use what’s called a liquidity sleeve, which is a dedicated portion of an investment portfolio that helps provide market exposure with a set of liquid assets, and can be tailored to align with the benchmark indexes that define a policy portfolio. By constructing the sleeve using index ETFs, the strategy can offer prompt access to liquidity and precise beta1 exposure as well as operational and cost efficiencies.
“More and more asset owners, including pensions, foundations and endowments, are working with our iShares Portfolio Consulting team to create strategic ETF liquidity sleeves,” said Brett Talbott, a vice president in BlackRock’s iShares institutional group. “By incorporating ETFs, investors may reduce transaction costs, especially in times of stress, and have trading flexibility.”
Addressing three challenges
Liquidity sleeves can address the three challenges associated with the historical methods of liquidity management, which include operational headaches related to frequent benefit payments or other operational needs when the portfolio is fully invested, the underperformance of cash vs. other assets when a portion of a portfolio is invested in cash, and the difficulty in using derivatives to line up with policy benchmarks, especially in fixed income and international equities.
First, having an ETF liquidity sleeve allows the asset owner to move in and out quickly with little operational hassle.
Second, since the sleeve is not simply invested in cash, tracking error to the policy benchmark — or a comparable institutional benchmark for non-pension asset owners — can be minimized when an appropriate ETF is paired with each benchmark index.
“Matching the right asset class and the right index can significantly decrease anticipated tracking error versus cash,” said Bart Sikora, a senior pension consultant on the iShares Portfolio Consulting team at BlackRock, which partners with investors to provide access to portfolio and investment expertise and build customized solutions in an effort to build more efficient and effective portfolios. “Often, pension funds manage their portfolios with set parameters on how far they can deviate from their benchmarks. A properly matched up liquidity sleeve can help minimize that deviation so more of the portfolio can be devoted to the pursuit of outperformance instead of accounting for benchmark tracking error.”
Third, because of the growth of ETFs, it has become easier for an institutional asset owner to align an index-based ETF strategy with policy benchmarks.
During the market disruption earlier this year, institutional asset owners using an ETF liquidity sleeve approach could have rebalanced quickly, lowering their fixed income allocation and proportionately increasing their equity weight, to get back to their target portfolio weights. The traditional path would have likely involved a slower execution — buying and selling — of physical securities, especially in the bond market as liquidity dropped. For asset owners using external managers, redemptions could have been delayed by communication deadlines and preset notification schedules.
How does it work?
Liquidity sleeves have been most often adopted by public and corporate pension plans that need a liquidity buffer because of frequent flows. According to data from Pensions & Investments, as of Sept. 30, 2019, the typical public pension plan allocation is nearly 80% public assets. As such, a liquidity sleeve can be built that closely aligns to a significant portion of a policy benchmark. Over the last three years, the iShares Portfolio Consulting team analyzed more than 100 policy benchmarks and found that, on average, public pension plans obtained a predicted tracking error on the public portion of the allocation of 0.05% to 0.20%. Corporate pensions tend to have an even greater public allocation and as such may have greater opportunity to employ liquidity sleeves.
For endowments, which typically have a significant allocation to alternative assets such as hedge funds and private equity, few public-asset proxy solutions exist to help better align the beta exposure to the alternatives in the portfolio.
BlackRock has found that asset owners tend to establish a liquidity sleeve that makes up 3-5% of the investment portfolio. It is designed to mimic the policy benchmark but can be customized to meet a variety of needs.
Because of the growth of market exposures available through equity and fixed income ETFs, institutional asset owners today can more precisely pair up the appropriate ETFs with various policy benchmark components. That is how a liquidity sleeve can match the public asset policy benchmark.
“The iShares portfolio consulting team partners with institutional investors to build tailored liquidity sleeves,” Sikora said. “Asset owners explain to us their desired objectives and constraints and we help them assess options that minimize tracking error or costs or maximize liquidity.”
Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Shares of ETFs may be bought and sold throughout the day on the exchange through any brokerage account. Shares are not individually redeemable from the ETF, however, shares may be redeemed directly from an ETF by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
Transactions in shares of ETFs may result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders.
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1Beta is a systematic risk measure of portfolios relative to their respective benchmarks.
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