When it comes to liquidity, market events gave asset owners plenty to think about in 2022. The UK pension crisis, in particular, offered a number of lessons: Market liquidity can seize up quickly, as it did after an unexpected fiscal policy decision by the UK government. And strategies intended to reduce specific portfolio risks (in the case of UK pensions, the extensive use of interest-rate derivatives to hedge liability risk) can potentially increase liquidity risk.
While this particular crisis was driven by a number of circumstances that were specific to the UK pension market, I think it was a good reminder of the need for asset owners of every type to think about liquidity risk across a portfolio and to plan for some degree of uncertainty. To help, I’d like to propose a framework for assessing portfolio liquidity based on the intended uses and sources of liquidity.
In addition to the lessons learned from the UK pension crisis, there are a number of reasons to take a fresh look at liquidity.
First, as I discussed recently, we may be at the beginning of a more volatile time for economies and markets broadly, following what was a remarkably stable period after the global financial crisis (GFC). And if we are headed into more volatile waters, then investors may face greater liquidity risk than they have in some time — if also more opportunity to be a liquidity provider after a decade in which central banks filled that role.
Second, asset owners are especially conscious of their illiquid allocations right now. Public market declines in 2022 left many with an overweight to private market assets in their equity portfolios — the “denominator effect,” a topic I address in more detail here.
And third, it’s important to keep an eye on portfolio liquidity as an input into risk management, as it does not automatically factor into many common risk-management processes (e.g., VaR models).
Defining the framework
Liquidity risk should be evaluated separately from other portfolio risks, and I think the process can be fairly simple and straightforward, with a focus on the uses and sources of liquidity. The uses might include:
Beneficiary payments — To put it another way, this is the purpose for which the asset owner’s pool of assets exists (payments to retirees from a pension, to a university from an endowment, etc.). From a liquidity management standpoint, the good news is that these payments are generally predictable (although there can be exceptions).
Capital calls — This includes commitments to private assets or other investments where the manager can call capital from the asset owner to take advantage of opportunities as they arise.
Margin calls on levered assets — Asset owners who use leverage to increase returns, to gain exposure in a capital-efficient way (e.g., using fixed income futures to gain duration exposure, as in the UK), or even to take risk off the table (e.g., currency hedging) must be prepared for the liquidity impact if the market moves against them and their counterparties demand additional collateral.
Portfolio rebalancing — For asset owners who, in the wake of a big market move, want to sell assets that did well and buy assets that did poorly, liquidity will be key.
New investment ideas — This might include funding ideas on an ongoing basis opportunistically.
Turning to the sources of liquidity, I’ve attempted a high-level (and admittedly subjective) ranking of them, from most to least liquid, in Figure 1. On a case-by-case basis, this list could certainly vary (e.g., some hedge funds might be more or less liquid), but I think this is a reasonable starting point. Some asset owners’ lists would also include additional leverage being used in their portfolio (e.g., drawing down a line of credit).