Why cash should not be king … often

Sam Sicilia

The superannuation industry’s promise to deliver steady investment returns over the long-term is unnecessarily compromised by funds’ need to maintain a high level of liquidity.

Sam Sicilia, CIO at the $7.9 billion HOSTPLUS, justified his call for a super fund “liquidity window” by arguing that routine, short-term liquidity demands should not stand in the way of large investments in unlisted assets – particularly since members’ money is held captive by the system.

Sicilia floated the idea at the 2010 AIST Australian Super Investment conference last month. While member contributions and investment income should more than adequately cover funds’ near-term liabilities, a liquidity window – functioning like the cash window operated by the Reserve Bank of Australia – would ensure funds could more fully exploit the illiquidity premium in their investment programs.

He says funds’ need to reserve a high level of liquidity – chiefly to pay benefits, but also fund capital calls from unlisted managers, maintain currency hedges and enable member switching –should not be onerous as members’ money is locked in the system for 40-plus years.

The cost of keeping this liquidity at hand can be forgone opportunities. And although super funds have clubbed together to co-invest in unlisted assets, reducing the cost and illiquidity burden while increasing their control over unlisted assets, “like-minded is not like-liquid”.

“Super funds are unnecessarily hamstrung to take advantage of illiquidity, given that members’ money is locked in the system,” he says.

“I can see no reason why we have to hold liquid cash for member investment choice [MIC] options. We need to develop mechanisms to transfer liquidity between funds or within funds.”

The liquidity window would act as a safety net and embolden funds to make further investments in unlisted assets and, if the opportunities fit, take part in nation-building infrastructure projects.

“Can we participate as super funds or are we going to be spineless and hide behind MIC arrangements?” Sicilia asks.

So far, the liquidity demands experienced by HOSTPLUS – even during the financial crisis – have not been severe. Its membership has an average age of 27, and fewer than 3 per cent of members moved their balance to cash during the crisis.

While the fund defines an illiquid asset as one that can’t be redeemed at a fair price within 90 days, Sicilia says, ratings agencies take a more selective view, classifying only the obvious contenders of direct property, infrastructure and private equity as being illiquid.

This resulted in the last assessment from a ratings agency stating that 28 per cent of HOSTPLUS’ portfolio was invested in illiquid assets. “It’s actually 38 per cent, going by our definition,” Sicilia says.

The fund divides its cash holdings for three purposes. First, an ‘illiquid’ bucket is left untouched to fulfil existing commitments, such as benefit payments and slated allocations to unlisted asset managers. Second, a ‘contingency’ reserve is kept to meet tax and currency hedging contracts, and other obligations which can vary in size. Finally, a ‘liquid’ stash is used to make new investments.

HOSTPLUS recently ran its portfolio through four stress tests to understand its liquidity limits. The first scenario demanded 30 per cent of the fund’s assets be immediately redeemed; the second assumed that HOSTPLUS’ investment earnings dropped to zero within 12 months; the third saw contributions to the fund fall to zero; and in the fourth, all the fund’s unlisted asset managers called for committed capital at once.

Then it cranked up the pressure by creating a world in which all of these events happened simultaneously, and assumed its illiquid assets could not be sold.

“And HOSTPLUS never becomes fully illiquid even in this perfect storm,” Sicilia says.

Reflecting on this, he says 40 per cent illiquidity is a “comfortable upper limit” for HOSTPLUS.

“We can easily tolerate for greater levels of liquidity of up to 40 or 50 per cent and you may need to move into that territory to take advantage of illiquid assets the fund may want to move into.”