Singapore’s sovereign wealth fund GIC and PGIM, one of the world’s largest asset managers, have collaborated to develop a world-first asset allocation framework that explicitly models the impact of private assets on total portfolio liquidity, incorporating both the top-down allocation view and the bottom-up cash flow view.

Grace Qiu, senior vice president in the economics and investment strategy department at GIC and one of the authors of the model, says one of the motivations in designing the frameworkwas to understand liquidity risk in the context of failing to meet liabilities, or capture attractive opportunities because of market dislocation.

Liquidity, or illiquidity, shouldn’t be viewed in the context of private asset allocations alone, Qiu explains, but also total portfolio construction issues such as rebalancing activities. By modelling liquidity at the total portfolio level, liquidity can be traded with other dimensions of risk.

During volatile periods rebalancing is key to capture mean reversion, Qiu says, and illiquid investment allocations can impact the ability to rebalance. Another total portfolio implication is the opportunity cost of locking up capital that subsequently can’t be used for opportunities in a market dislocation.

“Many top-down asset allocation models don’t capture the bottom-up. We wanted to capture both the bottom-up and top-down and get the liquidity risk at the total portfolio level,” she says.

“Private assets have their merits; they may generate higher returns and there is diversification from public market volatility, but there are trade-offs and we model those so we can make more informed decisions.

“The trade-off between higher returns and liquidity is not an easy decision for all of us. Illiquidity risk is not linear and changes with market conditions. This model is very customisable for different investors who can put in their own capital market assumptions, return assumptions and cash flow assumptions. Our hope is it helps investors make better asset allocation decisions.”

The model, which is outlined in the paper Building better portfolios: balancing performance and liquidity, was developed after more than a year of collaboration between GIC and PGIM.

PGIM, which had an existing relationship with GIC, had worked on a framework to bring liquidity to the forefront in asset allocation, and published the paper The trade off between performance and liquidity in January 2019.

Bruce Phelps, who heads up the IAS division at PGIM a research department separate from the investment business, says asset allocation models had not previously treated private assets properly.

“A lot are just modelled as a public asset and put into asset allocation tools developed a long time ago, and out would come an allocation,” he says. “We found that risk measured as volatility was not the right way to think about it. Public and private assets are very different: with private assets, cashflows are uncertain, you can’t sell them, and they may ask for more money from you. We felt that when we started working on this there wasn’t a true appreciation for the attributes of private assets. So we built a framework to bring liquidity to the forefront and be faithful to the characteristics of private assets.”

Phelps and principal author of the report Junying Shen, focused on explicitly bringing liquidity to the forefront, to look at the playoff between returns and liquidity requirements, rather than return and volatility tradeoffs which had been the more traditional modelling approach.

“We said ‘if you want to have this degree of liquidity in the portfolio what type of performance might you expect?’ The CIO can make the choice about how much liquidity they wanted, and we can help them see the type of return they can get. We wanted to give a CIO a framework to see the tradeoff and make the decision. If you’re saying I need to get 8 per cent return then are you willing to live with a 5 per cent chance you will run out of money?”

GIC’s Qiu and her colleague Ding Li saw the original PGIM paper and contacted Phelps and Shen with some ideas on how to enhance it. GIC, which has more than $100 billion in assets, has a target allocation of about 25 per cent of the portfolio in private assets and liquidity is something it carefully considers in portfolio construction.

“We got a call from GIC saying they wanted to meet and talk about what we were missing – which was incorporating the private asset commitment strategies,” Phelps says. “We are not a GP firm, so we didn’t know much about the mechanics of PE investing. Ding and Grace have responsibility for portfolio construction, and they said to us ‘it’s an interesting framework but it could incorporate the top-down and the bottom-up, including the commitment strategies which will deliver cashflow’. This was a great observation and really helped bring the whole thing together.”

PGIM and GIC worked on refining the model for about a year, with Shen modelling the private assets and commitment strategies and how they would interact with public assets. The result was fuller asset allocation model.

Shen, who is a senior associate at PGIM, says the collaboration with GIC brought to the fore the importance of the bottom-up investing view as part of the asset allocation process. Working with GIC also demonstrated the differences in obligations and liquidity needs for different institutional investors.

The result is the model allows for investors to visualise the distribution of cashflow in different possible scenarios.

“We can model the cashflow using a framework with different market scenarios – like an L-shape or a V-shape – and what type of cashflow investors would experience,” Shen says. “We can change different variables like allocation to private assets, commitment strategies and how the cashflows of private assets will vary. We can integrate all the information giving investors a holistic view of how they think about portfolio performance and liquidity.”

COVID-19 applications

The framework can be used for stress testing different scenarios including different recovery scenarios for the current economic crisis.

Kevin Bong, who is the director of economics and investment strategy at GIC, says the paper demonstrates that the shape of a correction and recovery will impact the liquidity of the portfolio.

“This is salient for every investor with regard to the COVID-19 recovery,” he says.

“For us the most important thing is that we think about the liquidity of the portfolio both in terms of the long-term portfolio construction and design perspective taking into account liabilities, as well as shorter term market cycles,” Bong says. “It is clear to us that the longer the duration of a downturn, the deeper the downturn, it will have an especially strong impact on the liquidity of the portfolio, our risk appetite and the rebalancing impact.”

The paper explicitly shows that a slow downturn and recovery will impact the portfolio more significantly than a V-shaped, quick recovery.

“During a long lasting downturn, investors can experience bigger liquidity demands, which can also come from private asset drawdowns from prior commitments and total portfolio rebalancing,” Shen says. “All of this can impact the liquidity of the total portfolio quite a lot. The duration of a downturn makes a difference. When you design a portfolio you need to remember that and account for scenarios with a longer lasting recovery.”

Bong says the model is one of a variety GIC uses to make asset allocation decisions.

“It has sharpened our ability to understand what the trade-offs are from a long-term design perspective,” he says. “It has heightened our ability to look at the importance of liquidity. We haven’t made any specific asset allocation changes, but it gives us more confidence in how to manage the liquidity.”

PGIM’s Phelps says the model is a highly-customisable tool for CIOs to analyse liquidity and performance.

“Leading up to the COVID-19 crisis CIOs still had the 2008 crisis in the back of their minds, and we were surprised about how conservative they were with regard to how much liquidity they needed. One of the surprises of this work has been that many CIOs were running their portfolios at very high levels of liquidity,” he says. “Even if you look at their allocations to say buyout funds, when you look at the cashflow obligations over say the next 10 years, a 15 per cent allocation to buyout funds is not that unreasonable. When we were working with investors in the early part of our work, we were surprised at how liquid some of these plans were. Some other funds may not have thought of unexpected liquidity needs such as people withdrawing their money. There are investors out there that now have a framework for looking at liquidity and performance and could take more liquidity risk, some have taken too much. They both will understand their portfolios better.”

 

The $50 billion pension fund for employees of United Parcel Service is poised to increase its allocation to risk assets. The fund doesn’t time the markets and Ernie Caballero, CIO for the last two years and with the postal group for 28 years, says any shift into risk assets in the wake of recent extreme market volatility will be prudent. But judging the bottom of the market is now his keen focus.

“We should prudently increase risk seeking asset exposure given the recent sell-off in the markets. You can’t time the market, but the environment is ripe for considering this approach.”

The pension fund’s assets are divided across three portfolios comprising a closed management plan which accounts for around $25 billion, with the remainder equally split between two union plans, still in growth mode. Assets in the larger management plan are split between a 48 per cent allocation to risk assets and a 52 per cent allocation to fixed income in a strategy carefully balanced to try and earn a return but protect the 90 per cent funded status.

As for where the fund will invest, Caballero says everything is on the table because all markets are down. He also says UPS has dry powder at the ready, thanks in part to high valuations throughout 2019 which left the fund more focused on reducing leverage in the portfolio than “jumping on assets.” The fund’s managers have discretion on the leverage they can use within set boundaries, and the investment team spent much of last year working with managers to keep leverage at the low end because of high valuations, he says.

Rebalancing within bands

The move into risk assets will also reflect UPS re-adjusting its strategic asset allocation back within its bands for each asset class in the wake of the market sell off. Market falls have left the fund’s equity and fixed income allocations at the lower end of their bands, which Caballero wants back to mid-range.

“We are not panicking, the portfolio is built around a strategic asset allocation that achieves expected long-term returns. With that said, I do believe it’s time to optimise and increase our allocations to risk-seeking assets. One could argue that recent market conditions have made the equity risk premium more in your favour to generate a long-term excess return over the risk-free rate. Over the next few weeks, we are planning to implement this approach.”

Equity hedges

The pension fund’s general preparedness for a downturn has helped it withstand the worst of the virus impact. Strategies that have helped protect the fund include equity hedges, he explains.

“We also benefitted from equity hedges we put on when markets were much higher. Although the premium paid for these hedges were a drag on returns, they were relatively inexpensive insurance policies that were monetised as the markets sold-off in Q1 2020.”

Elsewhere UPS bought US Treasury STRIPS in 2018 when rates were higher. As rates fell the investment helped with the hedge ratio and returns.

In a nod to the need to track liabilities, the management plan won’t invest anymore in private markets, taking all private market deals off the table as it matures and prioritises liquidity. We don’t want to lock up funds, he says. In contrast, the union plans will still invest in private assets.

The challenging times have revealed the strength of UPS’s 50 to 60 manager relationships.

“We’ve had a tremendous dialogue with our managers in Q1,” he says. These strong relationships have been fostered by UPS’s increasing focus and bias towards separate accounts. They require “a lot more work” but give the pension fund “a say on what happens” and ultimately produce better returns, he says.

“A good part of our portfolios are customised; this is the direction we are going in. We are very particular about our investment exposures and the managers we choose to work with. We have a symbiotic relationship and we have aligned goals and objectives – this is the core foundation that facilitates a very close and active dialogue with our investment managers,” he says.

UPS selects managers according to the usual filters around due diligence and compliance and Caballero stresses managers are not necessarily dropped for a loss of performance. A first priority is to understand what went wrong; his overwhelming concern is that the fund’s managers stay true to their strategic rationale, and don’t stray from the mandate.

While the investment team continues to work remotely, Caballero schedules a minimum of two daily market and portfolio impact sessions with various members of the 26-strong team.

“We talk about what is going on in markets, how our portfolio is positioned both tactically and strategically, and the impacts we can expect to materialise under certain scenarios. The team is so connected that we have even made time for virtual happy hours a few times at the end of the week after the markets close,” he says.

COVID-19 is taking its toll on the world, causing deaths, illnesses and economic despair. But how is the deadly virus impacting global poverty? The World Bank argues that it is pushing about 40-60 million people into extreme poverty, with its best estimate being 49 million.

Read about it here

COVID-19 is taking its toll on the world, causing deaths, illnesses and economic despair. But how is the deadly virus impacting global poverty? The World Bank argues that it is pushing about 40-60 million people into extreme poverty, with its best estimate being 49 million.

Click here to read the blog published by The World Bank on April 20, 2020.

In this Fiduciary Investors series podcast Amanda White talks to Joel Prohin who is director of the portfolio management division at Caisse des Depots in France. Prohin heads the portfolio management team and is responsible for €140 billion across fixed income, equities, real estate and private equity. They talk about how Caisse is positioning the portfolio during this time of uncertainty and how sustainability as a long-term issue, can be prioritised at a time when short-term risks, and survival, are taking priority for many investors.

 

 

What is the Fiduciary Investors series?
The COVID-19 global health and economic crisis has highlighted the need for leadership and capital to be urgently targeted towards the vulnerabilities in the global economy.
Through conversations with academics and asset owners, the Fiduciary Investors Podcast Series is a forward looking examination of the changing dynamics in the global economy, what a sustainable recovery looks like and how investors are positioning their portfolios.

The much-loved events, the Fiduciary Investors Symposiums, act as an advocate for fiduciary capitalism and the power of asset owners to change the nature of the investment industry, including addressing principal/agent and fee problems, stabilising financial markets, and directing capital for the betterment of society and the environment. Like the event series, the podcast series, tackles the challenges long-term investors face in an environment of disruption,  and asks investors to think differently about how they make decisions and allocate capital.

About Joel Prohin
Prohin heads the portfolio management team and is responsible for €140 billion across fixed income, equities, real estate and private equity. He manages five asset management teams and 60 staff with most of the assets of the fund managed internally. He is also member of the French institutional investors association’s strategic committee.

About Amanda White
Amanda White is responsible for the content across all Conexus Financial’s institutional media and events. In addition to being the editor of Top1000funds.com, she is responsible for directing the global bi-annual Fiduciary Investors Symposium which challenges global investors on investment best practice and aims to place the responsibilities of investors in wider societal, and political contexts.  She holds a Bachelor of Economics and a Masters of Art in Journalism and has been an investment journalist for more than 25 years. She is currently a fellow in the Finance Leaders Fellowship at the Aspen Institute. The two-year program seeks to develop the next generation of responsible, community-spirited leaders in the global finance industry.

Now more than ever, investment leaders have the opportunity to make life-changing differences for roughly four billion people’s savings and investments. They will do so by drawing from the widest range of leadership skills to manoeuvre through the epic challenges this crisis presents and by emerging with stronger, fairer and more sustainable businesses.

Research from management science identifies dominance and serving as the two critical pathways for leadership. There is a dominant, confident and support-demanded approach, and there is a serving, empathetic, and support-volunteered approach.

In times of uncertainty and stress, the confidence you can get from dominant leadership styles is favoured because it can mobilise the organisation to high-velocity action and compensate employees for their feeling of loss of control (think of how China dealt with the coronavirus).

But the management thinking is clear that this leadership choice is not a case of either / or but and. Essentially, both should be used and the exact mix should be reflective of circumstances.

One unique aspect of the coronavirus crisis is how personally challenging this is for the workforce. In Maslow’s hierarchy of needs it is basic safety that everyone craves right now. This suggests that the empathy shown to workers through this period of vulnerability will be preciously valued. For example, in the choice of what’s right to do now when family issues arise while working from home; this is the time to choose to do the family thing. For the best organisations, it’s not even close.

This crisis will probably turn out to be the biggest challenge faced by current leaders in their lifetimes. Previous experience suggests this leadership defining moment will be brilliantly handled by a few organisations, adequately handled by the vast majority, and probably botched by the remaining few. Which organisations will get into each group? This triage will take some time to be memorialized; but we know it will be through memorable stories of leaders with a human touch.

I would wager that many of the best stories will come from organisations where leadership and culture are strongest. They will have a few things in common: a balance in the craft of exercising dominant and serving leadership styles; a purposeful culture as a north star; clarity that profit play a supporting role in that purpose; and a culture that accommodates this ‘it’s all about the people’ moment.

With all this present disruption it’s hard to start work on an exit strategy, but good leaders should. The present crisis quickens the pace of three disruptive workplace realities which should be front-run.

First, there is growing complexity in organisational settings. This makes command and control-style leadership actually lose control because it cannot get enough accurate real-time information from the frontline. By contrast, good leaders always manage to stay in touch.

Second, there is a growing need for emotional intelligence among investment leadership. Employees increasingly expect work and life to be integrated and this is central to good employee experiences where well-being, purpose and personal growth rank highly and intrinsic motivations are more lasting than extrinsic forms like pay.

Third, there needs to be a culture of openness in the workplace. Leaders previously hoarded information. Now the open-cultured organisations can create the positive state of psychological safety at all levels with everyone feeling included. This plays to better decision making all round and helps people with their resilience during tough times.

These disruptions most importantly require leaders to be T-shaped. Most industry leaders will be deep experts in their field – this constitutes the vertical bar of the ‘T’. But many will not have the horizontal bar of the ‘T’ which only comes with having situational fluency around wider societal and business issues and is achieved through being in-touch with a wider network and other disciplines.

This being more in-touch means for example: a greater understanding of stress and fight or flight responses in brain science; the balancing of dominant and serving leadership in management science; the critical quality of safe space in psychology; and how to apply the delicate art of being human.

An additional, and highly relevant, T-shaped skill is the understanding of systems-theory. This is about how pandemic systems affect our lives and health; how systems may brutalise our planet; and also, if we get it right how the financial system can lay the foundations for wealth and well-being to be more fairly distributed.

The investment challenge of tomorrow is to build sustainable organisations that harness people and technology to create value in a wholly integrated sustainable investment system. We should resume our sustainable investing quest after the crisis abates with considerably more zeal than before.

Investment leadership needs to step up. It needs to project confidence that it can crack through this crisis. It then needs to re-group with the benefits of extraordinary lessons learned through extraordinary times and morph into something better. While this crisis is rightly producing stories of heroes in scrubs and gowns, the investment industry will be discovering its own heroes. They are likely to be T-shaped leaders: both sure-footed in strategy and steeped in humanity.

Roger Urwin is the co-founder of the Thinking Ahead Institute and head of global content at Willis Towers Watson.