What price liquidity?

Two interwoven areas of investment management – liquidity and risk management – have become a boon for academics in the wake of the financial crisis and the liquidity black holes that apparently formed within endowment and pension funds. It may seem to be an overabundance of research, but it’s in line with demand.
Risk management in general has to be the most touted portfolio and organisational revolution among institutional investors in the years since the financial crisis. A subset of this is defining and measuring liquidity, and the risks of not having enough. The academics are exultant, and a new groundswell of research has emerged.

The diverse research includes work from esteemed academics such as Andrew Ang of Columbia in NYC (who has studied portfolio choice with illiquid assets), Mark Kritzman at MIT in Boston (who looks at better ways of measuring liquidity) and Tobias Moskowitz of Chicago Booth who is working with Lasse Pedersen from the NYU Stern School of Business (whose specialty is liquidity risk). The good news is they are all looking at liquidity from different angles.

Most institutional funds have boosted their stores of liquidity by increasing their allocation to cash in the past couple of years. CalPERS has a target of 2 per cent, raised from 0 per cent in June 2009; the corporate pension fund for GE has around 3 per cent; and Harvard Management Company’s cash allocation sat at -5 per cent for 10 years from 1995 but is now 2 per cent.

Australia’s Future Fund famously got lucky when, as a relatively young fund, it had about half its assets in cash throughout the crisis. It still has a relatively large allocation of about 11 per cent, down from 16.5 per cent a year ago.

However at the risk of sounding like a consultant, liquidity needs are different for different funds (just like my liquidity needs are clearly different to most of those with a 06831 zip code).

The CPPIB, for example, doesn’t need to make a payout for 25 years, so its liquidity needs are different to an endowment which provides up to 40 per cent of its school’s funding.

Clearly holding cash can be an expensive exercise, especially when yields are low and the opportunity cost is factored in.

One option for cash management is to use ETFs. Research by Greenwich Associates shows an increasing use of the instruments by endowments and pension funds.

According to the study – which was sponsored by giant ETF provider iShares – institutional investors showed higher allocations to ETFs for liquidity management, rebalancing and cash management.

But ETFs will not necessarily, in themselves, be the cure for liquidity stress. Especially now they have the attention of regulators.

In April three separate documents from the Financial Stability Board, International Monetary Fund, and Bank for International Settlements all voiced concerns about the potential risks to financial stability posed by exchange-traded products.

A lot of this concern is with the rate of innovation, and not necessarily connected to the more vanilla products used in cash management, with a word of warning about complexity and opacity.

But the IMF report points out the most basic of liquidity problems, but one not yet solved, by ETFs or academics – in chaotic conditions there may be sellers but no buyers.

“While most ETFs are supported by one or two market makers, there is no guarantee of active trading under illiquid conditions.”