Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Time for a chief liquidity officer: PGIM
Modelling expected and unexpected liquidity demands across entire funds might go beyond their chief risk officer function, according to PGIM. So to avoid deadweight losses from liquidity risk it might be necessary to bring liquidity management to the fore under a dedicated person or team – a chief liquidity officer (CLO).
“For long-term, institutional investors such as pension funds, sovereign wealth funds and defined contribution plans, volatility risk is rarely life-threatening,” writes Michelle Teng (picture at top), co-head of PGIM’s Institutional Advisory and Solutions private assets research program. “Volatility comes and goes… However, there are events that can threaten a fund’s survival – a sudden need to raise cash (a “cash spike”).”
A CIO faced with a sudden cash spike faces the “distasteful task” of having to offload assets they might otherwise have kept. If the liquidity need is small, selling liquid assets incurs “few adverse consequences”. But if the need for liquidity is great, additional assets will have to be sold, potentially during periods of poor valuations or particularly wide bid-ask spreads.
So to avoid deadweight losses from liquidity risk, PGIM says, it might be necessary to bring liquidity management to the fore under a dedicated person or team – a chief liquidity officer (CLO).
PGIM justifies its call for a new CLO role by pointing out that liquidity demands can cascade –
for example, in 2020, when a super fund (or other defined contribution plan) might have gotten capital calls to take advantage of market opportunities spotted by its general partners at the same time it was likely to receive reduced inflows owing to the economic slump and have to keep large amounts of cash on hand to meet FX hedging variation margin calls – as well as deal with members switching into lower risk options.
Tack on to that existing liquidity cascade the fact that “new and novel liquidity” demands are appearing – including, for example, the Morrison government’s early release scheme (ERS), which allowed all participants to withdraw $10,000 from their superannuation in two periods. PGIM says such a situation is plausible to consider before it occurs – but asks “who at the fund would have connected all these dots as a potential scenario?”.
“A cascade of these varied liquidity demands originating from the top-down and bottom-up investment teams, participant behaviour and government policies, can produce a significant and prolonged liquidity drain which may have permanent adverse consequences for a fund,” Teng wrote.
“Typically, however, modelling these expected and unexpected liquidity demands across the entire fund, including those driven by participant behaviour (e.g., member switching) or by government decisions (e.g., an ERS), may go beyond the chief risk officer function. To avoid deadweight losses from liquidity risk, it may be necessary to bring liquidity management to the fore under a dedicated person or team.”
The CLO would monitor both explicit and potential liquidity demands and sources, maintain external liquidity facilities, and quantify the sensitivity of the fund’s liquidity risk in alternative situations – for example, how portfolio performance and liquidity risk change with a 10 per cent higher allocation to private equity.
“While a new and separate chief liquidity management function may generate cumbersome organizational overlaps and internal confusions within a fund, the long-term benefits are likely worth the effort and stress,” Teng wrote.
“The ability to have a dedicated chief liquidity officer will likely depend on the type and the size of a specific institutional fund. For smaller funds, the CIO may select an existing officer and formalize their liquidity management coordinator role. Ultimately, it is the fund’s decision whether now is the time to either appoint a chief liquidity officer, beef up liquidity management expertise and analytics, or confirm and validate that the existing investment and risk management teams can adequately analyse, monitor and manage overall fund liquidity.”
