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Why the IMF is wrong on illiquid assets
Super funds’ high exposure to illiquid assets could result in an illiquidity mismatch that might become a systemic risk during a period of financial stress – or at least, that’s what the International Monetary Fund (IMF) thinks.
Unless you need a loan tied to dubious economic ‘liberalisation’, it’s not clear why you should care what the IMF thinks, let alone what they think about the niche area of unlisted assets in the context of defined contribution pension funds. But in case you do care, here is their thinking.
“Australian superannuation funds are required to allow clients to switch between different investment options generally within three business days, even though these funds hold, on average, illiquid exposures exceeding 20 per cent of their total assets,” the IMF wrote in its most recent Global Financial Stability Report.
“This liquidity mismatch could affect members’ outcomes in a liquidity stress event. Furthermore, liquidity stress could spill over to financial markets, especially those markets in which pension funds and insurers have a large footprint, such as government bonds, equities, and corporate bonds.”
As David Bell and Geoff Warren of the Conexus Institute put to this publication (in much less strident terms than those used in the introduction), it’s a big call to make. The superannuation industry as a whole is in substantial net inflow, and the funds with the largest allocations to unlisted assets are receiving the lion’s share of those inflows. And in the unlikely event (never say never) of a mass run on a specific fund, redemptions are paid from the sale of liquid assets. That results in the denominator effect – where (in this case) illiquid assets would exceed the allocation limits set for them, which is bad for the remaining members of the fund but isn’t a systemic risk.
“Yes, there’s a risk that a specific fund could manage that poorly – but we don’t really see that risk of the whole industry having too much exposure to unlisted assets,” Bell said, adding that some funds that were in outflow did have questionably high allocations to unlisted assets.
The famous example of things going wrong in this area is MTAA’s excoriating experience during the GFC. Per the paper Optimal foreign exchange hedge tenor with liquidity risk (Rongju Zhang, Mark Aarons and Grégoire Loeper) MTAA was around 45 per cent invested in illiquid assets, and was hedging its offshore assets using short-dated FX forwards. When the Australian dollar fell, it had to fund large settlement obligations by selling liquid assets at “the worst possible time”, with illiquid assets rapidly coming to form 70 per cent of the portfolio – at which point it decided to cease currency hedging entirely, just as the AUD rebounded, creating massive losses as the now unhedged offshore assets declined sharply in value in AUD terms.
But that lesson was “well learnt”, Warren said, and there’s been massive improvement in processes since then. APRA’s standards are much higher and more explicit, and if things get really bad for an individual fund APRA can suspend redemptions if it’s asked to.
None of this is to say that there’s no problems with illiquid assets. Justified concerns about their illiquidity and lack of transparency are at the heart of the fear of systemic risks arising from within them. Making sure that unlisted asset valuations are correct and timely – and that everybody gets paid out the right amount when they inevitably switch at the bottom of the market – is of paramount importance.
But despite the IMF’s opinion, it’s unlikely that large allocations to illiquid assets will be where systemic risk arises – and more time and research would be better spent on the problems they do have rather than the problems they (most likely) don’t.
