NEWS

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Background

The depressing of rates of Central banks steered the focus of pension funds and endowments to illiquid assets, given that they chased higher yields (and these managers benefitted from low borrowing costs). The fact that these assets were not marked-to-market frequently gave both the appearance of a lack of correlation and the additional benefit of protecting funded status during minor meltdowns. However, the lessons of 2008 have apparently been neglected. For those who cannot recall, the much-vaunted Ivy League endowments had plowed into illiquid assets after the Tech Bubble burst and were badly liquidity-constrained when markets corrected in 2008, compelling many of these institutions to borrow billions in public markets to offset the hit they took on their private assets. The fallacy that the sticky downside marks provided were exposed as these illiquid asset risks were left unmanaged, and a serious market meltdown implied economic impairment of assets whether or not the fallacy of high marks continued. With other public assets being marked down, soaring illiquid allocations in portfolios required a rebalancing – ergo, more selling of equity risk and a continued tailspin. The similarities in 2023 are eerie, given that  an illiquid asset could easily become an ill-liquid asset if investors are not smart about managing risks – as exemplified by the need for a simple technique that we helped apply in the case of San Diego County Employees’ Retirement Association and a corporate pension fund.

Relevance Today

Given that the external managers ignore beta risk of illiquid assets, which is the responsibility of the investment team, one could question the governance of a fund that does nothing to manage these risks.

Consider the current environment. The allocation to illiquid assets across institutional investors is anywhere from 20 to 40% of the total fund. While rates have been increasing, commercial real estate is definitely rolling over – the defaults/fire sales by Blackstone, Brookfield, Sternlicht, and others suggest the worst is yet to come.[1],[2],[3] In addition, credit availability is shrinking in the aftermath of the Silicon Valley Bank debacle, and this is showing up in rising credit rejection rates.[4] The typical response from CIOs when asked how they manage the risks of illiquid assets is: “top-down diversification across strategies and diversification in bottom-up asset selection.” Further, is the considerable discourse on “steerability,” namely, a desire to be nimble with illiquid assets, factual risk management? In a crisis event like 2008, correlations of both liquid and illiquid high beta assets all go to 1, and private credit, private equity, and venture capital are a daunting, concentrated pile of risk.  The impairment of both liquid and illiquid assets results in ‘di-worse-ification’ -  when  illiquid become ‘ill-liquid’ (as evidenced by the Ivies and other investors in 2008)..

The Solution

So, what is an innovative CIO to do? Ideally, before even initiating these investments, they should have set up a process to map these exposures to liquid futures contracts. The question is: Why choose liquid futures and not the various factors embedded in proprietary risk measurement software that many investors implement?

Clarity emerges when risk measurement is differentiated from risk management:  risk measurement calculates the risks of the portfolio to various factors but does not opine on whether they are good exposures (factor likely to rise in value) or bad exposures (factor tending to decline in value). Current software gives risk measurement parameters such as value-at-risk or some other metric; risk management is about tilting portfolios dynamically, keeping your portfolios long in respect of the factors/futures that are likely to rise and selling/hedging these exposures when they are likely to decline. Leaving the portfolio untouched is a tactical view too; namely, presuming that the factor exposure implied by the decisions of the external managers (who have no understanding or concept of beta risk management) is appropriate. Given that the external managers ignore beta risk, which is the responsibility of the investment team, one could question the governance of a fund that does nothing to manage these risks. For example, one of the most popular software packages provided to investors by asset managers carries the risk in terms of their proprietary factors (that neither the vendor’s staff nor the investor can explain with any degree of certainty), leaving investors captive to the factors that not even their own staff understand. More importantly, such investors are committed to trade through them, whereas the simple solution is to use liquid futures and thereby avoid dependence on third parties, where the data is freely available.

It may be argued that this is market timing and mind boggling. But all investing is market timing and tactical. To assume that private assets will return 9% p.a. over 10 years is a tactical call and “doing nothing” over the next 10 years in managing the beta is market timing. Moreover, given that most assets lose money at least 45% to 47% of the days, to do well, especially in bear markets, requires one to be right 55% to 58% of the days – hardly a hurdle for well-compensated and trained CIOs to overcome. Moreover, shorting the exposures during a declining market is also re-liquifying illiquid asset beta – thereby giving a measure of credibility to the claim of “steerability.”

To do nothing and hope for the best invokes the famous quote of Wolfgang Pauli: “That is not only not right; it is not even wrong."