In a previous post, I examined how to assess the liquidity requirements of a pension fund at the total fund level. In this post and the next one, I’ll explore two different methods for managing the liquidity risk of a fund of direct (less liquid) investments.
The first method for managing the liquidity of the fund would be to include a cash buffer, which supports liquidity requirements (specifically redemption requests). The fund manager determines the amount of liquidity required based on historical analysis of redemption requests and may implement stress testing for requests that are higher than normal. The allocation to cash would generally create what is known as a “cash drag” on the fund since cash returns tend to lag those of direct investments.
One method to solve the problem of a cash drag is to substitute a relatively less liquid asset with a qualitatively equivalent asset that can be sold quickly in the event that liquidity is required. Real estate investment trusts (REITs) would represent such a substitute for real estate: REITs are more liquid than direct property investment, yet REITs are substantively equivalent because real estate represents the underlying investment.
Unfortunately, the market behaviour of REITs is not equivalent to that of direct real estate investment. Since REITs are listed on stock exchanges, they are subject to the same logic-defying volatility of public markets.
Furthermore, the leverage ratio on REITs tends to be higher than that of direct real estate investments. As a result, REITs will have greater potential exposure to interest rates, which can also magnify the volatility of the portfolio (click here for more details). By substituting either cash or similar assets to retain a buffer for liquidity, the portfolio manager may create a drag on returns or an amplification of return volatility.
Read: REITs: A good idea?
If a fund manager chooses to provide liquidity using a buffer of either cash or a substitute asset, investors can invest funds or redeem for cash almost immediately. New investments into the fund will serve to temporarily increase the liquidity buffer asset until suitable direct investments can be found to deploy the cash. Therefore, from a client’s perspective, the funds invested will immediately participate in any appreciation of the asset class. The drawback of such an approach is the impact on current unitholders, as their investment in the underlying asset has been diluted by the new investable funds.
Alternatively, the manager may only accept a portion of the new funds into the liquidity buffer and call on the remaining funds when suitable direct investments have been made. Upon redemption, the manager will reduce liquidity buffer assets to provide funds to the redeeming client and increase the buffer once direct assets can be sold. From a client’s perspective, units redeemed for cash immediately cease to participate in the asset class.
What if the fund receives requests for redemptions that exceed the size of the liquidity buffer? In such a case, the fund will often freeze redemptions as direct assets can’t be sold quickly enough to meet the liquidity required by redemption requests. This potential situation highlights an important aspect of any direct investment fund: alignment of clients and proper communication with clients. Client interest must be aligned so that no single client’s redemption request can adversely impact other clients. Even when a liquidity buffer is held and there is a high probability that any requests for redemption can be met by such a buffer, clients must always be informed of the possibility that cash may not be available immediately upon request.
Read: Liquidity risk: four questions to ask
Providing liquidity to clients is often a challenge for funds with underlying assets that aren’t easily purchased or sold. One approach to managing this process involves establishing a liquidity buffer in the fund consisting of either cash or equity securities with similar underlying exposure. In doing so, clients are able to gain immediate access to such asset classes upon investment and to cash upon redemption.
Unfortunately, this can also result in the fund’s characteristics differing from both client expectations and assumptions underlying an asset-liability study. Returns may lag the asset class due to substantial cash holdings or the fund volatility may resemble that of equity markets, which is precisely what the client expected to avoid in the asset class. In this structure, the liquidity premium expected by the client may never materialize due to the management of liquidity.
In the next post I’ll explore another approach to managing the liquidity of a fund that invests in non-tradable underlying assets.