In 2008 and early 2009 investors faced liquidity constraints from many sources all at the same time. Sources of liquidity constraints were many and included:
- Settlements on derivative overlays used for rebalancing and portable alpha,
- Private equity and infrastructure contractual fundings,
- Hedge funds with formal lock ups and unplanned closures,
- ABCP, SIV’s and other short-term securities that stopped trading,
- Almost all OTC fixed income securities except government issues.
The only instruments and markets that had liquidity were government bonds and exchange-traded equities and derivatives. Nearly all other OTC fixed income and derivatives were completely illiquid in the fourth quarter of 2008 and first quarter of 2009. With market values down significantly, equities could have been sold, but they were one of the only assets that institutions didn’t want to sell.
Policy allocations to cash equivalents are typically 0.5% or 1% with some at 2% but very few above this level. Over the last decade the typical allocation to less liquid alternatives and the allocation to non-government bonds in fixed income portfolios have increased while the allocation to cash equivalents has been steady or even declined. The result was that plans gradually had less and less liquidity. For a long time nobody noticed because liquidity had not been challenged.
A simple rule of thumb may be that there needs to be at least 1% cash equivalents for each 10% allocation to less liquid assets. For example, the WCB – Alberta fund is moving to an allocation that is 25% less liquid assets (real estate, infrastructure, mortgages) and therefore the cash equivalents allocation may need to increase to 2.5% of total assets.
Individual circumstances such as liquidity needed for benefit payments and the extent to which derivatives are used to manage asset and currency exposures should also influence the policy allocation to cash equivalents.
The lesson learned is that there can be a huge benefit to having more liquidity and better liquidity planning. Portfolios may need a higher cash allocation and perhaps a higher policy minimum allocation to government bonds. Investors also need to do a better job of knowing their future commitments to less liquid asset classes (private equity, infrastructure, real estate, and hedge funds), which will help avoid getting into a position where cash is not available to fund commitments.