The presentation covered some experiences from managing the WCB-Alberta portfolio through the global financial crisis of 2008 and 2009. The focus was on portfolio management for institutional investors: what was learned, what worked well and where opportunities for improvement exist. The key message was that crisis creates opportunity and that excess returns can be generated from taking advantage of the excess pessimism that is reflected in asset prices in times of crisis and extreme uncertainty.
Capital markets are susceptible to fear and greed – they are the primary drivers of pricing. As institutional fund managers with long time horizons, we are in a position to take advantage of this and adjust portfolios accordingly. Crystal balls and technical models are not necessarily required as it can be as simple as good old-fashioned rebalancing between bonds, cash and equities. At WCB-Alberta, we firmly believe in rebalancing between equities and bonds and also between government and non-government bonds. With the WCB portfolio, several transactions were made to sell bonds, and buy equities and credit throughout and after the crisis. The chart below illustrates the transactions that were implemented to purchase equities.
In hindsight it seems simple, but at the time it is more complex, and the advance preparation is critical. While WCB-Alberta was successful in some rebalancing and therefore some sales of expensive bonds and purchases of cheap equity, unfortunately, we were not able to transact nearly to the extent we would have liked. Our fund was like many, in a position with very limited liquidity and very limited ability to take action. The primary problem was that there was not enough cash or liquid cash equivalents and bond portfolios were loaded up with credit and did not have any liquidity.
The prerequisites to being opportunistic and taking action are a functional governance structure, sound risk management practices, a process to adjust portfolios using derivatives and enough liquidity to be able to fund the transactions.
A functional governance structure and sound risk management practices are a first prerequisite for a fund to put itself in a place where it can act on opportunity. Decisions on rebalancing and management adjustments to portfolios need to be delegated to a level where action can be taken on fairly short notice and where expertise exists. This may be internal or external, depending on the size and structure of the fund.
Adjusting our portfolio with a derivatives overlay was critical, but still required significant liquidity to post margin and to cover potential margin calls. Using derivatives to buy equities and sell bonds is a necessity for any mid or large-sized fund. The key thing is that transactions can be executed quickly and efficiently and then the cash market holdings can be sorted out at a later date.
Having the ability to transact with derivatives is not enough; ample liquidity is still required. There are technical methodologies for measuring liquidity across multi-asset class portfolios; however I would argue that in this case, a simple method is better. What you need to monitor is upcoming potential commitments, operational needs and a buffer or margin to allow for opportunistic transactions. This is matched up against a tally of liquidity. Ample liquidity, in a time of crisis is only cash, cash equivalents and government bonds. Publicly traded equities should remain liquid, but in a crisis, they are the asset class you want to buy and not sell.
The main point of the presentation was that in order to be able to act, you need to be ready and you need to have the ability and the liquidity. Playing good defence will provide the opportunity to go on the offensive when it is most advantageous.
I don’t think this is a case of being good at solving yesterday’s problem because we have seen over the recent past and over a longer history that market crisis events happen regularly. I think you could argue that they may happen even more frequently in the environment we face, which has unprecedented fiscal and monetary policies, large global imbalances and rapid information dissemination.
In closing I reference a quote from Peter Drucker, author and management guru.
“You can either take action, or you can hand back and hope for a miracle. Miracles are great, but they are so unpredictable.”
Chart (click to enlarge)
Dave Lawson, CFA, is chief investment officer, Workers’ Compensation Board-Alberta.