The Folly of the Fetish for Liquidity
- In our recent survey* of over 60 defined contribution (DC) plans in the UK we found that many DC schemes have both the liquidity reserves and a positive intention to invest in illiquid assets. The link that follows to our white paper “A Fetish for Liquidity”, gives a comprehensive view of how UK DC schemes view the benefits of investing in private markets.
- We also add to a DC portfolio an allocation to a multi-asset credit strategy with 50% in private senior leveraged European loans and 50% in public credit assets. The allocation considerably lessens the impact of severe market stress by reducing annualised volatility and improving the Sharpe Ratio.
- Investors need the long-term returns that equity markets bring, but also need lower volatility at critical times on their pension journey. DC schemes need to offer members a less bumpy ride, through investments such as private and illiquid credit assets
When John Maynard Keynes said “there is no such thing as liquidity of investment for the community as a whole”1, he was theorising about times of economic downturn or correction. In these instances, liquidity in a wide range of assets can evaporate overnight as institutions lose trust in one another. Liquidity vanishes when investors rush out of the door at the same time, with daily liquidity requirements exacerbating the problem.
That’s why mechanisms are in place to help investors who choose to stay invested: swing pricing, discounts between bond ETFs and their underlying indices, and bid/offer spreads widening significantly. Public equities remain liquid, although there at the cost of huge sell-offs.
In today’s COVID-19 crisis we are seeing the implications that the fetish for daily liquidity is having on equity-heavy DC default funds that track markets down, with little in the way of diversification to steady declines in value. For DC Investors, short-term volatility can be very damaging. Although investing for the long term will bring its rewards, within each portfolio members are continually transferring in and out, and retiring. Not all members have the luxury of 40 years in the same plan, or a five-year retirement window, and volatility can hurt.
Reducing Volatility With Alternative Credit
Let’s look at how an alternative credit allocation may improve portfolio efficiency during market corrections. We add to a DC portfolio an allocation to a multi-asset credit fund that has around 50% in private senior leveraged European loans and 50% in a public credit asset fund. We assess the impact of adding 20% and 40% proportionately to a default fund that is made up of 85% global equity and 15% gilts.2
The main benefit of including this alternative credit allocation in a DC portfolio is to reduce its risk profile, without materially impacting returns over the time horizon, leading to a more efficient portfolio. The allocation has the potential to lessen the impact of severe and prolonged market stress. Over the period from 2002 to 2020, which includes the Global Financial Crisis (GFC), the maximum drawdown decreased from approximately 27% in the traditional portfolio to 23% with the addition of a 20% allocation to alternative credit, and 25% by adding a 40% allocation to the alternative credit strategies.
From the start of the GFC (Nov 2007)3, a portfolio with a 20% - 40% alternative credit allocation would have made members whole again by the end of 2009 (specifically, +0.7% with a 20% allocation, and +3.3% with 40%). The standard DC portfolio, on the other hand, is still in the red (-2.12%) at the end of 2009, and does not recover its losses until February 2010.
So an allocation to this type of alternative credit strategy would have protected against a market correction. But what about its performance over the longer term?
The overall performance is broadly similar, but how the portfolios get there is very different! The traditional default portfolio (85% - 15%) has more upside potential, with an upside market capture ratio4 of about 86% (vs 63% and 76%). However it suffers on the downside with a down market capture ratio of about 82% (vs 53% and 68%).
Other benefits of the allocation to alternatives are a reduction in overall portfolio risk (measured by annualized volatility) from 11.67% to 9.97% and 8.45% In addition, the portfolio delivers better risk-adjusted returns, with the Sharpe ratio improving from 0.42 to 0.45 and 0.52.
In fact, the portfolio containing the alternative credit allocation, outperformed the MSCI World index5 in 18 of 20 down quarters, so protecting against the downside while maintaining the performance level of the fund overall.
Traditional Allocations Expose DC Members to Drawdowns
Some DC pension schemes have been able to provide appropriate default funds which meet the needs of the older consolidating and retiring members, so the damage to portfolios during downturns is mitigated. However, the findings in our survey of UK DC schemes6 show that many schemes only have one default option available to members, indicating that those members could suffer greatly (notwithstanding any lifestyle or target date arrangements) if nothing changes in default fund allocations.
Investors need the overall returns that equity markets can bring over time, but with lower volatility. DC schemes need to help members get to a point of retirement, but with a less bumpy ride on the way. A sensible investment in private markets can help them to do that.
Pension schemes target illiquid assets
- A recent survey* of over 60 defined contribution (DC) plans in the UK found that many DC schemes have both the liquidity reserves and a positive intention to invest in illiquid assets. Key findings:
- Master trusts are much more likely to invest in illiquid assets in the future, compared to Group Personal Pensions (GPPs) and trusts. On a scale of 1 to 10, where 1 is very unlikely and 10 is absolutely certain, master trusts gave their likelihood to invest in illiquid assets as 7.4, compared with 4.2 for GPPs and 4.6 for trusts.
- Asked what would be an appropriate allocation to illiquid assets, master trusts said 24.4%, compared with 25.6% for GPPs. However, trust-based DC schemes said 14.8% was an appropriate allocation.
- The desire of DC plans, particularly master trusts, to use illiquid assets is supported by their liquidity position. According to the survey findings, master trusts are in receipt of annual cash flows equivalent to 30.2% of their total assets, compared to 12.6% for GPPs and 11.2% for trusts. The proportion of master trust members expected to transfer out or retire in the next 12 months is 4.4% of total active members (vs 4.2% for GPPs and 5.5% for trusts).
- Asked to estimate their current and future liquidity requirements, the average percentage of current assets that need to be liquid was estimated at 3.8% now, 7% in five years from now and 14% in ten years, reflecting the maturity of some of the single trust schemes. Given the positive cash flows and the fact that most of the funds are liquid, the relatively low liquidity required in the next five years shows that DC schemes have the scope to handle illiquid assets.
- Average combined employer and employee contribution rates are 16.2% for trusts, 13.2% for GPPs and 13% for master trusts. This is not surprising, given that trust-based DC plans were often set up by employers actively involved in occupational pensions, whereas master trust members are more likely to be receiving contributions at the minimum mandatory rate under the auto-enrolment regime (currently 8% combined contributions).
2 The study was conducted over the time period January 2002 to March 2020 using monthly observations and returns expressed in GBP. The public credit asset fund includes the asset classes Global HY, Global IG and EMD Corporate. For all asset classes in the study we have used broad market indices as proxies. Report available on request.
3 Start drawdown of the DC default fund proxy with 85% global equity and 15% gilts.
4 Benchmark: MSCI World NR USD.
5 Over the time period January 1, 2002 to March 31, 2020.
6 Natixis Investment Managers, survey of UK DC Pension Schemes on liquidity requirements. Research was conducted from 01/07/19 - 31/07/19. This survey was of 65 UK based DC pensions schemes, representing Trusts (27), GPPs (21), Master Trusts (17).
* Natixis Investment Managers, survey of UK DC Pension Schemes on liquidity requirements. Research was conducted from 01/07/19 - 31/07/19. This survey was of 65 UK based DC pensions schemes, representing Trusts (27), GPPs (21), Master Trusts (17).
Published in May 2020
Natixis Investment Managers
RCS Paris 453 952 681
Share Capital: €178 251 690
43 avenue Pierre Mendès France
This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.
Copyright © 2020 Natixis Investment Managers S.A. – All rights reserved