Among the many stress points for institutional investors in recent years, greater portfolio liquidity is near the top of the list. In many cases, pension plans face funding challenges with fewer active participants. The story is essentially same for other institutions, such as insurers, foundations, and endowments – and family offices can be included in the mix, too. Each has ongoing obligations, and when capital calls and asset manager review and rebalancing are taken into consideration, the need for improved liquidity – particularly in a “lower for longer” environment – becomes crystal clear. In fact, 2019 research by Greenwich Associates indicates that liquidity and risk management are ongoing priorities for 75% of chief investment officers.
What might be considered “traditional” ways of meeting liquidity demands, however, are often not sufficient or strategically viable. Adding to cash allocations, for example, can be a drag on overall portfolio performance, increasing tracking error relative to policy benchmark. At the same time, tactical selling of holdings in asset classes with higher trading costs can be expensive, operationally inefficient, disruptive to the underlying managers, or restricted by a lock-up period. Moreover, such an approach may leave investors in the position of being forced sellers – a scenario that doesn’t sit well with any investor.
Magnifying the liquidity challenge, allocations to alternative assets are growing as well. According to a 2018 report by Prequin, an alternative data provider, the alternative investment industry is expected to have $14 trillion in AUM by 2023. But investors’ commitments to alts are not immediately invested, resulting in cash drag from dry powder waiting for capital calls. In addition, such investments are often illiquid, and while they may make sense strategically over the long term, don’t do much to help more immediate liquidity challenges.
Solutions to investors’ liquidity challenges continue to evolve, however, led in large part by innovations from BlackRock, and are the focus of this report.
To help meet these growing institutional liquidity needs, BlackRock created and launched its Liquid Policy Portfolio (LPP) strategy in 2011. LPP strategies are designed to reflect the median asset allocation of pensions, foundations, and endowments. An LPP strategy consists of a portfolio of exchange-traded funds (ETFs) and seeks to deliver a typical policy benchmark allocation with exchange-traded flexibility and liquidity.
LPP strategies were an early example of BlackRock setting the pace for what would become (and remains) a growing trend of institutional investors using cost-efficient ETFs to help meet liquidity demand. According to 2019 Greenwich Associates research, 81% of asset owners cited liquidity as a primary reason for using ETFs, and overall allocations to ETFs increased to 25% of total assets in 2018, a jump of 6% from one year earlier.
Potential benefits and considerations of LPP strategies
As on off-the-shelf offering, LPP strategies are designed to address the challenges common to many institutional investors, and to deliver a core set of benefits that are underpinned by the traits of ETFs.1
For starters, LPP strategies offer operational efficiency. ETFs offer intra-day liquidity, with the possibility of T+1 settlement.2 In addition, using a liquidity sleeve to help meet cash needs can reduce disruption to actively managed mandates.
They also offer cost and investment efficiency. Compared to holding excess cash, LPP strategies can potentially reduce tracking error relative to policy benchmark.
LPP strategies use median allocations. For pensions, the median allocation data is provided by Pensions & Investments, while Greenwich Associates provides the median allocation for foundations and endowments.
In executing LPP strategies, asset-class exposures are mapped to the most relevant indices and assigned to related iShares ETFs. This mapping is complemented by additional mapping of alternative asset classes (private real estate, for example) to their most relevant index counterparts (in the private real estate example, that could be REITs adjusted for leverage). The result is a combination of iShares ETFs.
LPP strategies may also raise certain considerations related to risks and exposure. LPP strategies hold non-cash vehicles and therefore are more volatile than cash. Also, a client’s long-term investment policy may have a different risk/return profile than the LPP allocations.
1Capabilities may vary depending on the specific implementation and/or investment vehicle.
2 For redemptions, T+1 settlement is conditioned on the ability to short settle ETF trade orders with brokers. If short settlement is not available, settlement will revert to standard T+2 settlement.
No two institutions have the exact same needs, nor does any one institution have unaltering challenges. In short, things change, and investors want to know they can customize strategies to meet their current requirements, and that they have the flexibility to meet future challenges as they evolve.
Prior to the widespread adoption of ETFs, liquidity strategies were typically constructed using cash or other liquid asset classes that could have non-trivial tracking error to policy benchmarks. While this approach may still be sufficient for some investors, it may result in unintended overweights or underweights relative to their benchmark or policy statement.
To that end, BlackRock has engaged with clients that seek more tailored liquidity allocations to reflect their full investment policies, subcomponents of the allocation on the public or private side, or other portfolios – and to seek to avoid unintended consequences of investment strategy decisions.
Precision liquidity management and factors
Among the many new and innovative uses of ETFs that have accompanied their growth and development is increasingly precise liquidity management. This is possible thanks to the growing number of sizeable and sufficiently liquid ETFs in multiple asset classes. Transacting in ETFs may offer a reduction in implementation time and transaction costs relative to individually trading in the underlying assets.
When a tailored portfolio is under construction, various tradeoffs are considered to help determine an efficient fit for an investor, including active risk to policy benchmark, trading cost, management fees, and liquidity of the ETFs.
Factor-weighted exposures have been increasingly important in numerous customized liquidity solutions. The solutions utilize either the bottom-up or the top-down factor investing approach. Each approach has a distinct effect worth consideration by investors.
Making allocations to individual factors typically requires strong investment beliefs, as factor returns have been cyclical in nature. In one study, MSCI used a bottom-up approach to build a multifactor index from stocks that are favorably exposed to the value, size, quality and momentum factors, and compared it to an alternative top-down approach combining single factor indexes. The two approaches were compared in terms of their level of exposure to the target factors as well as their capacity and investability profiles.
MSCI’s analysis, which included hypothetical back-tested performance, showed that both approaches would have demonstrated outperformance versus a market cap-weighted parent index during the study period. In the context of multi-factor index construction, the top-down allocation offered the advantages of simplicity, relatively higher capacity, and lower active risk. However, the exposure to the target factors was muted due to a dilution effect caused in part by offsetting stock weights across the single factor portfolios.
On the other hand, the bottom-up approach, which used optimization, did not have this same dilution effect. Instead, it showed higher and more persistent overall exposure to the target factors. As a result, both risk and return were attributed more to the target factors as desired. However, the level of active risk may be higher in the bottom-up approach and relative capacity may be lower. The choice between these approaches may depend most on the particular needs of the institutional investor.
As noted in the introduction to this report, institutional investors generally have significant and increasing exposures to alternatives – notably to hedge funds, private equity, private credit, and private real estate. Such allocations have the potential to diversify and enhance portfolio returns, they are often illiquid (not to mention costly).
Alternatives, as such, present investors with a bit of a conundrum. Investors appreciate the potential return premia of “traditional” alts, but acknowledge they can be significantly illiquid at a time when liquidity needs are pressing down on them. It makes sense, then, that there is growing demand among institutional investors for liquid solutions that are designed to mimic the role of standard alternative allocations in their portfolios. That demand is being met.
Liquid alt proxies
Most institutions regularly conduct reviews of their asset managers, and often as a result decide to reallocate among various alt strategies, resulting in disruption of exposures and benchmarking risks. It is in this scenario that a new use for ETFs has emerged, namely as liquid alternative proxies for short-term exposures to equitize cash during alternative manager transitions. ETFs are being similarly used for longer-term strategies where institutions are looking to reduce cash positions while maintaining liquid exposures.
To create liquid alternative proxies, BlackRock assesses the risk and return profiles of hedge funds, private equity buyout, venture capital, and private real estate, and maps each of these asset classes to the combination of iShares ETFs that efficiently approximates these characteristics. The methodology used adjusts for the effects of private asset class autocorrelation to better estimate risk profiles.
These liquid public proxies can complement the allocations of four private asset classes, allowing institutions to gain flexibility in meeting liquidity needs while helping to mitigate the performance drag that can result from holding excess cash.
To proxy buyout private equity, a three-pronged approach combined academic research, returns-based regressions, and holdings-based analysis of buyout targets. All three approaches identify the value factor as a strong (though not identical) public-market proxy for the private equity return premium. Buyout private equity cannot be fully replicated through public markets, but factor-weighted strategies are attractive alternatives to market cap-weighted strategies.
To proxy venture capital, research has shown the presence of the momentum factor in the regressions. As was the case with the value factor in buyouts, this is a public-market anomaly that can be accessed through an MSCI index in seeking to close the venture capital return premium gap.
- 75% of CIOs consider liquidity an ongoing priority, according to Greenwich Research.
- Liquidity is a priority due to funding shortfalls, ongoing obligations, capital calls, asset manager review, and rebalancing.
- At the same time, allocations to alternative investments are on the rise – but “traditional” alts do not provide liquidity. In addition, commitments to alts are not immediately invested, resulting in cash drag from dry powder waiting for capital calls
- ETFs are widely used by institutional investors, and can play a major and innovative role in answering the liquidity challenge.
- Among the ETF-based solutions is the off-the-shelf Liquid Policy Portfolio (LPP) strategy, through which investors can potentially achieve operational efficiency, cost efficiency, and investment efficiency.
- Customized strategies allow for precise liquidity solutions using ETFs.
- Liquid public proxies can help investors mimic “traditional” alternative investments, but with the potential for liquidity, ease of use, and low costs – all through using ETFs.
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There can be no assurance that the investment objectives of any strategy referred to herein will be achieved. An investment in any strategy referred to herein involves a high degree of risk, including the risk that the entire amount invested may be lost. Strategies are not guaranteed by BlackRock or its affiliates.
An investment in ETFs is not equivalent to and involves risks not associated with an investment in cash.
T+1 settlement is conditioned on the ability to short settle ETF trade orders with brokers. If short settlement is not available, settlement will revert to standard T+2 settlement. Two-day financing cost for T+1 settlement would be incurred by the transacting client.
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. The information provided is not intended to be a complete analysis of every material fact respecting any strategy and has been presented for educational purposes only. Asset allocation models and diversification do not promise any level of performance or guarantee against loss of principal.
Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the LPP strategy.
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