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Pensions & Investments: After extinguishing fires, asset owners turning to liquidity

Read Pension & Investments' article, "After extinguishing fires, asset owners turning to liquidity" by Paulina Pielichata (May 18, 2020) here: 

Asset owners may be temporarily done putting out fires in their portfolios that followed market declines in March and April. But calmer credit and equity markets aside, executives say they remain watchful of their cash needs and are being careful when selecting investments to ensure portfolios are more liquid.

Investors' income has declined since the virus struck because of slashed dividends and decreased fund distributions from private market investments, sources said. To avoid becoming forced sellers of assets to free up cash during the next bout of volatility, sources said, investors are focusing on building up liquidity. In addition to cash needed to pay out pension obligations, investors are adding liquidity to be in a position to settle losses from foreign-exchange risk hedging, to fund margin calls and to meet capital calls from private markets managers.

All of these needs, which could all happen at the same time, are making planning more uncertain when it comes to determining how much cash to have on hand, particularly if plan executives want to take advantage of stock market opportunities.

In response to that unpredictability, consultants said plan executives have extended liquidity cushions to last four to five months, compared with the two- to three-month buffers they had set up before the crisis. More sophisticated investors have replaced physical equities with synthetic equities to top up cash. Investors said they are also working to keep transaction costs low to preserve cash.

‘Not out of the woods'

"We are not out of the woods yet," Ben Clissold, head of fixed income and treasury at the £68 billion ($84.9 billion) Universities Superannuation Scheme, London, said in a telephone interview, adding that the fund is holding more cash than before the crisis for general liquidity purposes. "We have a relatively large cash buffer at the moment," he added.

The fund doubled its buffer to 3% from 1.5% before the crisis to manage cash requirements related to its derivatives exposure. "We clearly need cash. We run derivatives overlay, foreign-exchange hedges and efficient portfolio management and the requirements for cash on those have been significant through the turbulent times we have seen," he said.

Due to increasing transaction costs for some asset classes, Mr. Clissold also noted that USS is careful about investing disproportionately in asset classes, for example, emerging markets debt, where it is not worth sacrificing liquidity.

"We need to make sure we are not overtrading and not incurring costs," he added.

USS invests 41% of its assets in equities, 21% in private markets, 19.8% in index-linked government bonds, 8.6% in other fixed-income assets and 4.9% in nominal government bonds. The rest is invested in real estate, commodities and absolute-return strategies.

Executives at the 365.8 billion ($37.1 billion) AP1, Stockholm, which also invests more than a fifth of the fund's assets in private markets, have been freeing up cash since the pandemic accelerated to avoid becoming forced sellers. CIO of the fund Mikael Angberg said in a telephone interview that the crisis was far from over. "We want to avoid being in a position when we have to sell private markets or having to sell equities at the bottom," he added.

But Mr. Angberg said AP1 is also preserving liquidity to take advantage of the next stock market rebound. "To rerisk we needed to free up cash to buy equities," he said.

Mr. Angberg said he has had to focus on liquidity management over recent months as a result of investment constraints associated with a high proportion of allocations to private markets as well as domestic requirements on AP pension funds in Sweden to invest at least 20% of assets in investment-grade fixed-income securities.

"We need enough dry powder to participate in the recovery and not be stuck at the bottom (of the market)," he said. To create more liquidity, Mr. Angberg said the fund recently liquidated most of its small-cap equity exposure and some of its emerging markets and high-yield exposures.

"We have liquidated exposures that will be difficult to sell during market stress," he said. He declined to specify the amounts sold and the current cash allocation. AP1 invested 36.3% of its assets in equities, 32.3% in investment-grade fixed income, 4.3% in hedge funds, 3% in high-yield bonds and the remainder in private markets as of Dec. 31.

Increased liquidity

In the U.S., investors have also increased liquidity buffers to manage ongoing cash needs.

Total net institutional assets in money market funds increased to $3.2 trillion as of May 6, from $2.3 trillion as of March 4, according to Investment Company Institute data. Federated Hermes Inc.'s money market accounts rose by $55.8 billion in the first quarter, compared to $36.2 billion in the fourth quarter of 2019. The firm's money market AUM was up $132.9 billion over the 12 months ended March 31, to $451.3 billion.

Plan executives' worries of a liquidity squeeze stem from cash collateral requirements on derivatives transactions as well as foreign-exchange losses from hedging that investors with high overseas exposures experienced in March. Almost all pension fund clients have more cash now than before the crisis, said Robert Wayne Fitzgibbon, partner and senior investment consultant at Mercer Ltd. in London, who noted that pension funds realized in March that they shouldn't be sanguine about access to collateral that was more easily available prior to the crisis.

Jan Ritter, head of hedging and treasury at the 889.5 billion Danish kroner ($130.8 billion) ATP, Hilleroed, Denmark, said: "The large volatility in market prices provoked a large increase in margin calls." Cash is required to be posted as collateral for initial and variation margin to cover the credit risk in derivatives trades under central clearing requirements of the European Markets Infrastructure Regulation and the U.S.'s Dodd-Frank Wall Street Reform and Consumer Protection Act. Both were implemented after the global financial crisis.

When margin calls increase as a result of losses, settling derivatives trades requires investors to post additional cash. For this reason, ATP bumped up its cash reserves as a guard against the different margin calls, Mr. Ritter said, declining to specify the size of the increase.

He added that investors have had to think about the right amount of cash to be available in all relevant currencies. "It's a problem if your margin call is in dollars and you only have euros at your disposal," he said. "Our cash buffers are in different currencies."

Other sources said that losses from settling foreign-exchange hedging cost U.K. investors millions of pounds during the height of the COVID-19 crisis when the pound sterling fell 12% against the dollar between March 10 and March 20 to $1.15 — and investors had to settle FX losses using cash.

In the U.K. "schemes bought a lot of oversees assets, but FX hedges have gone down in value due to the pound depreciating — they had big P&L losses that needed to be settled," said Jos Vermeulen, head of solution design at Insight Investment Management Ltd. in London. Insight managed about £498.5 billion as of March 31. The pound sterling climbed to $1.21 on May 15.

To alleviate the pressure from those derivatives trades that were draining cash, some investors have reduced foreign-exchange exposures instead. AP1's Mr. Angberg said: "As FX-hedging in the derivatives market puts stress on cash positions, the fund has allocated more to Swedish assets, reducing foreign exposure by about 5%." Non-Swedish equities constitute 25.8% of the fund's asset allocation. Assets in non-Swedish investment-grade bonds were not disclosed.

Private markets

Investors have also been looking to get additional cash to fund capital calls from private markets managers.

Those investors with portfolios that could be subject to capital calls tend to face them during crises as distributions decrease. Capital could be required at any time, said Andrew Bentley, partner at advisory firm Campbell Lutyens and Co. Ltd. in London. "This creates lack of certainty about investors' cash positions," he said.

For example, Barry Kenneth, CIO of the £32 billion Pension Protection Fund, London, said the fund received an opportunistic capital call toward the end of March from one of its private credit managers that drew down 0.75% of the fund.

"We had plenty of cash ready to deploy it," he said, adding that the PPF moved to invest in U.S. loans and high-grade corporate bonds when the Federal Reserve and the U.S. government announced its stimulus programs. He declined to specify details of the fund and its manager.

The PPF has 18.3% of its total assets in alternatives as of March 31, 2019, according to it annual report.

"We have approached the pandemic with excess cash because we have been running our portfolios defensively for three to six months given that asset prices continued to go higher (before the crisis)," Mr. Kenneth said. The PPF's strategic allocation to cash is 6%. "We went into the crisis with closer to 8%," Mr. Kenneth added.

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