While most consultants continue to concentrate on illiquidity premia, some consultants have shifted their focus to the other extreme . Fraser Lundie, Co-Head of Credit at Hermes Investment Management looks at how UK pension schemes, like many other areas of finance are grappling with structural change rarely seen to such an extent or evolving so quickly. Ageing populations, political changes, and regulatory shifts are combining to drive “cash” in all its forms, to become one of the most important components of a scheme’s portfolio.
Structural Change at work
As schemes are maturing and de-risking, they are increasingly positioned for this unwinding stage. This in itself brings cash more into play, as does the increasingly negative cash flow profile that such a mature scheme demonstrates. Pension freedoms have added an additional element of uncertainty over cash calls, as some members opt to cash out.
In recent years, pension schemes have increasingly employed leverage, commonly via interest rate and inflation hedges, to improve liability matching. However, this leverage has implications for a scheme’s ability to manage collateral calls and liquidity requirements (settlement payments or pension payments). Indeed, bank regulation around the central clearing of swaps means that, in future,, collateral will have to go beyond just Gilts, which are also becoming less freely available via repo - again an unintended consequence of regulation.
So cash is going to be more sought after, indeed, required at the very time its accessibility and expensiveness are adding complexity.
Unfortunately, the solution cannot be to just hold more cash. Even if one optimises liquidity facilities, required asset return assumptions are already under the spotlight for their rosiness . Schemes can ill afford another hit to returns at a time when the liability side is also being inflated by historically low discount rates.
A solution being put forward by the market is a ‘liquidity ladder” approach. This comprises three rungs – operational cash – literally, money in the bank. Then comes reserve cash – largely Gilt related exposure, offering a suitable buffer to day to day operational cash. Thirdly, strategic cash, which would be an allocation more tilted to short dated credit, ABS, and Absolute return credit strategies. As liquidity is taken out via the bottom rung, it is replenished by the one above.
The net effect of this liquidity ladder will reduce gilt exposure whilst increasing outright cash and credit based strategies at either end of a barbell formation. This barbelling immediately boosts overall liquidity due to the higher outright cash holding, increases asset return due to the higher credit allocation, and reduces the scheme’s basis risk given the reduced assumed gilt vs swap liability.
So more liquid, higher return, lower risk – what’s the catch? Allocating to a strategic cash strategy that avoids taking illiquidity premium as a driver of performance is key. Just because a fund has daily liquidity does not mean you are matching cash-like requirements with liquid assets. As such, strategies that employ large portions of illiquid credit, ABS, distressed, loans etc should be kept in their natural home of long-term, return-seeking areas of a scheme’s portfolio. Similarly, high fees, often associated with more illiquid or complex allocations can eat away a sizable portion of what is a relatively small gross return objective. Lastly, within absolute return, there has historically been an overreliance on interest rate duration as a means of downside protection, something which quickly looks like a double bet when traditional correlations break down a la taper tantrum 2013.
Absolute Return Credit well placed to fit on the third ladder
The term absolute return conjures up mixed messages and strong opinions about what it means, or should mean. At Hermes, we manage our Absolute Return Credit Strategy with three key objectives in mind. Firstly, we want to ensure Absolute means Absolute, by focussing on the downside protection properties of the strategy to the extent that we can deliver positive absolute returns on a rolling 12 month basis. This means restricting the amount of directional risk, whilst at the same time diversifying the means of downside protection away from interest rate duration exposure. Secondly, we look to operate the strategy with minimal liquidity and volatility risk, ensuring its appropriateness for a cash-like allocation such as the liquidity ladder approach. This involves a focus on companies with large, multi-layered capital structures, ensuring both potential to hedge and optimise the alpha generating opportunities intra-capital structure, rather than drifting into directional bets. Lastly, we look to achieve a return target through the full credit cycle of Libor+3% before fees, giving what we believe is an adequate return relative to the moderate risk being undertaken through a full holding period.
Liquidity requirements do not need to translate into forfeiting returns if structured in a beneficial way. The benefits of a liquidity ladder approach centre around a superior risk adjusted return potential and an improved operational environment. Such a change in approach may well end up being forced upon schemes via regulatory headwinds, particularly those who have moved toward a more heavily levered LDI structure in recent years. Having decided to move towards a dynamic liquidity ladder framework, it is crucial that the strategic allocation delivers on its mandate and does not deviate into illiquidity, complexity or directional premia. In this way, it will be possible to achieve the higher return, better liquidity, lower risk outcome promised by the liquidity ladder approach.
Any opinions expressed may change. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Any investments overseas may be affected by currency exchange rates. Past performance is not a reliable indicator of future results and targets are not guaranteed. All figures, unless otherwise indicated, are sourced from Hermes.
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