Most institutional investors have the capacity to take on some added illiquidity risk as a means of increasing both current income and longer-term returns.

By Jared Gross, Head of Institutional Portfolio Strategy

IN BRIEF:

• Investors tend to maintain a strong bias toward liquid market assets in their portfolios – while at the same time recognizing that less liquid investments may generate higher returns and improve diversification.

• Maintaining liquidity is essential, but it does impose opportunity costs that are particularly visible in a low-return environment. Fortunately, liquid assets need not sit idle. Employing dynamic asset allocation strategies can turn unused excess liquidity into a source of long-term value.

• The universe of illiquid assets is diverse, and asset allocation can be improved by increasing exposure to the full spectrum of less liquid investments. A well-constructed portfolio of less liquid strategies can add value through access to higher levels of return, income generation and risk diversification.

The role of liquidity in portfolio construction

Institutional investors consider risk and return to be the critical variables when setting strategic asset allocations.  Expected returns, volatilities and correlations drive this process, and a highly refined set of analytic tools enables the construction of efficient portfolios across these dimensions.

But there is another variable of great importance to the asset allocation process and to the overall success of the investment program—namely, liquidity. It too requires careful consideration given its pervasive influence over the investment opportunity set.  Put simply: Too much liquidity can be costly and inefficient in a low return environment; too much illiquidity can be risky given the need for ongoing access to capital.

If we can build portfolios that meet the long-term objectives of high returns and risk diversification with liquid assets alone, then the challenge of managing liquidity is a modest one. But frequently this is not the case.  Liquid markets may not offer adequate returns and diversification, while less liquid investments may offer much more attractive investment opportunities. Thoughtful investors should incorporate both the need for liquidity and the opportunity of illiquidity directly into the formulation of their investment strategy.

Three roles for liquidity in a portfolio:

Think of liquidity as a form of insurance that has a high value at certain times but also a persistent cost over time. It is critical to have a sufficient amount and the right type of liquidity, but it can be equally critical not to have too much, lest it serve as a costly drag on performance. In this context, one can map the liquidity of portfolio assets against three broad roles: baseline liquidity, excess liquidity and unneeded liquidity.

Baseline liquidity: Allocate across the liquid market opportunity set

All investors should place a value on having access to a baseline level of ready liquidity in their portfolios.  Operationally, they need to source cash for benefit payments, to support non-profit spending rates, or to provide other forms of regular institutional support.  There may also be less regular (but potentially more significant) obligations including planned capital expenditures, unanticipated special draws and contingencies, or lump sum payouts to retirees.  Finally, a store of safe, liquid assets may help a portfolio weather periods of market volatility by dampening fluctuations in asset value, avoiding the need to liquidate riskier investments at depressed prices and providing dry powder for opportunistic investment.

But what counts as liquid, and how much liquidity is needed?

There will always be some portion of the portfolio that should be invested in liquid assets that can be monetized on short notice and with limited risk of loss. It is natural to start from the safest and most liquid assets—short-term fixed income—and expand the opportunity set from there. The broader liquid markets—including not just short-term but also securitized assets, high quality credit and even equities—can serve as sources of liquid capital over time.  This is a large and diverse universe, and several factors influence the use of specific asset classes as liquidity vehicles (Exhibit 1):

• Transactional efficiency: the degree to which the assets can be monetized with low transaction costs
  
  
• Price stability: the ability to maintain stable value over time, providing certainty around the size of the liquidity pool
  
  
• Defensiveness: resiliency in a risk-off market environment, when liquidity may be most valuable
  

EXHIBIT 1: LIQUIDITY CHARACTERISTICS OF BROAD MARKET ASSET CLASSES

Source: J.P. Morgan Asset Management; as of January 13, 2021.

A prudent investor will look to maintain a safe minimum level in stable, highly liquid assets (i.e., cash and Treasuries) to cover expected near-term cash flows, and a larger buffer across the spectrum of liquid assets to cover a broader set of obligations extending further out in time. 

But how large should that buffer be? 

To provide a real-world example, we chose U.S. corporate pensions with AUM in excess of USD 1 billion as a sample population. Importantly, the logic holds for any large institutional category such as public pensions, health care institutions or nonprofit foundations and endowments. The ability to quantify future obligations is the first step.  We can then observe the asset allocation, estimate the amount of available liquidity and map this against obligations.  It is necessary to make some broad assumptions regarding the amount of liquidity to assign to various categories of assets, and apply some conservative judgment about the level of coverage required.  In this example (Exhibit 2), we assume that coverage of five years of benefit payments is the necessary baseline level of liquidity, with a distinction made between the first two years and the next three to allow for some discretion over the type of liquid assets used.  The remainder is considered “excess” liquidity, which can still serve an important role in the overall allocation but also has the potential to be deployed more opportunistically.  Others may, of course, view these thresholds differently, but the logic remains the same.

Investors maintain portfolios with liquid allocation well in excess of near-term needs

EXHIBIT 2: LIQUIDITY VS. OBLIGATIONS IN CORPORATE PENSIONS

Source: J.P. Morgan Asset Management, publicly traded corporate plans’ 10-K filings; data as of December 31, 2020. Total liquidity contribution equals 84.35%

Although simplified, this example has a clear message. The pension plans in our sample hold two to three times the amount of liquidity relative to the expected benefit payments over the next five years. While there is no single objective answer to the question of how much excess liquidity is prudent, it seems reasonable to think that this is more than enough. Additional customized modeling of a specific institution’s situation would be able to approach a more empirically precise answer. But the fact remains: the presence of sizable “excess liquidity,” presents an opportunity. Are there ways to use it more advantageously?

This leads directly to the second theme…

Beyond rebalancing: Turning excess liquidity into a resource

Returning briefly to a concept outlined above, it may well be that investors who hold the vast majority of assets in liquid market categories are paying a premium (in the form of lower returns) for insurance that they don’t really need. When expected returns across liquid markets are high, this cost may be immaterial.  But today, long-term expected returns for liquid assets are at historically low levels (Exhibit 3). The cost of liquidity and the insurance it provides may be very dear indeed.

Liquid market portfolio expected returns have declined

EXHIBIT 3: STOCK-BOND FRONTIERS: 2021 VS. 2020 AND 2008 (USD)

Source: J.P. Morgan Asset Management Long-Term Capital Market Assumptions; estimates as of September 2020, September 2019 and 2007.

Consider: Most investors set asset allocation at the strategic level and adjust only infrequently. In general, this makes sense, as they may not be operationally equipped to respond to high frequency market information. To the extent that shorter-term fluctuations across markets influence their strategic allocations, it is only through a top-down mechanical rebalancing process that returns the allocation back to its strategic target. This is akin to passive investing at the strategic level.

While some bottom-up tactical value is derived from active managers incorporating real-time views in their specific portfolios, the benefits at the broader asset allocation level are quite limited. Managers exercise flexibility only within the narrowly constrained boundaries of the asset classes, benchmarks and guidelines in which they are tasked to operate. For instance, even “unconstrained” mandates usually invest only within a single broad asset class such as fixed income; other managers face far more restrictive constraints. Therefore, despite a relatively broad exposure to a diverse mix of liquid asset classes and the presence of active managers within the various sleeves of the portfolio, investors are not really taking full advantage of liquidity to express tactical views across the strategic opportunity set.

A useful solution to this challenge lies in outsourcing portfolio liquidity to a manager with the flexibility to move across market sectors dynamically while preserving a direct linkage to the strategic benchmark. This model of investing, which frequently goes by the name of “multi-asset investing,” or “strategic partnership,” can offer a meaningful source of incremental return across a large portion of plan assets while preserving the intent of the overall strategic allocation (as a benchmark) and the liquidity of the underlying assets.

Below, we present a real-world example of this model in action—in this instance, for an institutional investor with a strategic 70/30 blend of return-seeking and fixed income hedging assets. The first chart (Exhibit 4A) illustrates the potential for dynamic allocation across the broad mix of return-seeking and hedging categories (relative to the static 70/30 benchmark). The second chart (Exhibit 4B) shows the remarkable flexibility that can be incorporated at the underlying asset class level via tactical allocation across the range of eligible investments.

An example of the dynamic nature of a portfolio’s allocations over time

EXHIBIT 4A: HEDGE ASSETS AND RETURN SEEKING ASSETS OVER TIME

EXHIBIT 4B: ALLOCATIONS TO HEDGE ASSETS AND RETURN-SEEKING ASSETS OVER TIME

Source: J.P. Morgan Asset Management; data as of December 31, 2020.

For investors with strategic allocations to liquid markets in excess of their actual liquidity needs, the addition of a strategic multi-asset strategy outsources some of the portfolio’s potential flexibility to a manager capable of using it effectively rather than letting it sit idle.  (To be clear: In many cases, this model would make use of only a portion of the assets and therefore would fall short of a fully delegated outsourced CIO [OCIO] style mandate.)  Returning to the insurance analogy, the plan is keeping the protection provided by liquid assets but is reducing the premium by way of higher returns.

Unneeded liquidity: Expand allocations across the full spectrum of less liquid opportunities

Once the need for the baseline level of portfolio liquidity has been satisfied, and some excess liquidity has been put to work more effectively, the third piece of the liquidity management framework comes into view: how to size and allocate a portfolio of illiquid investment strategies to improve return and diversification of the asset allocation. In today’s market, less liquid asset classes—such as private credit, private equity and private core real assets—offer meaningfully higher levels of return than their liquid market counterparts (Exhibit 5).

Less liquid private market asset classes typically have higher expected returns
and volatilities than their liquid market counterparts

EXHIBIT 5: EXPECTED RETURNS AND VOLATILITIES FOR PUBLIC AND PRIVATE MARKET ASSETS

Source: J.P. Morgan Asset Management Long-Term Capital Market Assumptions; estimates as of September 30, 2020. The expected returns and volatilities are for illustrative purposes only and are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns and volatilities shown above.

Balanced against these higher returns are other considerations such as:

• Income generation: Asset classes that provide direct income streams to investors serve to mitigate their own illiquidity and provide greater flexibility for asset allocators looking to bridge the gap between liquid and illiquid assets.
  
  
• Structural illiquidity: Illiquidity is impacted by the specific terms of the investment vehicle that allow it to invest effectively in less liquid underlying assets, such as open or closed structures, shorter or longer investment and lock-up periods, and potential extensions on the final return of capital.
  
  
• Risk factor concentrations: Despite being labeled as distinct asset classes, some alternative categories offer concentrated exposure to market risk factors, thereby limiting their diversification potential within the broader portfolio.

While high total return is a key goal for alternative investments, it should be recognized that there are consequences to making it the sole priority. By concentrating in private market strategies with very low liquidity and limited risk diversification, an investor’s capacity to allocate prudently in this space is self-limiting.  Conversely, if we can expand the opportunity set to include strategies that provide greater clarity on access to capital over time, higher levels of current income and lower correlation to equity factors, then we can both improve the quality and diversity of the illiquid portfolio and increase its potential weight in the strategic asset allocation.

Using Exhibit 6 as a guide, consider the relative merits of various less liquid asset classes.  (Given the breadth of the alternative investment universe, the descriptions below are generalizations – though broadly reflective of the real world opportunity set.)

• Private equity vehicles offer the highest level of total return, but this benefit is offset to some degree by high illiquidity, low (or negative) current income and limited risk diversification.
  
  
• Direct lending offers high returns and improved diversification characteristics versus private equity, but liquidity and current income can be limited by the investment vehicle (often a private closed-end fund with a delayed distribution of returns).
  
  
• Core real assets (core real estate, infrastructure and transportation) provide high expected returns, better diversification characteristics, high current income and some access to liquidity.
  
  
• Hedge funds are (usually) among the most liquid alternative investments and provide beneficial diversification, but they tend to have lower expected returns and limited income.
  
  
• It is true that a diversified and seasoned portfolio of illiquid alternative assets can achieve a measure of regular liquidity (primarily from return of capital) that an individual strategy alone cannot, but investors may be constrained in their ability to draw on this if they intend to stay invested across time.

Alternatives vary in their liquidity, income and diversification characteristics

EXHIBIT 6: TRADE-OFFS IN ILLIQUID ASSET INVESTING

Source:  J.P. Morgan Asset Management Long-Term Capital Market Assumptions (LTCMAs); estimates as of September 2020. The LTCMA expected returns are in USD terms and represent median manager performance.  The returns are subject to significant limitations. An investor should not expect to achieve actual returns similar to the target returns shown above. Distributable income for real assets is the annual cash yield that investors can potentially take as annual distributions via open-end private funds that also have quarterly best-effort redemption provisions subject to certain initial lock-ups. Hedge funds, direct lending and private equity asset classes are assumed to not have distributable yield. Distributable income for financial assets is the dividend yield and yield to worst for equities and fixed income, respectively. The initial yields are calculated as follows: real assets – 2021 LTCMA distributable initial yield net of capital expenditure and/or debt amortization, as of September 2020; global equity – MSCI Global dividend yield as of December 2020; fixed income –Bloomberg Barclays US Aggregate and U.S. high yield current yield to worst as of December 2020. Equity betas are calculated relative to AC World equity using 2021 LTCMA inputs in USD terms.

Each of these alternative asset classes offers genuine benefits to investors, though it pays to be mindful of risks beyond total return and volatility.  Liquidity, income and diversification are attributes that investors should consider carefully—particularly when looking to increase the overall size of the illiquid portfolio.   

Conclusion

Liquidity and illiquidity are critical to successful portfolio construction, but get far less attention than other factors, like expected return, volatility and correlation.  Most investors exhibit a pronounced bias to liquid assets, implicitly valuing safety ahead of higher potential returns.  But this may be something of a false choice: With thoughtful allocation across liquid assets, the ability to outsource liquidity to a strategic partner and the availability of diversifying income-driven alternatives, investors can build portfolios that balance risk and return alongside liquidity and illiquidity more effectively. In today’s low return environment, the optimization of liquidity may hold the key to long-term success.