MONEY managers and institutional asset owners are looking to allocate more to liquid investments as they believe the current liquidity drought is here to stay, according to a study by the Alternative Investment Management Association (AIMA) and State Street.
In their Let’s Talk Liquidity: Opportunities in a New Market Environment report, they say numerous institutional asset owners and managers have plans to increase their allocation to more liquid investments in the next 12 months.
Slightly more than half of them (53%) say they will adopt more
liquid investment strategies, such as exchange-traded funds (ETFs), so that they can maintain the desired exposure. Meanwhile, 44% say they will increase the size of their cash allocation against future liabilities or redemptions.
"The popularity of bond ETFs has grown as investors seek opportunities for yield and are attracted by the liquidity benefits that ETFs provide. However, some industry observers have expressed concern about the growth of the category as they fear a disorderly market environment if investors decide to reduce their exposure en masse. They ask whether structures that offer intra-day liquidity on inherently illiquid security types are creating a mismatch for investors, or an illusion of liquidity," says the report, as ETFs have structural characteristics that aid liquidity.
More than half (51%) the institutional asset owners and managers believe that there will be more liquidity bifurcation - where liquidity concentrates in more liquid securities at the expense of less liquid ones - over the next three years.
"More than a quarter of the respondents (26%) believe that market liquidity will decline for the security types in which they currently invest. Many institutional asset owners and managers are adapting their investment strategies accordingly," says the report.
"Notably, more than a third of institutional asset owners expect to increase their allocation to high-yield bonds, as their portfolios continue to be tested by the challenges of a prolonged low interest rate environment. But the appetite for high yield is notably lower among asset managers and hedge funds."
The report adds that some institutions are adopting a more defensive liquidity position as a means of protecting themselves in the next cycle of market stress. "They are asking deeper questions about how liquidity risks are modelled and compensated."
Almost half of the asset owners, investment managers and hedge fund managers predict the new environment will be "a secular shift that is here to stay" while 30% of the 300 respondents polled globally - made up of 150 asset owners, 100 money managers and 50 hedge funds - say the liquidity of their portfolio has decreased over the past three years.
"This shift has serious ramifications for investors globally. They are seeking to develop the right strategies and tools to help them succeed in this complex new environment," says the Nov 16 report.
Among the strategies taken is to improve the way they measure and report on liquidity risk and reassessing how they manage risk in their investment portfolios.
"More broadly, a new liquidity environment is emerging in which trading roles have been transformed, new market entrants are emerging and electronic platforms and peer-to-peer lending are changing the way firms transact business," says the report.
While some institutional asset owners and managers plan to increase emphasis on liquid assets, others will opportunistically allocate more to fast-growing illiquid asset classes. These liquid and illiquid options are important for institutional asset owners such as pension funds as they ensure better management of deficits and yield higher returns.
Globally, alternative investment assets under management had grown to US$7.4 trillion by the end of last year - an increase of US$500 billion from the previous year. "Global institutional investors continue to be a significant driver of this increased demand, despite widespread redemptions in the first half of 2016. They are looking for portfolio diversification, higher returns, reduced volatility, inflation hedging and income-generating investments.
"Pension funds, in particular, have long-term investment horizons and some may be well positioned to take advantage of the illiquidity premium of alternative investments. Their percentage allocations will depend on their liability profile, risk appetite and cash demand."
AIMA notes that more investors in hedge funds are receptive to locking up their capital for a longer period in exchange for a reduced fee. "In this arrangement, the client reduces the fee drag on performance, while the committed capital gives greater freedom to the hedge fund manager, who does not need to hold as much cash to meet potential redemption requests.
"Furthermore, tying up capital can allow investors to benefit from illiquidity premiums as they surface across markets. This is particularly pertinent for strategies involving activism, distressed assets or credit investing."
It is not uncommon to lock up capital for five years or more, adds the report. This is similar to the terms offered under a private equity arrangement.
"As ever, there is no one-size-fits-all strategy. Each institution needs to find its own way to balance risk and return in a fast-changing investing environment. Only by excelling in the analysis and management of liquidity risk can investors and managers make carefully informed decisions about their portfolio investments," it says.
The report says 43% of hedge funds say they would replace banks and other traditional market makers as liquidity providers, as opposed to 35% of asset owners and 16% of money managers. In addition, 49% of all respondents say there will be growth in the use of non-bank institutions to provide liquidity, while 42% believe the use of hedge funds as liquidity providers will grow.
New solutions and platforms such as peer-to-peer lending are gaining recognition as alternative sources of liquidity and driving major changes in the banking and wealth industry. "Increased peer-to-peer investment platforms are likely to bring together new players, from both the banking and non-banking spheres. Whatever their appetite for counterparty risk, market participants will find an increasing number of avenues that support new ways of transacting and providing greater market efficiencies.
"New solutions are emerging to help provide new sources of liquidity and new players are stepping forward to perform market-making roles. Institutional asset owners and managers will need to understand where they want to compete and what role they want to play in this rapidly evolving environment."