Lately, we have been advising our clients about issues that fall into two distinct categories:
- What can I do today with what I already own?
- What can I start doing now to give me a better set of tools in the future?
To the first category, liquidity has been constrained and transaction costs prohibitively high in certain markets, fixed income in particular. Most investors will be well advised to avoid selling in these market conditions.
To the latter category, one strategy we have recommended and that has seen a positive recent experience are futures-based portfolio overlay (or cash equitization) structures (defined in this blog post).
During the recent market sell-off, institutional investors noticed a particularly disturbing trend pertaining to liquidity and rebalancing. First, the typically liquid parts of the market were under extreme duress, resulting in higher transaction costs and spreads. Secondly, with the extreme up/down market moves—sometimes one day right after another—the ability to effectively rebalance was reduced due to a simple inability to get accurate asset values and then transmit trading instructions to the necessary parties before the asset values had altered direction.
A portfolio overlay would have allowed an asset owner to (a) generate cash from anywhere in the portfolio where liquidity could be obtained, and (b) actually rebalance/maintain strategic target weights on a more accurate basis without having to transact physical securities. The reduction in cost and the ability to maintain the target risk allocation in the portfolio would have also been simpler logistically as the overlay manager can complete this work automatically, and it requires no additional letters of direction.
The futures market was relatively well-behaved over recent periods, and typically overlay managers can take a direct feed from an investor’s custodian and use that data to rebalance the next day. Importantly, even if an investor chooses to raise several months’ worth of cash needs at one time, the overall risk or beta allocations in the portfolio can still be maintained at target with the overlay. There would be little cost to holding additional cash or to having raised it from an area of the market that was not overweight, but was more liquid.
For example, without an overlay structure in place most institutional investors during the recent market turmoil were forced by rebalancing ranges to sell the “overweight” asset (likely bonds) both to keep the total portfolio in compliance with target allocations and fund necessary cash needs. Trading of U.S. Treasuries and corporate bonds was problematic for a couple of weeks before the Federal Reserve reinitiated programs used in the 2008 Global Financial Crisis to quell investor fears and increase market liquidity. Raising cash by selling those securities might have resulted in poor and lengthy time to executions and/or an unbalanced bond portfolio after trades settled.
With an overlay structure in place, institutional investors could have raised cash balances from various asset classes (public equities of all types and bonds) regardless of the portfolio weight. The overlay would have simply replicated beta exposures on idle cash awaiting withdrawal for benefit payments, expenses, and other portfolio cash needs. An overlay could also have adjusted beta exposure by using both long and short futures exposures to alter total portfolio exposures to be closer to strategic targets. This beta-matching technique maintains the portfolio to its target allocation while giving access to much-needed cash.
The futures employed in successful overlay programs are efficient and exchange-traded, with daily notional traded volume exceeding that of their respective cash markets. These structures provide the investor with increased flexibility on where to gain liquidity in the portfolio and have been able to do so without taking an unintended risk position relative to the strategic asset allocation.
A portfolio overlay strategy may not be the right solution for every institutional investor, or it may not have been the best option for an investor based on prior circumstances. But for investors that think such a structure would be beneficial, portfolio overlay strategies can be put in place relatively easily and in a timeframe that is digestible even to the busiest of asset owners. Typically, the time horizon to get everything in order, from implementation decision to actual implementation, is about 6-8 weeks.
As with many things, a large part of success tomorrow is through preparation today!