Relative Risk to Policy in a Liquidity-Challenged Environment
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With an overlay program, there may be more blood in that turnip than you think
In good times, we all focus on expected return maximization, with most of us judged specifically in reference to a strategic policy portfolio meant to achieve those returns over time. In bad times, it’s easy to lose our way and to suddenly focus on the losses of yesterday and view the portfolio in absolute terms—with much regret—once the market is already down.
During a bear market correction, big market moves and big reactions to them impact long-term performance relative to policy in an outsized way. In the presence of a fear-or-greed response, actions tend to land on the detrimental side of the fence. We have decades of research highlighting that the week after a big sell-off is a horrible time to decide that you were really a 20/80 investor, not a 60/40 investor¹. That’s why we often say, “Rebalance to policy. That’s what it was there for.”
Rebalancing is a case where inaction creates risk to policy in volatile times. One of the most critical rebalancing points of the past decade is ahead of us. Liquidity concerns are nearing levels last seen during the Global Financial Crisis (GFC) of 2008-09, so rebalancing is not at the top of most discussion agendas. We are less than a week away from the month-end close, and as of Wednesday, March 26th, the Barclays Long Government Index has outperformed S&P 500 by 15.9% month-to-date.² With such a divergence, rebalancing is not just an opportunity. Instead, not rebalancing is a considerable risk.²
A policy benchmark is a paper portfolio with the advantage of a free rebalance each month. If you wait for an equity market rebound to restore policy weights in your portfolio, you end up underperforming policy— even if equities eventually rebound fully from this current crisis.
Let's start with a review of how a policy portfolio return is calculated:
Policy return = ∑ (Beginning of month policy weight of asset class) X (monthly return for asset class)
Most importantly, this is a monthly calculation. If the portfolio is at policy weight in equity at the beginning of the month, there is no created risk to policy by letting equity drift lower during the month (due to relative underperformance to fixed income). But the current market correction has almost certainly created an equity underweight to policy for most investors heading into April, with some investors approaching policy minimums for equity. To make matters worse, market volatility is four times higher than it was before the storm, so potential return differences in the coming month are notably higher. Being at the lower end of your policy band for equities could create a full year's worth of plan-level performance damage relative to policy, based on not doing this one thing.
The math is simple: 5% underweight to equities with 10% outperformance by equities over the month of April would result in the loss of 50 basis points at the total-return plan level.
For many, this exceeds the budgeted return expectation from active security selection for the next year. You and your colleagues are likely measured in reference to the policy portfolio. Years from now, there will be little memory that rebalancing discipline caused an uncomfortable addition to equity in a stressful time. But the relative hit to performance lives on in plain view for years to come.
Some segments of the fixed income markets are not functioning properly. Does that impact the ability to rebalance?
The public health crisis around COVID-19 has led to aggressive risk-off trades rippling through the global financial system and, in turn, has created a U.S. dollar funding shortfall around the world. U.S. Treasuries have been the major beneficiary here in terms of increasing demand and price appreciation. However, there has been great divergence across the broad fixed income portfolios. Treasuries have rallied, but other sectors have been in a state of impaired liquidity, generally more severe in issues with decreasing credit quality. With credit spreads widening notably, most fixed income assets that are not U.S.-government-issued, have declined in value, but their lack of liquidity is an even bigger challenge. A notable redemption from a fixed income account can skew the remaining portfolio into less liquid issues, or force liquidation of some securities at much higher trading costs than in calm markets. Investors that have dedicated Treasury mandates (for LDI or tail-risk-hedging purposes) should consider raising funds from these mandates, rather than from broader mandates with more credit exposure. That said, not all investors started this crisis with material allocations to Treasuries, so a full rebalance back to policy might be more challenging for some.
Investors with a derivative overlay capability have additional flexibility. Raising liquidity from Treasury allocations is still recommended first. If there is enough liquidity, it can be redeployed into physical equity mandates. However, current liquidity challenges may preclude a full physical rebalance. We believe institutional investors should hold onto this extra liquidity and consider overlaying the cash with equity futures. If further rebalancing is needed, consider shorting Treasury futures relative to additional long equity futures within the overlay program. Yes, adding to long equity futures could increase cash needs—for variation margin calls—if the equities decline further in April. That said, with a 10% collateral commitment for initial margin on equity futures, such an investor would be in a better liquidity position—vs. investing in physical equity—as long as equities don’t go down an additional 90%.
In short, investors may feel the stress of seeing more cash go out on volatile down-market days—compared to an equal drop in value of physical equity, which does not generate a variation margin need—but ultimately, there is more cash available with the futures case. Once cash levels increase notably with an equity rebound, cash balances can be invested in physical equities, as futures positions are simultaneously reduced.
For institutional investors feeling strains on liquidity, create and conserve precious liquidity where possible. Gradually move toward a state where investment concerns can move back to the forefront. The liquidity situation may not be as bad as it seems. With an overlay in place, liquidity concerns can be better managed without taking on undue risk to policy.
Disclosures
¹ The intent of this note is not to oversimplify the difficulty of the investment management challenges by a major market correction. This piece focuses on role of a CIO and investment staff implementing the policy approved by the governing body of a defined benefit plan. There are certainly cases where governance might override the decision to get back to re-risk to policy, an example being a Corporate plan that has shifted to a surplus volatility management. Those concerns might outweigh the strict adherence to previously set policy prior to the correction, and thus may not be a fear-driven or liquidity-driven reaction.
² Barclays Long Government Credit Index has outperformed the S&P 500 by nearly 6% month-to-date over same period. Similarly, Barclays Aggregate index outperformed S&P 500 by over 9%. These may be a more relevant index for some institutional clients, but the performance deviation between Treasury and equity markets is a more pronounced opportunity.
³ Added bonus to being long equity futures currently is that S&P 500 futures are pricing cheap, or at a financing rate less than 3-month LIBOR. This cheapness can be captured even more efficiently in a total return swap on the S&P 500 index. This avoids current elevated initial margin requirement of 10% in futures.
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