Op-Ed: Managing the Risks of Ill-liquid Assets

Photo credit: Princeton Headshots

Background

The depressing of rates of Central banks steered
the focus of pension funds and endowments to illiquid assets, given that they
chased higher yields (and these managers benefitted from low borrowing costs).
The fact that these assets were not marked-to-market frequently gave both the
appearance of a lack of correlation and the additional benefit of protecting
funded status during minor meltdowns. However, the lessons of 2008 have apparently
been neglected. For those who cannot recall, the much-vaunted Ivy League
endowments had plowed into illiquid assets after the Tech Bubble burst and were
badly liquidity-constrained when markets corrected in 2008, compelling many of
these institutions to borrow billions in public markets to offset the hit they
took on their private assets. The fallacy that the sticky downside marks
provided were exposed as these illiquid asset risks were left unmanaged, and a
serious market meltdown implied economic impairment of assets whether or not
the fallacy of high marks continued. With other public assets being marked
down, soaring illiquid allocations in portfolios required a rebalancing – ergo,
more selling of equity risk and a continued tailspin. The similarities in 2023
are eerie, given that  an illiquid asset
could easily become an ill-liquid asset if investors are not smart about
managing risks – as exemplified by the need for a simple technique that we
helped apply in the case of San Diego County Employees’ Retirement Association
and a corporate pension fund.

Relevance
Today

Given that the external managers ignore beta risk of
illiquid assets, which is the responsibility of the investment team, one could
question the governance of a fund that does nothing to manage these risks.

Consider the
current environment. The allocation to illiquid assets across institutional
investors is anywhere from 20 to 40% of the total fund. While rates have been
increasing, commercial real estate is definitely rolling over – the
defaults/fire sales by Blackstone, Brookfield, Sternlicht, and others suggest
the worst is yet to come.[1],[2],[3] In addition, credit availability is shrinking in the
aftermath of the Silicon Valley Bank debacle, and this is showing up in rising
credit rejection rates.[4] The typical response from CIOs when asked how they
manage the risks of illiquid assets is: “top-down diversification across
strategies and diversification in bottom-up asset selection.” Further, is the
considerable discourse on “steerability,” namely, a desire to be nimble with
illiquid assets, factual risk management? In a crisis event like 2008,
correlations of both liquid and illiquid high beta assets all go to 1, and
private credit, private equity, and venture capital are a daunting, concentrated
pile of risk.  The impairment of both
liquid and illiquid assets results in ‘di-worse-ification’ –  when 
illiquid become ‘ill-liquid’ (as evidenced by the Ivies and other
investors in 2008)..

The Solution

So, what is an innovative CIO to do? Ideally,
before even initiating these investments, they should have set up a process to
map these exposures to liquid futures contracts. The question is: Why choose liquid
futures and not the various factors embedded in proprietary risk measurement
software that many investors implement?

Clarity emerges when risk measurement is
differentiated from risk management:  risk measurement calculates the risks of the
portfolio to various factors but does not opine on whether they are good
exposures (factor likely to rise in value) or bad exposures (factor tending to
decline in value). Current software gives risk measurement parameters such as
value-at-risk or some other metric; risk management is about tilting portfolios
dynamically, keeping your portfolios long in respect of the factors/futures that
are likely to rise and selling/hedging these exposures when they are likely to
decline. Leaving the portfolio untouched is a tactical view too; namely, presuming
that the factor exposure implied by the decisions of the external managers (who
have no understanding or concept of beta risk management) is appropriate. Given
that the external managers ignore beta risk, which is the responsibility of the
investment team, one could question the governance of a fund that does nothing
to manage these risks. For example, one of the most popular software packages provided
to investors by asset managers carries the risk in terms of their proprietary
factors (that neither the vendor’s staff nor the investor can explain with any
degree of certainty), leaving investors captive to the factors that not even
their own staff understand. More importantly, such investors are committed to
trade through them, whereas the simple solution is to use liquid futures and thereby
avoid dependence on third parties, where the data is freely available.

It may be argued that this is market timing
and mind boggling. But all investing is market timing and tactical. To assume
that private assets will return 9% p.a. over 10 years is a tactical call and “doing
nothing” over the next 10 years in managing the beta is market timing.
Moreover, given that most assets lose money at least 45% to 47% of the days, to do
well, especially in bear markets, requires one to be right 55% to 58% of the days
– hardly a hurdle for well-compensated and trained CIOs to overcome. Moreover,
shorting the exposures during a declining market is also re-liquifying illiquid
asset beta – thereby giving a measure of credibility to the claim of
“steerability.”

To do nothing and hope for the best invokes
the famous quote of Wolfgang Pauli: “That is not
only not right; it is not even wrong.”