Looking at asset allocation through the lens of liquidity

Liquidity buckets are shaping up to be a key investment management trend in 2010. But to fully appreciate them, a historical context may prove helpful.

The market meltdown of 2008 and early 2009 was a difficult period for all investors. No one was immune. Everyone suffered, even the Yale University endowment, whose strategic allocation had been highly praised before then. Pension funds, in particular, suffered large setbacks.

The Center for Retirement Research at Boston College estimates that a total return of around 52% cumulative over the next three years will be needed for the average pension fund to return to its pre-meltdown fund status. Even with a good return in the Standard & Poor's 500 in 2009 of 26.47%, including dividends reinvested, we still have a ways to go.

To bail ourselves out of this hole, it will take time. The key is to stay the course. We need to recognize that the meltdown was not a normal occurrence. It was a panic driven by a credit and liquidity crisis.

However, looking back at 2008-2009 and looking forward to 2010, pension funds and other institutional investors have begun to consider “macro buckets” of risk exposure that take into account liquidity. These buckets are defined broadly as:

• A liquidity bucket consisting of U.S. Treasury bonds, U.S. agency bonds (not mortgage-backed securities), short-duration funds based on the London interbank offered rate, and investment-grade corporate bonds.

• A market-risk bucket consisting of developed and emerging markets equities, high-yield and other credit-sensitive bonds, mortgage-backed securities and asset-backed securities.

• An inflation hedging/natural resources bucket consisting of Treasury inflation-protected securities, commodities, energy-related equities, real estate investment trusts and infrastructure investments.

• An illiquid bucket consisting of private equity, venture capital, mezzanine financing, collateralized debt obligations, direct real estate, timber and hedge funds.

The four macro buckets are really a consolidation of the major asset classes used in most strategic asset allocation models by institutional investors. The difference is the emphasis on a liquidity bucket. In prior years this was not a concern, but liquidity contingencies will likely be built into the asset allocation models for pension funds and other institutional investors.

The meltdown was a bizarre period. What is fascinating is that there was a nice linear relationship between return and risk-taking in the meltdown: the higher the risk, the more negative the return. In fact, I plotted the returns to the Lipper mutual fund categories for 2008 vs. the volatility of their 12-month returns and discovered a nice straight line declining at a 45-degree angle. At the top of the line with small but positive returns were the government bond funds, followed by slightly negative returns earned by investment-grade corporate and municipal bond funds. Next, there were high-yield bond funds earning even more negative returns, followed by large-cap stock funds, then midcap and small-cap stock funds. Last, earning the largest negative returns were real estate and emerging market funds.

To deal with meltdown investing, first we need to recognize the market was in disequilibrium. The period, in fact, was the mirror image of the capital asset pricing model, developed by William F. Sharpe, 1990 Nobel laureate in economics. Instead of being rewarded for risk-taking, we were all penalized. Keep in mind that the brilliance of Bill Sharpe's pricing model is that he also established the first equilibrium model for how security prices should react given their level of embedded risk.

Let's accept that we are not out to disprove Bill's beautiful equilibrium model (and earn ourselves a Nobel Prize in economics). Instead, let's consider that eventually, the market will correct and return to some semblance of an equilibrium first established by Mr. Sharpe. The Yale endowment model is not dead. Nor is the model of the California Public Employees' Retirement System, or any of the other large institutional investor models in existence.

As noted at the outset, in a market meltdown, there is no immunity. Everyone feels and shares in the pain. Still, we have our work cut out for us.

But this gets back to the point: stay the course, with adjustments for liquidity. Many pension funds have undertaken a strategic asset allocation review. Often these reviews tend to be skewed by the most recent past; in this case, a market conflagration. Now would be the wrong time to chuck long-term strategic allocation out the window and burrow into the sand.

Sure it will take time, but we have seen the financial markets in 2009 snap back into what we would consider more normal market equilibrium where risk-taking is being rewarded again. Furthermore, pension funds, endowments and other institutional investors are long-term investors — this time frame should play right into their hands.

Mark Anson is president and executive director of investment services, Nuveen Investments Inc., Chicago. The views expressed in the commentary are his own and not necessarily those of the firm.