updated with correction
Among the myriad uses that institutional investors have found for exchange-traded funds, few intersect with the investor's ongoing operating model more than as an overlay for liquidity management.
Implementing such an overlay, or liquidity sleeve, often requires reconsideration of the institution's cash management program as well as the risk it is willing to take relative to short- and medium-term cash flow needs. It should come as little surprise, then, that only 32% of foundations, endowments and defined benefit plans surveyed recently by Pensions & Investments indicated they use ETFs for liquidity. Uses more uniformly aligned to investment decisions — rebalancing, tactical adjustments, long-term investing and transition management — were indicated by 39% to 41% of respondents.
Yet, according to a Greenwich Associates survey sponsored by BlackRock Inc., in the five years following the financial crisis, liquidity management has been the fastest growing application for ETFs among institutional funds, rising to 55% in 2014 from 3% of those surveyed in 2010.
For years, liquidity overlays — primarily used as a way to enhance return on “cash” while keeping funds nimble in the face of a liquidity crisis or extraordinary cash flow need — were the realm of futures, swaps and options. Such securities and contracts permit greater notional exposure on a lower base than physical assets such as ETFs, yet the inherent leverage in derivatives also exposes investors to financing costs and counterparty risk. Still, for certain exposures, futures and swaps remain a core, price-competitive part of liquidity programs.
But as assets have surged into exchange-traded funds — nearly $3 trillion globally at the end of April, according to research firm ETFGI — expense ratios have compressed, liquidity has increased, and product proliferation has allowed pension funds, endowments and foundations to more finely tune a liquidity overlay to their policy portfolio benchmarks.
While many overlay strategies are designed specifically to correlate just to the more liquid debt and equity portions of an institutional portfolio, some are now extending the overlay to manufacture the returns and risk profile associated with less liquid asset classes such as private equity and market neutral strategies.
For example, the $1 billion IQ Hedge Multi-Strategy Tracker ETF uses a blend of 34 other ETFs and cash to approximate hedge fund returns. The ETF has a total annual fund expense ratio of 0.91%, including acquired fund fees.
Managing the exposures within the liquidity overlay largely depends on the preference of the fund and its trustees. Some view the overlay portfolio as a source of assets for benefit payments and disbursements — including commitments to private equity and more opportunistic direct investments or co-investments — funding this overlay semiannually or annually and drawing down from there; others view the overlay as a constant exposure using more liquid instruments, including ETFs.
“Many investment funds don't actually have a standing commitment to cash in their policy portfolio,” said Tom Lee, managing director of investment strategy and research for Parametric Portfolio Associates in Minneapolis. Moreover, some funds will commingle/conflate custody of liquidity management with other types of overlays — tactical tilts, cash equitization and transitions. Mr. Lee noted that separate accounts allow for better tracking of returns and expenses for particular types of overlays.
“The dynamics of the fund — more than size — really dictate the implementation,” said Mr. Lee. “Running separately provides cleaner reporting, but you could end up short an exposure in one asset class (from rebalancing), when you are long in the cash securitization portion.”
After the financial crisis, many funds re-evaluated their liquidity planning and increased cash levels.
“Getting some level of policy return on that cash can be very meaningful,” said Ravi Goutam, managing director at BlackRock in San Francisco. “Additionally, a liquid policy portfolio removes the operational burden of redeeming from active managers looking to provide alpha.”
Eaton Corp. chose ETFs for liquidity management in its defined benefit plan beginning in May 2012, and did not previously have a liquidity overlay with market exposure. “The pension committee focused on the negative returns for cash, including fees,” said Rosanne Potter, senior manager for pensions in Cleveland.
“In a stable environment, liquidity may not be an issue for most institutions,” said Darek Wojnar, managing director at investment strategy firm Lattice Strategies in San Francisco. “But changing expectations in the market, particularly around interest rates, could make some parts of the portfolio harder to manage for liquidity.”