After many global share indices broke new records after one of the longest bull markets in history, the first quarter of 2020 sees capital markets in turmoil as the COVID-19 crisis unfolds. Setting precise expectations for the likelihood and severity of market crashes is impossible due to all of the moving pieces, an ever-connected global economy, and unpredictable human behaviour. The 2008 financial crisis was described as an unforeseen tail event or ‘black swan’. As the chart below illustrates, we may need to recalibrate or abandon, prior expectations.
Figure 1: Recent Market Crashes
While the speed of this latest market correction may be unprecedented, our experience in the capital markets until now suggests there are three fundamental investment themes;
These principles are crucial in all market cycles but are paramount during times of crisis. They are independent of asset allocation decisions and capital market views. We describe the importance of each theme in the following sections.
Broadly defined as the ability to turn an asset into cash to fund liabilities (such as member pension payments), liquidity has many practical meanings and has been brought to the forefront during the COVID-19 pandemic. While funds may have reliable estimates of cash flows during normal times i.e. forecast superannuation guarantee (SG) contributions net of pension payments and member switches, the need for liquidity has skyrocketed for the following reasons:
- Members are reacting to the market crash by switching to cash1.
- The Australian Government has approved early access to superannuation of up to $20,000 per person affected by the COVID-19 pandemic2.
- As equities have fallen, many funds are forced to rebalance and buy more equities due to their strategic asset allocations (SAA). The cash to purchase these assets must come from liquidating other assets in the absence of cash or new SG contributions.
- Many funds have hedged foreign exchange exposures and must raise cash to settle FX forwards on the US dollar, which has rallied over 13% relative to the Australian over the first quarter of 2020.
The investment thesis for holding illiquid assets, i.e. that these assets should deliver excess returns as compensation for illiquidity, is currently being challenged. Only asset owners who can ride out the storm and hold these illiquid assets for the long term, will benefit from the illiquidity premia. Funds should, therefore, balance this with their need for liquid cash, particularly during times of market crisis.
Without sure footing, or knowing where your assets stand, it’s challenging to navigate the way forward or make sound decisions.
As asset values fall, transparency is more important than ever. The nature of all assets held by a given fund may be opaque in the typical ‘fund-of-funds’ structure where a superannuation fund delegates investment management to a dozen or more asset managers.
Funds should have a total portfolio view of:
- Individual assets held including holdings common across managers
- Exposures to risk factors, including where managers may hold offsetting positions.
- Exposures excluding any netting e.g. where offsetting risks are held with separate counterparties
- Manager-level redemption periods (stated and stressed).
This ideal view of assets is often obscured due to:
- Differences in reporting formats
- Timing differences
- The proprietary nature of manager investment decisions.
Transparency is crucial for funds to make sounds decisions, identify which assets to liquidate, or hedge exposure as needed.
As described in the Liquidity section, the humble SAA can create issues in times of crisis. The bounds of an SAA are important from a governance point of view and ensuring that funds maintain a long term investment strategy. However, fund trustees should consider whether the forced sale of assets solely to maintain SAA is in the best interest of members.
Flexibility helps navigate these scenarios, for example:
- Revising investment policies and product disclosures to consider extenuating circumstances
- Implementing funds level derivative overlays, to temporarily rebalance asset exposures as efficiently as possible
- Allowing for dynamic asset allocation strategies or other convex strategies which can deliver protection in times of crisis, which may not neatly fit into existing SAA frameworks.
These three investment themes will help asset owners navigate all market cycles and are all related and dependent. For example, full transparency of all asset exposures facilitates the implementation of a derivative overlay to maintain target asset allocations and preserve liquidity, providing funds have the flexibility to implement the strategy.
All funds should consider their capabilities in these three aspects of investing. Milliman is here to help clients through challenging market environments for the benefit of their members.
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