Collective Defined Contribution (CDC) Schemes: Assessing Capacity for Alternative Investments
There is growing interest in collective defined contribution schemes as pension systems adapt to changing economics and demographics.
The Tradeoff of Liquidity and Performance of Using an External Liquidity Facility
Cash is needed to provide portfolio liquidity, but it often carries a high opportunity cost. While CIOs may contemplate reallocating a portion of portfolio cash into investment assets to help improve expected portfolio returns, they know that having cash on hand is beneficial to cover unexpected liquidity needs and avoid having to sell assets, especially during poor market environments. But is there a better way to balance the costs and benefits of cash?
Perhaps the CIO can raise cash, when needed, through an external liquidity source? For example, the CIO can have a lending arrangement (i.e., a “liquidity line” – LL) with a financial institution that allows the CIO to draw on a collateralized line of credit as portfolio cash needs arise, paying interest on the amount advanced and for the time the loan is outstanding. Such a liquidity facility may give the CIO more flexibility in both asset allocation and liquidity management.
To help CIOs evaluate such a decision, we provide a framework to quantify the portfolio performance and liquidity consequences of using an external liquidity facility, specifically:
- How can reallocating a portion of cash into investment assets, particularly illiquid assets, help improve expected portfolio returns?
- How would such a reallocation of cash to illiquid assets change the portfolio’s liquidity attributes and ability to respond to sudden liquidity needs? and;
- To what extent can a liquidity line mitigate any portfolio liquidity consequences while maintaining the expected portfolio performance benefits of the cash re-allocation?
We quantify how an external liquidity source might improve expected portfolio performance and measure the possible liquidity consequences”
We illustrate our analysis from the perspective of a CIO for a hypothetical $3b foundation. We assume the foundation is required to spend a minimum of 5% of its assets each year and that there are no anticipated external capital contributions.
The graph on the right illustrates the portfolio’s performance-liquidity tradeoff for various cash levels, with and without a liquidity line. Without a LL, the portfolio has an expected return of 1.59%/y (net of spending) and 0% liquidity risk as measured by the probability of violating the CIO’s preset liquidity target.
The CIO then considers reallocating some cash to illiquid assets, with higher expected returns, along with a LL capped at $40m (or 1.3% of the portfolio’s value). As shown in the chart, as the reallocation of cash increases, portfolio expected returns increase while liquidity risk barely
budges. For example, with cash at 1.5% and a $40m LL, portfolio expected return increases to 1.65%/y.
However, once cash falls below 1.5%, liquidity risk increases rapidly. Even with a LL, a 1% cash holding produces high liquidity risk.
Tradeoff of Liquidity and Performance
While the expected return improvement in this example may seem small, the expected benefit can be scaled by increasing the size of the liquidity line.
There are other benefits of a liquidity line. Some CIOs hold liquid passive stocks and bonds for liquidity purposes because they are less disruptive to sell – and easy to repurchase. With a liquidity line, CIOs may be more willing to invest for alpha to improve returns. In addition, being a forced seller of assets to raise cash during stressed markets can impose a large cost (e.g., wide bid-ask spreads) on the portfolio, which is a permanent capital loss. An external liquidity source can help CIOs avoid such situations. Other potential benefits of a liquidity line may be harder to quantify, but are no less real. For example, a liquidity line may help CIOs avoid having to sell assets and disrupt external manager relationships which took time to cultivate and would take time to re-engage.
While an external liquidity source can be an effective portfolio management tool, CIOs must pay careful attention to its terms and conditions (e.g., are there any additional costs? Are there any contingencies on changes in the portfolio’s assets or the financial health of the lender?) CIOs also need to manage repayment so as not to create additional portfolio liquidity drains. In addition to a short-term liquidity line, CIOs could consider alternative liquidity sources such as repurchase agreements (repo facility) or a futures program (buying futures and selling assets) to raise short-term cash.
A CIO can use this analysis to determine whether an external liquidity facility, and its size, could help improve average portfolio return while keeping liquidity risk under control.
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