Study Session 16: Cases in Portfolio Management and Risk Management

Reading 37: Case Study in Portfolio Management: Institutional

Background: Liquidity Management
Institutional investors have several important “tools” to manage a portfolio’s liquidity risk:
• Liquidity profiling and time-to-cash tables
• Rebalancing and commitment strategies
• Stress testing analyses
• Derivatives
Liquidity Profiling and Time-to-Cash:
• Start by identifying potential cash inflows and cash outflows for a defined investment horizon
• Once the sources and uses of cash have been identified, establish the need for liquidity and the desired liquidity maturity profile
for the overall portfolio:
▪ Create a liquidity classification schedule (time-to-cash table): defines portfolio categories based on the estimated time it
would take to convert assets in that particular category into cash
▪ Define an overall liquidity budget: assign portfolio weights considered acceptable to each liquidity classification in the
time-to-cash table + establish a liquidity benchmark for the portfolio construction process
▪ Different investments within the same asset class may have
very different liquidity profiles
▪ There could be differences in the liquidity profile of similar
investment vehicles in the same asset class depending on the
underlying strategy used by the investment manager
▪ It is appropriate to conduct liquidity analysis on a bottom-up basis for each investment, aggregate at the portfolio level, and
monitor changes over time to keep the portfolio within liquidity budget parameters
Rebalancing, Commitments:
• Illiquid assets carry extremely high rebalancing costs
• Asset liquidity tends to decrease in times of market stress → important to have sufficient liquid assets and rebalancing
mechanisms in place
• Systematic rebalancing policies:
▪ E.g. calendar rebalancing and percent-range rebalancing
▪ Control risk relative to the strategic asset allocation
▪ Use pre-specified tolerance bands for asset class weights
▪ Size or width of the bands should consider underlying volatility of each investment category to minimize transaction costs:
more-volatile investment categories should usually have wider rebalancing bands
▪ Transaction costs, correlations between asset classes, and investor risk tolerance are other factors that may influence the
size of the band
• Automatic adjustment mechanisms:
▪ Maintain a stable risk profile when exposure drifts from targeted exposure e.g. constant equity beta
▪ E.g. when allocation to private equity increases by 1% versus the target, the allocation to public equities would
automatically be adjusted down by 1%to maintain a stable systematic market risk profile
• Private market funds: investors do not control the pace of committed capital and capital distributions → difficult to maintain a
desired exposure
• Commitment-pacing strategy:
▪ Has annual level of commitments: result of cash flow modeling exercise that takes into account expectations about the
speed at which committed capital is drawn, the pace of distributions, the evolution in overall asset size, and other
circumstances specific to the investor
▪ Forward the expected asset class exposure at various commitment levels → reduce risk of overshooting target allocation
▪ Scenario analysis should also be used to consider the impact of different market stress conditions
▪ Evolution of the asset allocation must be monitored over time
Stress Testing:
• Stress testing exercises would seek to “stress” both assets and liabilities simultaneously to understand how these may be
impacted during stress conditions
• The stress test can cover distributional assumptions regarding prices (e.g., volatility, return), correlations across assets, as well
as liquidity characteristics
Derivatives:
• Can be used to manage cash outflow needs and changing risk exposures
• Can also be used to modify a portfolio’s liquidity profile through the use of leverage e.g. use future contracts to gain economic
exposure to US equities and then deploy cash that is not required for posting margin into other investments with different
liquidity profiles or to satisfy short-term liquidity needs
• Can also be used to generate additional cash by employing leverage at the overall portfolio level
Earning an Illiquidity Premium:
• Extract illiquidity premium from illiquid investments e.g. private equity or private real estate
• Illiquidity premium size is positively correlated to the length of the illiquidity horizon
• Alternative approach:
▪ Illiquidity risk premium = value of a put option with an exercise price equal to the marketable price of the illiquid asset at
the time of purchase
▪ Price of illiquid asset = marketable price – put price
• There may be a positive relationship between lack of liquidity and expected returns in the case of public equity
• It is difficult to isolate the illiquidity premium with precision and separate its effects from such other risk factors as the market,
value, and size in the case of equity investments