Changing market liquidity conditions present major challenges for long-term investors. The situation has been complicated by the quantitative easing (QE) policies at central banks and a prolonged period of relatively low interest rates. This is encouraging investors to look toward assets that have a higher risk profile or are less liquid to generate returns.
In a new State Street survey of 300 institutional asset owners, asset managers and hedge funds , nearly half (48 percent) said that decreased market liquidity is a secular shift that is here to stay. More than half (51%) of asset owners and managers predicted more liquidity bifurcation in the next three years, where liquidity concentrates in more liquid securities at the expense of less liquid ones.
Consequently, companies are adapting their investment strategies to manage this liquidity conundrum. Our research found that one-third of institutional asset owners are increasing their exposure to high-yield bonds to help drive returns in the current low interest rate environment. Nearly a quarter of asset owners are putting capital to work in illiquid securities including bank debt and credit. Interestingly, the appetite for high-yield is markedly lower among asset managers and hedge funds.
Liquid versus illiquid exposure
Dealing with challenging liquidity conditions is a priority for market participants. Market shocks and volatility are occurring with increasing regularity, and it is imperative firms position themselves to manage these risks. One option is to increase allocations into liquid investment strategies. Approximately 53% of survey respondents are incorporating more liquid investment strategies, such as exchange traded funds (ETFs), while 44% are ramping up the size of their cash allocations to guard against future liabilities or redemptions.
The popularity of bond ETFs has grown as investors seek opportunities for yield and are attracted by the liquidity benefits that ETFs provide.
While it is important that the liquidity characteristics of the underlying assets are always considered by investors before investing in any fund, ETFs have important structural characteristics that can aid liquidity.
This includes the process for their creation and redemption, and the existence of several dozen market-makers, Authorized Participants (AP), arbitrageurs and other investors who collectively help maintain an orderly secondary market in ETF shares. In addition, providers who offer rigorous, rules-based methodologies, and who are able to respond to market events quickly and transparently, can help to promote liquidity and stability in the market.
Liquid alternatives are also an option
Liquid alternatives have also seen marked growth as institutions look to diversify their portfolios, boost returns and enjoy liquidity benefits. They typically share some of the characteristics and upside potential of hedge fund strategies, packaged within more liquid and regulated vehicles including 40 Act funds in the US and Undertakings for Collective Investment and Transferable Securities (UCITS) in Europe. Figures from Eurekahedge indicate that assets under management (AuM) for UCITS hedge funds stood at $286.4bn at April 2016 — a rise of 40% over the past five years.
Meeting the liquidity challenge
Liquidity constraints are presenting firms with challenges, and there is clearly a bifurcation of liquidity occurring in the market. That said, some investors are exploring liquid asset classes such as bond ETFs and liquid alternatives as a way to help diversify portfolios and drive portfolio returns. However, they need to be cognizant of the underlying assets and the liquidity profile of these investments — wherever they choose to invest.
Riccardo Lamanna is Italy country head at State Street Global Services