In the first episode of the new season of Long Story Short, we dive into the importance of liquidity and the ways it can be measured and managed.
In the first episode of the new season of Long Story Short, we dive into the importance of liquidity and the ways it can be measured and managed.
In this first episode of Liquidity Matters, Michael Turner, CEO at Man Solutions, joins Robyn Grew, President at Man Group, to discuss why the selloffs of 2023 mean that liquidity is of more importance than ever. In their wide-reaching conversation, Robyn and Michael share how sophisticated investors should be thinking about liquidity in their portfolios, how it can be measured, and how to adapt to sudden liquidity shocks such as the UK’s LDI crisis.
Recording date: May 2023
Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.
We all know that liquidity matters in investing, but how is it measured, how is it managed, and how can you use it to deliver returns? I'm Robyn Grew, president here at Man Group. And in this season of Long Story Short, I'm going to dive into the importance of managing liquidity and strategies you can use to put those ideas into practice. I'll be talking to investment professionals, analysts, and strategists so that they can share their insights and examples of using liquidity and liquid alternatives to deliver better results for investors and savers.
Welcome to the first installment of Liquidity Matters, a brand new season of our investment podcast, Long Story Short. Joining me today is Michael Turner, CEO of Man Solutions, one of our top experts on portfolio management and risk. Mike, thanks for joining us today.
It's a pleasure, thank you.
Let's start with a simple one, and that's the appointment for the name of this series. Why does liquidity matter so much?
So I thought about, how do I answer that? And as I often like to do, reflect through my career, is that I started off in quantitative research, systematic trading where everything was liquid. Futures, equities, you name it. And I joined FRM, our fund of funds arm in 2007 where I got a bit of a shock about just the range of complexity of what can actually go in the fund of hedge funds portfolio. And then we had this delightful thing called 2008 where I quite literally spent the entire year, or actually probably 18 months, two years, working with the CIO modeling liquidity for fund of hedge funds portfolios.
So to me, it's almost like a personal thing, which is I'm just absolutely obsessed with making sure the balance of liquidity in portfolios is right. And over the past certainly year to two years, I think it's just become something of greater and greater importance to clients as they start to understand, how do we navigate this rather challenging set of environments?
Let's think about that in the course. You're talking about ... that liquidity has really come to the top of the agenda for clients. Why was there a gap? You talked about 2008 where everybody was obsessed and started to really think about that, had enormous focus. And then is it, it's back on the agenda, but it was off the agenda before that? Or did it just take a lesser position in importance? Why is it coming back on? Why wasn't it since 2008 top of everybody's agenda for the entire time?
I think post-global financial crisis, liquidity was top of everyone's agenda. I was running a managed futures portfolio at the time. I was quite literally flying all over the world talking about that. Then when things calmed down, we entered a world where low rates, relative stability for quite a period of time that actually one way to think about it, if you want to generate, if your credit portfolio were to generate yield, you need to move into less liquid assets. So it became a little bit of a thing, I think, where actually to generate returns, you can accept liquidity, you have safe funding levels, you have relatively stable macroeconomic conditions. So hey, it was fine to have illiquidity in your portfolio.
But I think if I reflect post-COVID, it's not just the world has become more uncertain. It's also, I think, the uncertainty with that uncertainty has dramatically increased. So every single day we hear, are rates going up? Are they staying the same? Are they going down? Is it inflationary? Is it deflationary environment we're entering? We have geopolitical risk, which I think is as high as I can remember for a very, very long period of time. And that just creates a tremendous amount of uncertainty in portfolios.
And then what do you do with that? Well, I've worked out three things that investors may want to think about. First of all, if there's a problem in another part of your portfolio, you may need to raise cash to fix it. You need liquidity. If there's losses in another part of your portfolio, well, you may want to risk manage it, reduce exposures, you need liquidity. But there's also the flip side as well is that as things evolve, opportunities will arise. You want to be able to move into those opportunities quickly so you need liquidity.
So there's all sort of things going on in the world at this point in time. But I think at the moment people are probably more focused on risks as opposed to opportunities. But that's an important facet to think about that. If you want to protect your portfolio or invest, you are going to need liquidity.
I'm going to take you up on two of the points you raised. The first one, people talk about liquidity waterfalls, the amount of liquidity in the market, all of that stuff. And these are often covered by the all-encompassing phrase of risk management. You talked about risk management. So how do you think about liquidity from a risk profile perspective?
And then I'm going to lead you into the second point we want to cover and I'll give you that so you can line it up, I guess, as you're thinking. Are there drawbacks to maintaining too much liquidity? And you covered a couple of them in that previous answer. First of all, let's talk about risk and the profile, the risk profile of liquidity itself. And then actually, how do you get the balance? Can you have a portfolio that's too liquid?
This is one of the topics which has again fascinated me since I really moved into the wider hedge fund industry is that from my background it was very, very easy, go liquid, go liquid. I understood that. But one of the things I've learned over the past 15 years is there is a benefit to having illiquidity in your portfolio.
So to me, it's about achieving that balance. And if we pick a couple of examples there, if you only have liquid investments in your portfolio and the liquidity you're offering your clients as weekly, then as soon as clients come along and say, give me some cash back, you are going to have to raise cash. And you will always get a price for something illiquid, it may not be a very good price though. That's one of the spectrum.
Similarly, if you have long period liquidity to pay back your investors and you're only trading in liquid instruments, so let's say focus on credit, you're only trading very liquid investment grade, very liquid high yield, the chances are you are, over the past few years, you are going to struggle to generate sufficient yield. So you may need to move into spaces where you can generate access yield in the private credit space or other areas of investment.
So that balance is really important and we see it, I mentioned credit, we see across hedge funds as well where there is a thing called illiquidity premium, where if you can put money aside and lock it up for a bit longer, you will generate additional return. So understanding that balance about how you go between liquid and liquid is really, really important. And as we'll hopefully talk about later on, that raw risk frameworks you can use to try and understand about what balance you should strike. So there is a risk return profile you need to consider. And getting that balance right, I think, is something that's very, very portfolio dependent.
And then to follow up, can you have too much liquidity? Well, yes. I've already mentioned that there are areas where if you want to generate either yield or generate additional returns, you want to go into investments which are less liquid. Whether that's the credit space, whether it's distressed hedge funds, whether it's more esoteric hedge funds in structured credit, fixed income, relative value. If you just focus on the liquids end of the spectrum, then you may struggle to generate the returns you really, really do need to do.
So investors should care about liquidity. That's what I'm hearing loud and clear. I think we understand if they have too little liquidity, risking opportunity set, risking the ability to be flexible across their portfolios, as you talked about earlier. Maybe it's useful to bring in some practical examples here just so that people can anchor it in a real life thing. And I think perhaps very recent in experience has been the LDI crisis, if I'm allowed to call it that, in the UK last year. Maybe worth explaining to people what that was about because it isn't always clear to everybody. And what that resulted in and whether that's actually changed any of the behaviors of allocators either in the UK or actually beyond the UK. What did you see globally post a UK crisis?
Let's think about the structure of the UK pension or the pension funds that were impacted in September. At a very, very simple level you can think there were essentially three components to their allocations. There was a bigger liquid block which generated returns, yield. There was a growth portion, which is generally more liquid equities, hedge funds. And then there's this block, LDI hedges, which is about protecting their assets from changing interest rates. The difference or the special thing about the LDI hedges was that they were levered investments. So if there's a small move in a market, then your losses could be substantially bigger than that small move.
Now, typically day by day, that's not a huge problem. If you make money on your hedge, there's some variation margin paid to your account. If you make a loss on that hedge, you'll need to pay a variation margin, but you may have excess cash or you may be able to release a small amount of liquid assets. Not a problem. The problem happens is when you get moves like we saw in September, where guild markets or the yield and guilds rallied hugely in a very, very short space of time. So when you have that levered investment and you get a large move, that can lead to quite substantial losses in a very, very short period of time. Now what do you need to do? You need to raise a lot of cash. And we saw through that period late September of a lot of pension funds making demands on us to raise cash from their portfolios, selling down in some cases virtually all the liquid investments. That's not a good place to be in.
Now, what does that mean for funds that I think they got away with it? They managed to raise enough cash, but if they needed to start to dip into that liquid portion, and as I alluded to, you will always get a price from a liquid investment, it just may not be what you want. That was the anatomy. That's why I said they got away with it. They could raise the liquidity. They probably needed a little bit more liquidity to be nice and safe, but the next step for them would have been to start to sell liquid investments. And that's hard and time-consuming and could be very, very damaging to the fund.
Have we seen any particular changes in investor behavior? We've certainly seen pension funds restructure their funds a little bit. A lot of the people now that managed to do that are coming back into those risk-seeking assets. We've seen a lot of funds come back into ... reallocate to us. But I think it was a bit of a shock to everyone that in a relatively safe space or what seems like a relatively safe space, the UK pension fund, liquidity really, really hurt. And that, I think, is another fact that has really brought this liquidity topic to the top of people's minds that it's not something you can ignore.
That's the dark side, if I'm allowed to put it like that. Star Wars styley, the dark side of illiquidity.
If you're sitting down with investors and when they ask you this question or if they don't ask you this question, how should investors think about trying to understand and manage the portfolio liquidity conundrum in front of them? Can you share some examples about what a sophisticated liquidity aware strategy might mean or look like in practice and how we're advising and guiding and working with our clients to affect that?
One of the most important things to really think about is if things are normal, you need to move cash around your portfolio a little bit, then there's generally enough liquidity to any portfolio. That's not what you really need to worry about. What investors, and whether they're investing in external funds or they're running their own portfolios, need to worry about is what I call destabilization risk. And that's the point where, to give you an example, you've sold all your liquid investments, you now need to start selling down illiquid investments. You will get a price for those illiquid investments. Funny enough, that price will not be the price you were marking at it last week. That causes losses. Investors see those losses, they start to redeem.
So you need to sell more of your portfolio, which by this point is the illiquid part of the portfolio at an even greater loss. And you start to get this spiral, I call the liquidity death spiral, where your own actions are just taking down your own portfolio. It's that point of where the fund becomes destabilized is where we've seen, historically, the very, very big blow ups. Particularly in the hedge fund space where all of a sudden you just can't meet investor liquidity.
When I think about liquidity, so I call it liquidity triangle, which has basically got three elements. There's your investor terms, how often do you need to give your investor money back? There's the financing terms. Have you got leverage involved or you're using banks for credit facilities, what are the terms around that? And the third element is then, what are you trading? So what type of instruments? How leveraged are they? Are you using leverage at all? How complicated is the overall strategy?
And those things interact in certain ways. For example, if you never need to give your investors anything back at all, then you can go with a really illiquid portfolio. Take the yield benefit. If there's a sell off, you don't need to do anything assuming they recover. That's a safe portfolio. If I contrast that to say a highly levered relative value portfolio where you've got leverage, complicated instruments, well, all sorts of financing going on, if there's a small move in the market, then you can get huge losses generating very, very quickly. You need to sell things down in quite a large amount of volume. You will then possibly see the banks go, well, actually I'm not very happy here. So can they pull your funding? How quickly can they pull your funding? How secure is that funding line to you? You will start to see investors go, I'm not sure I like this. Here's my redemption order. And then once one starts to go, the natural thing for everyone else to go is to try to jump to the front of the queue.
These things interact in rather complicated ways. But understanding those three facets is important. And it's important if I put my hat on looking at allocating to external funds. One of the things we always look at, or our risk team look at is, how do those fees interact? Can that fund get destabilized? When we're looking at internal multi-strats, it's the same thing. How much liquidity? What financing terms do we get? What are we offering investors and does the strategy fit in with those criteria?
That's the way I always look at it. There are then two other elements which shouldn't be underestimated. Having the systems to actually collect that data. It's no point having to run around and scratch it from a variety of different sources when you're under pressure. But then secondly, culture. So having a culture of awareness of risks so that when these things happen, the risk manager's not just ignored, they're actually listened to seriously.
That's the way I view it. And that liquidity triangle, I think, is pretty central to the way I look at the entire portfolio.
It sounds like there's a decent amount of quantitative information there, but there's also a qualitative judgment.
How do you think people can genuinely manage and measure portfolio liquidity accurately? How much is there that qualitative piece and that judgment piece, which will always mean you're within a parameter but you're not necessarily at a, and here is a number. So how accurate can these things genuinely be? How possible is it to make them more quantitative than qualitative? And how sophisticated are our clients in doing justice?
I think there are certain areas of investing where there's been a lot of work done on liquidity and trading costs. So we've been market impact models and equities since late '80s, something like that. It's a very, very well understood area, but you've got a lot of data. You can see daily volumes, you can see bid offer spreads, you can collect more and more data all and all the time. So there is places where it's highly suited to a very, very quantitative approach.
You can move into the credit space where more and more effort is being placed to try and understand what the real liquidity around trading credit is. I've not seen anyone do it hugely successfully yet, but there's efforts there. I'm sure as more data comes online and they become available, that's something I could see while [inaudible 00:19:24] becoming a space where you can get a little bit more accurate and more quantitative about it. And then there are really esoteric spaces where you can do as much modeling as you like, but whatever answer you get, I can just guarantee is going to be spurious at best.
I think in normal markets you can do quite a lot to a point, but you need to know the limits of your models and your modeling approach. That being said is that if I go back to my tenant of what I really care about a destabilization risk, that in stressed markets, I'm not sure how much of a worth you can place on a model. Every single type of market stress is going to be different. You need to think about what's going on.
I think that's a place where you need to step back, be a bit more reflective, try and be a little bit more critical about what you really think you can get out of a market at any given point in time. A lot of its experience, intuition, challenging. And I wouldn't try and over-quant that process. As I said, you could probably come up with a model for how any market behaves under stress, but the chances are it'd be over-prioritized, spurious, not accurate. And actually, if anything, possibly damaging. You will try and push the envelope too soon in those times of market stress. So I think it's a little bit of both. As all these things about liquidity, it's a balance. There is some elements where you can use quantitative methods. There are some parts where it's going to be, you need to rely upon experience.
Let me challenge you a little bit. In risk modeling, and I think since the GFC you've seen certainly the investment banks take a very serious approach to risk analytics and liquidity. We saw liquidity fall off a cliff post-GFC in products that we thought were liquid. Overnight we found illiquidity where there had never been any. I think the modeling around that is smarter than it's ever been in stressed scenarios.
It's an interesting piece that you think that still, despite that greater effort and greater ability to navigate and put stress scenarios through books, you still think that that doesn't protect you ultimately in a stressed environment from a liquidity perspective. Look, I'm going to push you on that point because it feels to me like we are better able to do that than we've ever been able to do. So what is it that you think means that the modeling parameters may not work, really?
I think there's two parts there. I think the ability to risk model has grown dramatically. If I look at a few years ago, maybe 10, 15, probably 15 odd years ago, the range of instruments that a standard risk engine could risk model of any degree of certainty was actually quite narrow. What we see now is those more complicated, more exotic instruments, you can definitely risk model them. And we're seeing more and more move into the real esoteric spaces of exotic credit where you can actually, you can stress things, you can get better answer about what's going on in the portfolio under market stress.
Now, understanding the size of losses in a move is fundamental to liquidity management. The thing I am more skeptical about is, now I've got to get out of that position, how much can I sell?
Understood. So depth of market is what-
Depth of market is hard, but the risk analytics thing is dramatically improved over the past 15, 20 years. It's just that if anyone wants to give me, we can sell this much structured credit position to give a market with certainty, no, don't bother at all.
So the more esoteric the product, the less able you are to predict, potentially, the stress in the market and the depth of the market if you need to sell?
If you need to sell. That's what I'm getting at.
Understood. That's useful clarification. Thanks, Mike.
Listen, let me ... last couple of questions for you. If you were going to give a bite size piece of advice to investors on how to manage this risk, what would be literally the top three things you would say to a client to help them navigate this space and really think about liquidity risk effectively?
The three things I would say are, first of all, be aware it's a problem. Don't just sit there and say, "Oh, this will never happen," because the chances are it will happen. So just awareness. Be aware that this could hit you. And as we've seen over the past few years, it may hit you at times you're not expecting. No one predicted COVID. No one predicted the LDI crisis. You need to be aware that it can happen.
The second thing is, look what tools you have available to you. We've seen dramatic interest in the use of managed accounts and hedge funds. That gives you the transparency what's going on. It can give you greater control, give you greater insight into how managers are trading. And I think if I contrast 2008 where the majority of our investments and client investments were in co-mingled funds and what information you got then and what control you had in that situation to the COVID period, it was night and day. We felt we were under control. And that additional liquidity, transparency, control, and managed accounts, I think was beneficial. So if you have access to a different set of tools, they can make a fundamental difference to how well you can navigate.
The third thing is practice. I was thinking this morning, I think it was Glenn Hoddle in the '98 World Cup decided, we're not going to practice penalties for a penalty shootout because there's no way you can recreate the pressure a penalty shootout. Well, there's a little bit of, you certainly can't recreate the pressure, but you definitely not recreate the pressure if never practicing penalties before a penalty shootout in the World Cup quarterfinal, whatever it was, and expecting it to go well. It's the same thing with liquidity, where if you don't know when it's going to happen, the last thing you want to be doing is learning how to respond to it on the fly. That just, to me, sounds like it's a dangerous recipe. There'd be lots of moving parts, lots of contradictory data. You may not even know where to get that data from. You'll be stressed, pressurized.
So actually sitting down and working out how you would handle such a situation I think is possibly the most important thing to do. And each situation will be different, but you will learn something from every time you walk through how you manage that portfolio.
Thanks, Mike. I think we've learned a lot through this conversation. It's clear that liquidity does indeed matter. I guess it was in the title, but liquidity matters. I think understanding and taking it seriously is your number one, was your number one response. I think we heard it. Understanding your data, knowing it. Understanding your portfolios, significantly important. And lastly, don't wait until the event to come about before you actually think about how you're going to manage it.
Thanks for joining us today, Mike. It's been great and I hope this has inspired a few questions and maybe a couple of more actions on anybody who's listening in. Thanks very much.
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