To view this article in digital magazine format, click here.
It is potentially a useful exercise—it is probably a good exercise—but whether they can get to the bottom of this issue and form consensus is another matter. We await the outcome with interest (and a hot chocolate).
The Netherlands has a liquidity problem. Unfortunately, the financial regulator, the Dutch National Bank (DNB), is not quite sure what it is.
This may sound like an unfair dig, but it isn’t. The DNB has launched an investigative consultation exercise to delve into a raft of aspects around liquidity, and has called on the army of pension fund professionals in the country for help. The Netherlands is home to some of the world’s largest and most sophisticated investors, so if anyone is able to give an accurate description of what liquidity actually is—where it comes from, how it should be measured, and crucially, how useful it really is—it is them.
The European Pension Fund Investment Forum’s Netherlands branch has set up a working group that will meet before Christmas to discuss what the regulator needs to know, and what they should provide to trustee boards and investors.
Even outside the Netherlands, this is a useful exercise. Earlier this year, aiCIO looked into how investors managed to price the illiquidity in their portfolios—if they attempted to at all. As it turns out, although the premium has been routinely touted as one of the most useful and valuable to institutional investors, very few of them could put a figure to just how much it was worth to them. One suggested that the value shifted depending on market cycles and demand. Another said he counted the first 100 basis points as an additional premium to high-yield fixed-income assets that he was earning for the lack of liquidity inherent in the security.
There are no doubt formulas and models to find an exact number, but as we have all realised, models work very well—until they don’t. The Sage of Omaha’s line about selling his assets in order to value them is also applicable to the discussion on liquidity.
So this is what the Dutch regulator is looking into, and it fits well alongside its post-crisis mindset. Since the plummet of Lehman Brothers and the subsequent quasi-collapse of the Eurozone, Dutch pensions have fallen off their pedestal somewhat. Once lauded as leaders of the pack, these investors have had to lick their wounds and come up with plans to repair their solvency ratios to the required 105% minimum.
The DNB has demanded that trustees understand exactly what is in pension fund portfolios to the point they can explain it to a third party (which has spelled termination for a range of alternative asset managers), and risk management has come under a very bright spotlight. This is where liquidity comes in.
Even the term itself is woolly. Liquids can be clear and free-flowing or thick and viscous—so to which type does the term refer? And to which should it be applied? It’s obvious that pension funds need a certain amount of cash available at any time—they cannot pay pension benefits in stock certificates—but how much is enough? And how much is too much?
Just as a gooey hot chocolate is comforting on a winter’s day, having an allocation to infrastructure, well-rented real estate, or a poorly traded bond can give an investor peace of mind. But do we really understand how the illiquidity premium we get from this fits on the portfolio? And how it should sit in a risk budget?