Limited functionality available
COVID-19 has increased attention on the need for robust investment governance and effective, proactive liquidity management. The current situation goes beyond other liquidity challenges due to:
The first two challenges could have been readily foreseeable – grey rhinos as per Michele Wucker – highly obvious and probable but still neglected - and the third challenge was possible if not probable, but the fourth was definitely a black swan event - effectively impossible to meaningfully foresee, as it represents a change to the underlying rules of the system.
Effective investment governance
Effective investment governance includes an effective liquidity management plan, an investment strategy that is resilient to foreseeable economic conditions, and meaningful stress testing that is used to formulate responses.
Funds that have done this are experiencing the benefits of their governance arrangements as they address the immediate challenge. Those still working on this will need to undertake daily liquidity forecasting and stress testing to map out their projected cash flows, so they can update them as new data become available.
The criticality of data is highlighted here. The majority of funds will have by now considered the extent to which their membership will be likely to switch to cash options, opt for early release super, or be impacted by unemployment. The two key criteria being the industry they belong to and the availability of financial resources to them outside superannuation.
There is often a relationship between these factors.
Advice is another important factor. It should be noted that members with limited financial resources outside superannuation will often not be advised so there is likely to be a correlation here as well.
If the liquidity projections indicate a deficiency, the question is how to raise liquidity.
It is important to do what is necessary to survive the immediate liquidity challenge. However, the temptation to pursue the simplest solution with the lowest immediate cost, such as selling the most liquid assets, and so replenishing liquidity quickly at a lower discount also increases the risks of leaving an unbalanced portfolio after the event, resulting in a portfolio susceptible to further dislocations.
There is also the associated legal obligation to restore the option to its appropriate strategic asset allocation.
Funds could address the immediate problem with losses incurred selling assets to find liquidity showing up immediately in performance numbers. Reducing this discount could increase the portfolio risk. It is important to note that funds are obliged to maintain and restore their investment strategy. Furthermore, funds would have less liquidity to address any further problems that arise, or to pursue opportunities.
This is a difficult trade-off and ideally Trustees would have considered this scenario in advance. It is a requirement to conduct liquidity stress testing and have a liquidity management plan (LMP). The key issue now is to evaluate the trade-offs and, importantly, to build a resilient investment governance framework for the future which will also help manage the aftermath.
It should be noted that often the decision is not a digital one, between selling ‘liquid’ or ‘illiquid’ investments – even within the same asset class different assets have differing degrees of liquidity - and the precise options open to each fund will vary based on exactly what they’re holding.
Effective investment governance, and the stress testing programs that form part of such a framework, do not provide the ability to foresee all possibilities. They do however facilitate the thinking required to address such situations and the ongoing impacts once we exit the current dislocation.
While the short-term challenge is liquidity, there is still the long-term challenge of the investment strategy and asset allocation, and importantly, considering the nature and needs of the membership.
Craig Roodt is a Director in Deloitte’s Investment & Wealth Advisory practice, with more than 20 years financial services experience across the investment value chain focusing on superannuation and investment governance. Immediately prior to joining Deloitte, Craig was the Head of Investment Risk at the Australian Prudential Regulation Authority. His experience includes: Developing key parts of the investment prudential framework in Australia, including SPS 530 Investment Governance and the Good Practice Guide to Unit Pricing Leading specialist investment risk teams, reviewing investment and governance frameworks, policies and processes and customer outcomes at numerous superannuation funds and asset managers and recommending improvements. Advising, developing and implementing liquidity management frameworks, processes, and stress testing programs, including investment strategy formulation.