Looking back at prior financial crises, the first lesson offered by Callan is to assume liquidity is not there when you need it. Callan suggests that to prepare for the next liquidity crisis, investors should define their ongoing short to medium-term liquidity needs and budget for them accordingly. According to the paper, this process identifies the reliable sources of cash flow from investments (i.e., interest income, stock dividends, maturing high-grade paper) that do not depend on selling long-term capital at risk, like long-duration credits or equities.
Callan says this risk-budgeting exercise should be an integral part of a strategic asset allocation policy, and adjusted to reflect current market conditions. Defining one’s risk budget requires consideration of the investor’s liquidity needs and liability structure, and investors should not simply use someone else’s asset allocation as a benchmark.
The paper also points out that systemic equity risk is not diversifiable. “Given the inherent risk of systemic equity exposure, fund sponsors less able to endure such risk should consider strategically lower allocations to equities, however diversified,” the paper said.
Another key lesson from financial crises past is that rebalancing only works with liquidity. The paper points out that in the most recent market crisis, investors had to postpone or limit their rebalancing programs to avoid extraordinary costs until the needed liquidity returned. Callan noted that fiduciaries should document the decision to postpone rebalancing.
“Given the wildly divergent views on the economic outlook and their potentially volatile effects on market prices, adopting wider rebalancing ranges, however temporary, may be appropriate,” the paper said. Callan suggested investors consider rebalancing strategies using exchange-listed futures.
Other topics covered in the paper include leverage, securities lending, fixed income and bond portfolios, the illiquidity premium, hedge fund alpha, and CIO and Board decisions.
The report, The Odyssey of Risk: Find your Compass, can be downloaded from Callan’s home page, www.callan.com .
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