Liquidity Woes Have Abated, But Don’t Get Too Comfy, JPM Says

Ooooops, you can’t sell that security to pay for Junior’s tuition. The liquidity problem, which flared in March, has improved, but still exists—and could erupt anew, according to JPMorgan Chase strategists.

Lack of liquidity, namely that buying and selling are frozen, hit financial markets hard in March as panic over the pandemic spread. Timely intervention from the Federal Reserve and other moves staved off a catastrophe. But JPM cautions that this could happen again.

“Liquidity conditions have improved considerably, though not fully, and overall functioning has mostly been restored, but markets remain in an unstable equilibrium and vulnerable to shocks,” the bank’s strategists wrote.

Liquidity problems aren’t new. The growth of passive investing, which ropes stocks and bonds off the market, and high-frequency trading (you can’t sell that stock because a computerized trader monopolized all the buyers in a jiffy) have been growing factors for some time, the JPM report observed. Add in high volatility, which is the case nowadays, and fresh trouble may brew.

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“Credit and bonds seem to be closer to a full recovery in terms of liquidity, while equities and [currency] still seem to be some way from pre-correction levels,” the report said.

The credit markets are in better shape, especially investment grade bonds, the report said. And stocks? Well, some folks can’t get their asking price now. And next time they crash, transactions may be limited, to say the least. Currency market liquidity, the report warned, is “skating on thin ice,” in a fragile state owing to low depth and overly wide spreads.

As for Treasuries, the Fed’s vast purchases have restored “some semblance of normalcy” in market operations, the bank said.

The notion that the Treasury market could stall out seemed unlikely—before March. That was when spooked investors rushed out of Treasuries and into cash, mainly because trust in anything had plummeted. The market couldn’t handle the explosion in Treasury sales.

The Federal Reserve jumped in by buying Treasury securities and making other moves. “The Fed’s actions seem to have worked,” a Brookings Institution report noted. “Treasury futures are once again pricing in line with their cash deliverables, market depth has started to recover, and repo rates have fallen in line with the federal funds rate, the Fed’s key short-term rate target.

As Ardia Asset Management wrote in a report about that scary time, “Episodes like March remind us that it is easy to take liquidity for granted until you really need it, and that need tends to be greatest in times of market stress, which is also when market liquidity will be most challenged.”

This liquidity problem has been around since before the pandemic slammed into the financial system. In November, Pascal Blanque, CIO of Europe’s largest asset manager Amundi, said at a Reuters conference that “the dollar liquidity that lubricates the system is challenged.”

Markets stumbled in mid-September when overnight US repo rates shot up to 10% —which was five times the Fed funds rate then —causing banks to scramble for cash and forcing the New York Fed to inject dollars into the system for the first time in 10 years.

In a time of unpleasant surprises, it’s not reassuring to know some more may lie ahead.

Liquidity Crisis? We Can Cope, Say Managers

Liquid Alternatives and the ‘Illiquidity’ Premium: Perception versus Reality

Tags: currency, Equities, investment grade bonds, JPMorgan Chase & Co., Liquidity, Pandemic, repos, Treasury bonds

Aside from a select few fund managers, endowment CIOs would be wise to abandon alternative investments, as the asset class is likely to underperform for the vast majority of endowments, according to a new paper from investment consultant and co-founder of EnnisKnupp Richard Ennis.

“Alternative asset classes have failed to deliver diversification benefits and have had an adverse effect on endowment performance,” Ennis wrote in his paper. “Given prevailing diversification patterns and costs of 1% to 2% of assets, it is likely that the great majority of endowment funds will continue to underperform in the years ahead.”

Since the financial crisis of 2008-2009, US endowment funds have significantly underperformed passive investing, Ennis said. His analysis shows that over the 11 year-period ending June 30, 2019, none of the 43 largest individual endowments outperformed passive investing with statistical significance.

Ennis examined the diversification and performance of large educational endowment funds and public pension funds in the US over the past decade and found that alternative investments ceased being the “putative diversifiers” they had been before 2008 and have become a “serious drag” on institutional funds’ performance.

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“The decade ended in 2009 coincides with the glory days of the endowment style of investing,” wrote Ennis. “What remains unexplained is what transpired at about the time of the Global Financial Crisis of 2008 to cause endowments to lose their steam.”

In his research, Ennis created a dataset of fiscal-year annual returns and percentage allocations to alternative investments for 43 endowment funds with assets of more than $1 billion and created a benchmark for each individual fund. Ennis found that a composite of large endowment funds underperformed a passive benchmark by an average of 1.6% per year, and a composite of public pension funds underperformed by 1%.

He said investment costs, which were estimated independently of performance measurement, are approximately equal to the margins of underperformance of the institutional composites.

The 43 funds’ alphas ranged from a low of -3.56% for Southern Methodist University (SMU)’s endowment to a high of +2.07% at the Massachusetts Institute of Technology (MIT). After MIT, the endowments with the highest alphas were Bowdoin College and Michigan State University at 2.03% and 1.39%, respectively.

After SMU, the endowments with the lowest alphas were Harvard University and Cornell University at -3.13% and -2.93%, respectively. None of the positive alphas were statistically significant; however, 11 of the negative alphas were statistically significant.

Ennis’ research also found that the average endowment has earned 8.5% per year over the past 50 years, compared with 9.3% for a 60/40 passive benchmark portfolio, which equates to a shortfall of 0.8% per year. The 60/40 portfolio beat the average in four of the five decades, with the lone exception being the decade ended 2009.

“Notwithstanding the existence of a handful of arguably skillful endowment fund managers in the realm of alternative investments, the vast majority of endowment funds incur costs that overwhelm the limited opportunity to exploit mispricing,” Ennis wrote.

“Those confident of their ability to identify truly profitable alternative investments consistently should concentrate those investments to a greater extent, just as they should do with traditional active portfolios. Absent such confidence, they should shift assets to passive investments.”