Institutional investors have policy guardrails, so strategies that acknowledge them are always of interest. II recently sat down with Bart Sikora, Director, iShares Portfolio Consulting, and Brett Talbott, VP, iShares Institutional Team, to talk about their thoughts on how institutional asset owners might manage their liquidity needs and reduce the hassle of doing so.

We were talking a few weeks ago, Bart, and you mentioned a liquid beta sleeve, which sounds self-evident, but likely is more nuanced. Can you define it for the II audience?

Bart Sikora: Liquidity sleeve is defined as a portfolio of ETFs that attempts to match the most appropriate exposures with the benchmark indices which define a policy portfolio. Policy benchmark is defined as an established asset allocation composed of indices and their weights that is put in place at public and corporate pension plans, foundations, endowments or other entities with investment policy statements. A liquid beta sleeve is intended to deliver the convenience of a strategy that addresses policy benchmark in an investment through index ETFs which are closely aligned with components of the institutional client benchmark. Public and corporate pensions have been most frequent investors. For example, a public pension plan with 70% public market holdings can obtain a close tracking with 0.10%-.25% tracking error for about 0.08-0.15% in management fees.¹¹ A typical LBS represents 3-5% of a plan size and generally aims to precisely match the benchmark. Of course, LBS can be customized to any needs – rather than closely aligning with the benchmark, it can also be created to become a complement (i.e. offer desired attributes that differ from the policy benchmark). 

Brett, you’ve spent a lot of time thinking about precisely paring the right ETFs with policy benchmarks. What have you discovered?

Brett Talbott: The wide variety of beta exposures available through equity and fixed income ETFs allows asset owners to seek a precise pairing of the right ETFs with various policy benchmark components. In turn, we've seen the resulting ETF based liquidity sleeve can quite closely track the policy benchmark on the public asset side, down to 0.10-0.20% tracking error in many instances.¹² In the most common instance, liquid beta sleeves have been adopted by public and corporate pension plans looking to create a liquidity buffer for their plans that encounter frequent flows. A typical public pension plan allocation is nearly 80% to public assets¹³ allowing a very close alignment for a significant portion of a policy benchmark. Corporate pensions have an even greater public allocation. On the endowment side, alternative assets tend to be much larger portion – from 60% for larger plans down to 25% for small plans¹⁴ however, a few public-asset proxy solutions exist to help better align the economic beta exposure to the alts, especially as compared to another solution of sitting in excess cash.

Let’s take a step back – what were the options available to institutional investors prior to LBS?

Sikora: Historically, institutional asset owners took three different approaches. One approach was to keep the entire allocation invested, either internally or with third party managers. This approach led to operational headaches related to frequent benefit payments or other operational needs. A second possible approach kept a portion in cash for near term expenses, but that creates cash drag. The third approach, which is what we've been seeing lately, is ETFs replacing derivatives in strategies. The selection of ETFs now exceeds the selection of derivative instruments, and ETFs may better line up with policy benchmarks, especially in fixed income and international equities. Additionally, investing with futures requires a LIBOR-like rate of cash return for a full total return experience, which can be difficult for some institutional investors to achieve.

How does the liquidity sleeve work in the context of other strategies and managers institutional investors work with?

Talbott: Structurally, a portion of the plan is allocated to the liquidity sleeve, perhaps 3-5%. With ETFs in and out execution is generally quick (T+1 settlement with trade date notification deadline), there tends to be deep liquidity and operational hassle is low. Without the liquidity sleeve, when the plan is largely invested with external managers, there might be frequent and possibly disruptive flows going in and out, as the plan lacks the liquidity buffer.

iShares can help institutional investors determine the best course of action in creating a liquidity sleeve. We recently launched a tool on iShares.com where an institution can create customized ETF-based portfolios that align with policy benchmarks to get started in building the sleeve. And of course our Portfolio Consulting team can help in this effort.

So, what’s the primary goal of the liquid beta sleeve?

Sikora: The primary objective of LBS is to minimize the tracking error to the policy benchmark (or a comparable institutional benchmark for non-pension clients). As such, an appropriate ETF should be paired with each benchmark index. Matching the right asset class and the right index significantly decreases anticipated tracking error versus cash. Often, pension funds manage their portfolios with tracking error risk budget. With a properly matched up LBS, more of the risk budget can be devoted to the pursuit of alpha and not spent on cash-related tracking error. The LBS structure is intended to manage performance shortfalls in rising markets versus cash.

How has the unending vol of 2020 affected your investment strategy?

Talbott: Uptick in market volatility inevitably leads to more frequent instances of investment policy breaches. These breaches can happen in several instances: a) asset weight limits b) historical tracking error thresholds c) active risk thresholds. As was the case with the equity sell off in Feb-March of 2020, a lot of institutional owners found themselves with significant equity underweight and fixed income overweight. Having LBS in place ahead of this significant market disruption would have allowed an immediate redemption out of fixed income and proportional increase in equity weight. The alternative would have been a slower execution of physical securities, especially in the bond market as liquidity dropped. Otherwise the redemption could have taken place among external managers and be delayed by notification deadlines and month-end notification schedules.

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¹ See “Price Gap Triggers Fears for Bond ETFs,” Financial Times, 3/30/20; “Bond ETFs Will Never Be the Same After Coronavirus,” Bloomberg, 3/23/20; “Why Most Index Funds and ETFs are Not Good Investments,” Forbes, 4/7/19.

² Financial Stability Report, Bank of England, May 2020.

³ BlackRock, "Turning point: How volatility and performance in 2020 accelerated institutional adoption of fixed income ETFs". July 2020

⁴ Financial Stability Report, Bank of England, May 2020.

⁵ Credit trends: “How ETFs contributed to liquidity and price discovery in the recent market dislocation,” S&P Global Ratings, July 2020

⁶ ETF primary market participation and liquidity resilience during periods of stress, M.Aquilina, K.Croxson, G.G.Valentini, Lachlan Vass, Financial Conduct Authority, Research Note, August, 2019. 

⁷ BlackRock, "Turning point: How volatility and performance in 2020 accelerated institutional adoption of fixed income ETFs". July 2020

⁸ Bond ETFs and underlying price uncertainty, MSCI, April 2020, Refinitiv/Lipper data.  

⁹ Financial Stability Report, Bank of England, May 2020.

¹⁰ “Crisis? What Crisis? U.S. dollar corporate bond liquidity since COVID,” FTSE Russell, August 2020

¹¹ Source: BlackRock based on the typical portfolio consulting analysis results of 100+ institutional portfolios, aggregated over 2017-2020 period.

¹² Source: BlackRock based on the typical portfolio consulting analysis results of 100+ institutional portfolios, aggregated over 2017-2020 period.

¹³ Source: P&I, Feb 2020

¹⁴ Greenwich Associates, 2019

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