By Susan Dargan, executive vice president, head of Global Services Offshore, State Street Corporation.
Changing market liquidity conditions present major challenges for long-term investors. The situation has been complicated by the quantitative easing (QE) policies at central banks and a prolonged period of relatively low interest rates.
This is encouraging investors to look toward assets that have a higher risk profile or are less liquid to generate returns.
In a new State Street survey of 300 institutional asset owners, asset managers and hedge funds, nearly half (48%) said decreased market liquidity is a secular shift that is here to stay. More than half (51%) of asset owners and managers predicted more liquidity bifurcation in the next three years, where liquidity concentrates in more liquid securities at the expense of less liquid ones.
Consequently, companies are adapting their investment strategies to manage this liquidity conundrum. Our research found that a third of institutional asset owners are increasing their exposure to high-yield bonds to help drive returns in the current low interest rate environment.
Nearly a quarter of asset owners are putting capital to work in illiquid securities including bank debt and credit. Interestingly, appetite for high yield is markedly lower among asset managers and hedge funds.
ETFs - the majority's choice
Approximately 53% of survey respondents are incorporating more liquid investment strategies, such as exchange traded funds (ETFs), while 44% are ramping up the size of their cash allocations to guard against future liabilities or redemptions.
The popularity of bond ETFs has grown as investors seek opportunities for yield and are attracted by the liquidity benefits that ETFs provide.
Although it is important that the liquidity characteristics of the underlying assets are always considered by investors before investing in any fund, ETFs have important structural characteristics that can aid liquidity.
This includes the process for their creation and redemption, and the existence of several dozen market-makers, Authorised Participants (AP), arbitrageurs and other investors who collectively help maintain an orderly secondary market in ETF shares.
Liquid alternatives have also seen marked growth as institutions look to diversify their portfolios, boost returns and enjoy liquidity benefits.
They typically share some of the characteristics and upside potential of hedge fund strategies, packaged within more liquid and regulated vehicles such as 40 Act funds in the US and Ucits funds in Europe.