Fortifying portfolios for the next crisis

Armanda Senra: Good morning, good afternoon, good evening, everyone, and thanks for joining us at the BlackRock Future Forum.  My name is Armando Senra and I'm the head of Americas iShares.  Our goal today is to help institutional investors construct portfolios for the future which should be informed by the high volatility events we experienced this spring. 

So, for our discussion, four main parts:  What happened, how what happened in February and March affected asset allocation of typical assets on our portfolios and how timely rebalancing enhance returns meaningfully.  Two, the impact of high market volatility on liquidity and we will also compare the liquidity of ETFs with that of stocks and bonds.  We’re going to look at how to use EFT liquidity to build portfolios that will withstand market volatility better than most current portfolios.  And finally, we will talk about the role of cash in the portfolio of the future.

We have assembled a panel of experts to cover each one of these topics.  Today, we are joined here by Calvin Yu, head of BlackRock Client Insight Unit.  His team delivers portfolio analytics and insights to clients.  Del Stafford, head of the Multi-Asset Portfolio and Investment Consulting within our iShares business.  Del’s team analyzes portfolios for clients and helps design liquidity sleeves, as an example that we will discuss today.  And Ellen Bockius, head of Global Cash Management and US Corporate Treasury Sales.

Before we start, just as a reminder, you can ask questions through online.  We’ll have about five minutes to go over questions.  If we don’t have time to cover all your questions, your relationship manager will get back to you.  So, we’ll have all the questions recorded. 

Okay.  Let's get started.  Let's begin with Calvin.  Calvin, like I said, let’s begin with the events that took place in February and March and how they had an impact on asset allocation and what the strategies they could use, clients can use for rebalancing.

Calvin Yu: Thanks, Armando, and I'm glad to be here.  What made this stress period particularly significant was both the severity and the swift nature of that drawdown.  We leveraged data from our insurance and pension peer studies and other allocation data to analyze different portfolios and what we found was that throughout this volatility it really caused some large deviations in asset allocations relative to targets.  And so, for some investors this unintentionally led to high levels of active risk and this had unintended consequences as markets recovered in April.

So, going into some of those details on that first slide up on the screen, as COVID-19 started impacted – impacted financial statement – financial markets in late February, we entered the stress period which lasted all the way up until March 23rd.  And over that one-month period of time, global equities we saw falling by around 30% and the ten-year Treasury yield fell from 1.5% all the way down to just under 90 basis points.

And so, as we decompose the drawdown on the left-hand side of this slide, we found that the stress impact really varied by investors.  So, for example, the total losses for insurance portfolios varied by industry but were in the ballpark of the low to mid-teens on average.  And then foundation and endowments, as well as pensions, had large allocations to growth assets which led to larger losses in the magnitude of around mid to high 20s. 

And so, as we focus in on that public pension as an example, just to dive deeper on the impact of this drawdown, on the right-hand side we can see that comparing the COVID-19 drawdown to the ... expected portfolio volatility.  We also then compared it to historical drawdowns as well.  But just focusing in on that one-month volatility, we see it’s expected to be around 3%, so a 29% decline.  It was a real black swan event.  It measured at over eight standard deviation.  And just looking at probability distribution, the probability of an event like that is effectively 0%, which I personally find as really, really fascinating. 

But, before we look at how an event like this impacted portfolios, and in just the spirit of keeping things interactive, we have a quick polling question come up for everyone and you should see that pop up for the screen.  The question is during the extreme volatility of March and April of this year, which one of the following best matches your portfolio action?  One, did not rebalance because of high transaction costs and illiquidity.  Two, rebalanced through individual securities, i.e. fixed income and equities.  Three, rebalanced through fixed income and equity ETFs.  And four, rebalanced and increased cash.  And so, while we wait for those poll results and we’ll go over the results later in this discussion, we can move to the next slide and continue with our public pension example.

So, we looked at the original allocation of the pension plans and you can see that in the inner ring of this doughnut chart on the top left.  And then we compared it to the allocations after the drawdown, assuming those portfolios were not able to rebalance and also drifted with markets.  And you can see this new allocation as that outer ring in that doughnut chart. 

And as you can see, the allocations really shifted materially.  The fixed income grew by 7% and to help quantify this risk and redo that in more detail on the right-hand side, we looked at the active risk that resulted from this.  So, in this example, the drifted portfolio was taking 170 basis points of active risk relative to the original portfolio, which just highlights the potential for divergence in performance.  And that’s exactly what we see at the bottom of this slide.

As markets rebounded in April, portfolios are rebalanced.  They had returns of around 12.5% in April.  But, on the other hand, portfolios that drifted with markets and did not rebalance, they would have returned 1.8% less or around 10.7% in April.

So, Armando, I think while we learned many lessons over this period, the severity and the swift nature of this drawdown really just reinforces the need for just some thoughtful rebalancing programs to mitigate any unintentional active risks in the portfolio.

Armanda Senra: Thanks, Calvin.  So, clearly, we see that timely and thoughtful rebalancing adds significant performance for our clients and their investment returns.  Now, this is the interesting thing.  Just because clients have identified that they want to rebalance, that does not mean that they actually could or did rebalance earlier this year.  So, from Calvin’s presentation, we can see that most of our institutional clients wanted to rebalance from fixed income to equities to revert back to their strategic asset allocation guidelines.

However, when you look at February and March, the liquidity of the bond market was significantly impaired.  Many institutional clients were not able to move bonds in size without incurring significant transaction costs.  Risk appetite from the Street was dramatically reduced because of the uncertainty and high volatility and this resulted in driving transaction costs and bid asset spreads to very high levels. 

So, at the very time our clients needed to rebalance, the cost of rebalancing was incredibly high.  For example, the transaction cost to liquidate a typical investment grade bond portfolio was around 49 basis points and when it came to high yield bonds, the transaction costs were over 100 basis points.  These transaction costs were a serious impediment that resulted in many clients choosing not to rebalance and stay with their underweight equity positions.

Of course, in hindsight we all know what happened after.  Between the end of March and the end of April, the US equity market rallied around 30% and many clients who were underweight equities were not able to fully participate in one of the largest and most rapid stock market rallies of all times.  This lack of liquidity affected the bond market significantly, but the fixed income ETF market saw significant liquidity flow into it.  Clients who owned fixed income ETFs were able to tap into the liquidity of the ETFs.  The strong liquidity of fixed income ETFs market also kept transaction costs and the bid asset spreads low compared to the underlying bond market.

If we change this slide and this slide in your screen, you can see the comparison of bid asset spreads in ETFs compared to that of the underlying bonds.  And you can see that in the case of the investment grade ETFs, the typical bid asset spread is five basis points compared to 49 for a basket of investment grade bonds.  This is the reason that we saw so many institutional investors, large pension plans, foundations, insurance companies, even some of the largest asset managers, global asset managers, taking sizeable positions in fixed income ETFs.  And although what you see there is for fixed income ETFs and that’s one of the key areas where you saw the big divergence, you can also see it in equities and the slide in the screen shows the bid asset spread of small cap stocks at 40 basis points compared to the equivalent small cap ETFs trading at around three basis point spread.

Many clients were able to use ETFs to try to exit falling markets and enter rising markets.  In summary, using ETFs allowed many institutional investors to exit and enter illiquid underlying stock and bond markets in a far more efficient manner with much lower transaction costs. 

So, I think that ultimately March was a time that shows how ETFs clearly passed a test in the eyes of some of the largest and most sophisticated investors in the world.  Now, let’s look at some of the stuff that we already learned about the power of ETFs and market liquidity and smarter rebalancing that Calvin cover with Del Stafford, head of Portfolio Consulting for iShares, to share some ideas for portfolio construction for the future using ETFs.  Del, I’ll pass it over to you.  Thank you.

Del Stafford: Great.  Thank you so much.  Calvin and Armando set the stage very well.  During the crisis this year, clients were reluctant to rebalance given the uncertainty and cost to trade in underlying stock and bond markets.  And clients who didn’t rebalance missed out on nearly a two to three percentage point incremental return. 

So, now that markets have recovered, why does all of this matter?  We say for three reasons.  First, we’re not out of the woods yet.  Second, clients who have not done so should consider building a rebalancing sleeve now in advance of more turbulent markets.  And then lastly, more liquidity doesn’t equal less returns.  With ETFs, one can increase liquidity, express a view and remain fully invested. 

So, why do we say we’re not out of the woods yet?  Economies are still reopening.  Some are re-closing.  Yet, the US stock market and other markets have recovered, and volatility has abated.  But only in the last three to four weeks, we’ve seen significant equity market selloffs and rally. 

So, let’s bring this to life through a rebalancing sleeve example we shared with clients back in March and April.  It still applies today since it demonstrates how clients with a rebalancing sleeve could have easily rebalanced and benefiting from the subsequent recovery that was covered earlier.

So, as Calvin alluded to, pensions closely monitor their active risk level, then their asset allocation thresholds based on investment policy statement guidelines.  We’ve engineered two example rebalances on this slide for a 60/40 portfolio that’s governed by an asset allocation threshold.  We start with a simple two asset portfolio comprising individual stocks and bonds, tracking the MSCI Equity Index, as well the US Aggregate Bond Index.

So, as of March quarter end and considering the market drift, the 60/40 moved to around 52/48.  This allocation relative to the 60/40 equates to approximately 1.38 percentage points of active risk.  We highlight this because a drifted portfolio is an active decision and a source of active risk.  In other words, just by choosing to let it ride, clients are making an active decision.

So, how might a client consider rebalancing?  On the top right, let’s discuss three ways a client could rebalance back to what we call policy threshold, 55/45.  One could rebalance with individual stocks and bonds at an estimated spread or transaction cost around 19 basis points.  Those clients with a rebalancing sleeve would rebalance out of fixed income ETFs into equity ETFs at an estimated transaction cost ranging between six and 12 basis points at that time, depending on the region and fund range one is trading in.

A third example is one could rebalance out of individual bonds into fixed income ETFs and equity ETFs to fund what we would call a total portfolio liquidity sleeve.  The cost for that would be somewhere between the cost of the underlying transactions we discussed earlier and those of the ETF.  The threshold portfolio is still an active decision.  The active risk level is 91 basis points, but less than the drifted portfolio we covered earlier.

On the bottom right, we illustrate how we could move back to allocation target of 60/40.  But focus on being a bit more defensive.  This is still a popular conversation we have with clients today and the exposure is either through quality, a quality factor or a minimum volatility.  So, we’re moving out of fixed income into acquiem in vol.  Again, those that didn’t have one in place could rebalance with individual stocks and bonds at an estimated spread of around 23 basis points.  Those clients with a rebalancing sleeve would have rebalanced out of fixed income ETFs into equities at an estimated transaction cost of 12 basis points by time, roughly the same level across regions and fund ranges.  In this example, the minimum volatility exposure is still an active decision, but it’s equating to only 58 basis points of active risk.

Now, on the next slide we’ll cover that liquidity is even more important for those portfolios governed by active risk threshold since active risk is driven by the drifted asset allocation and the underlying market volatility.  This is what we see in this example.  We've created a portfolio with an active risk level between we’ll call it 1.5% and 1.8% using minimum volatility as our active component.  We’re going to assume normal markets.  Another way of saying that is we’re going to assume a long horizon risk model setting. 

As of the end of the March and considering market drift, the 60/40 is now 53/47, slightly better than the previous example because of the minimum volatility.  The drifted allocation equates to approximately 2.66 percentage points of active risk.  More important, however, is the active risk level during this heightened vol environment in March.  It’s not 2.66.  It’s nearly two percentage points higher at 4.51.  The difference between 2.66 and 4.51 is driven only by market volatility. 

Like the early example on the top, we rebalanced back to policy threshold at 55/45.  The portfolio is still an active risk – is still an active decision where active risk is 2.25, slightly more than the target.  And on the bottom, we seek to move back to the asset allocation target of 60/40.  So, we’re moving out of fixed income back into acquiem in vol.  Still an active decision, but much, much closer to the target of 1.89% of active risk.

In both examples, clients could have created a rebalancing sleeve during stressful markets.  But those going into challenging markets, having a sleeve would have avoided needing to transact in the underlying fixed income market at exactly the wrong time.  Just for some context from the poll that we took earlier, roughly 50% of the participants today said that they rebalanced their individual securities and around 18% said that they rebalanced with ETFs.

So, to recap, we’re not out of the woods yet.  One might or rather now might actually be the time to build a rebalancing sleeve since the T costs have normalized given the current market environment.  We estimate portfolios that rebalanced in March month-end probably sit somewhere between 65% equities to 68% for those that are holding more US equities and less emerging markets.  And lastly, ETFs can be used to build portfolio liquidity, even express an active view, all while remaining fully invested.

People often equate increasing liquidity with raising cash, which brings us to our next speaker.  Ellen, we’re hearing more and more about cash on the sidelines in 2020.  But we sense derisking isn’t the only motivation for higher cash levels.  So, what are you seeing and hearing from our clients today?

Ellen Bockius: Thanks, Del.  You’re right.  Derisking isn’t the only driver.  But, regardless of market cycle or abnormal conditions, cash plays an important role in all portfolios.  The magnitude of that role just varies.

Cash serves as a source of liquidity and in some interest rate environments it can even offer competitive yields relative to other asset classes, just maybe not in the environment that we’re experiencing today.  But sometimes, just like periods we’ve just come through, it’s the antidote that clients need when there’s significant volatility in the market. 

So, in times of crisis, cash takes center stage.  And in the last few months, we’ve seen over $1 trillion flow into money market funds globally, as you can see here on this slide, and there are valid reasons why.  Corporations have rushed to liquify balance sheets to obtain the peace of mind that they need when their future is uncertain.  They need to know that they can sustain operations and pay their employees and their suppliers.

We’ve also seen healthcare companies draw down credit lines or issue debt to support their overall enterprise.  We’ve seen health insurers sitting on more cash than they’ve had in the past, driven by higher liquidity buffers and lack of payouts for elective procedures.  We’ve seen universities grappling with uncertainty, challenging their revenues, leading them to increase cash balances.  And from pensions, we’ve seen increased allocations to cash to take advantage of market dislocation.

These are all prudent actions to be taking.  However, it’s really important to remember that increasing cash allocations isn’t a risk-free decision.  The important question to be asking in order to future-proof portfolios is how much cash do I need?  What tolerance do I have for principle volatility and how important is yield to me?  And maybe do ESG factors – should I consider ESG factors?

These are – these answers are different for every single client and they’re highly situational.  It depends on a number of factors, industries, desired long-term outcomes.  But, one thing that’s consistent across all clients, cash investing must be an active decision.  And like I said, just because it’s cash, it doesn’t mean it’s risk-less.  A passive strategy today gets you zero.  But, reaching for yield can create challenges for the cash investor.  So, it’s important to be thoughtful about this component of your portfolio.

The question that I'm getting a lot right now is with interest rates tethered to zero, what do I do in order to obtain yield in my cash allocation?  And this is a global phenomenon.  It’s an environment that we are likely to be in for quite some time.  Chairman Powell has said recently that the Fed isn’t even thinking about thinking about raising rates.  So, how do I future-proof my cash allocations?

The most obvious answer is separately managed accounts for institutions.  In addition to the customization from an investment perspective, a key advantage of SMAs in this market is the ability to take advantage of the frontend yield curve and earn incremental yield on the portion of cash that doesn’t need to be accessed on a daily basis.  These advantages are greater today than they have been in the past.  And as we hit a zero-rate interest rate environment, a story we’ve all seen before, the cost of liquidity, of holding liquidity will be high and removing the requirement for daily liquidity of portfolios is a significant advantage.

And remember, money market funds in the US must hold weekly levels of liquidity over 30%.  That's not a requirement for separate accounts.  It’s dependent solely on the institution’s liquidity needs.  So, in today’s environment SMA clients can pick up an additional 30 to 50 basis points just on that 30% to 40% of money that’s not sitting in overnights and treasuries. 

Another option for clients to consider is prime money market funds.  Currently, prime funds are averaging over 20 basis points over government money market funds.  Prime funds saw significant outflows in March, but we are seeing clients come back and it’s driven by the principle stability they’ve exhibited and the higher relative yield.

So, the punch line here:  In order to fortify your cash allocations for the future, pay attention.  And this is a PSA not just for institutions, but for individual investors alike.  Uninvested cash or inactive cash can create a real drag on portfolios in this interest rate environment.  Know and understand your liquidity needs.  Deploy an active strategy based on those assumptions and look for other opportunities to deploy the excess.  So, with that, I’ll turn it back to you, Armando.

Armanda Senra: Thank you, Ellen.  Before we go to questions, a quick summary of this session.  One, high market volatility can throw asset allocation out of line with clients’ strategic asset allocation.  Number two, typical stock and bond markets tend to be far less liquid during these times when the need for rebalancing is the highest.  And number three, building a liquidity sleeve using ETFs for 2% to 5% of a portfolio’s assets under management can allow clients to efficiently rebalance at low transaction costs and improve their overall portfolio returns in a very significant way. 

So now, let’s go to some of the questions that we have received.  There’s one question here.  Let me read it.  We have a large asset allocation to equities and fixed income.  These assets are in comingled funds.  How liquid are these assets, and can ETFs help us react more quickly in volatile markets?  Del, why don’t I pass this one to you?

Del Stafford: Thanks, Armando.  Like the examples provided earlier, comingled funds traditionally invest in individual stocks and bonds and would benefit from the inclusion of ETFs or ETFs alongside them that track the same benchmark.  The ETFs would provide operational efficiency from a trading standpoint but would also be or could also be first in line when the trust is tapped for redemption.  This also applies more broadly to institutional investors as we’re having very similar conversations and discussions with general account insurance PMs and CIOs that are looking after multi-asset portfolios and are looking to increase their liquidity to protect the underlying assets that might be invested in single securities.

Armanda Senra: Thank you, Del.  And it looks like we are out of time.  So, Ellen, Del, Calvin, thank you for joining us today to share your thoughts.  Thanks to all who listened and thank you for joining us.  And again, you know, like I think overall this is the last session.  Thank you for spending time at the BlackRock Future Forum.  We’ll continue tomorrow for day two at noon Eastern for our first session, hosted by BlackRock’s Chief Investment Strategist Mike Pyle and featuring former Treasury Secretary Larry Summers and BlackRock CIO for Global Fixed Income Rick Rieder.  Until then, thank you very much.

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