Cash is Not Always King

Takeaways:

• Cash is only one facet of liquidity management.

• Nothing replaces a balanced and diversified portfolio.
• Liquidity is a multifaceted, protean, abstract concept.

Cash is always helpful to meet redemptions, but it should not be the first—and certainly not the only—variable you look at when evaluating the liquidity of a fund. Indeed, the diversification of a portfolio and its overall investment process will usually prove more useful in assessing liquidity risks. For instance, the high-yield segment of the credit market is often considered illiquid. Instinctively, one might think avoiding the largest funds in that Morningstar Category and opting for one with plenty of cash in the portfolio should help mitigate liquidity risk. Unfortunately, history has proven those instincts insufficient.

The rise and fall of

The fund’s team made a practice of searching out deals in sectors and companies that were under pressure, positioning the fund as a competitor to distressed-debt hedge funds. The fund did tend to hold relatively high cash stakes—in theory for liquidity purposes. Over time, cash ranged from 5% during 2011's second half to 32% as of April 2012. By November 2012, cash stood at a more typical 14%. However, the portfolio comprised only 60 names at that time, and the fund's top-10 holdings accounted for close to 40% of its assets. That translated to a heavy concentration in lower-quality tiers of the market that are notorious for their light levels of trading: The fund held a whopping 60% stake in a mix of nonrated securities and securities rated below B. (The category norm at that time was less than 20%.)

As performance went south starting in mid-2014, outflows spiked. The fund saw nearly half of its assets go out the door in 2015, and the managers found themselves in a vicious cycle, sending cash to investors and being forced to sell their most-liquid positions to have cash ready for those next in line. Factoring in its losses, the fund’s assets in December 2015 were one fourth of what they were 12 months earlier, and even more heavily concentrated in its least-liquid and most-pressured positions. As redemptions continued, the firm transferred the fund's assets to a liquidating trust.

Ultimately, the investment process is key in managing the various facets of liquidity in order to mitigate losses during stressed markets.

Given the strategy’s girth--the $17.5 billion fund represents less than half of the team’s $45 billion high-yield market footprint--staying nimble in the cash bond market is easier said than done. The team attempts to overcome those challenges by broadening the fund’s scope to include up to 20% in bank loans and investment-grade corporates, and up to 10% in equities, which gives the fund additional levers to avoid selling less-liquid holdings in a period of severe outflows. Diversification is also taken very seriously: The portfolio typically counts close to 1500 holdings across more than 20 industries, and the allocation to nonrated securities and securities rated below B has been kept under 27% over the past five years, which is below the group norm.