What to Do When It Isn’t?
For liquidity and rebalancing, turn to an overlay program
How does an overlay program help maintain liquidity?
While counterintuitive at first, a unique solution used during the global financial crisis was to sell physical equities to raise liquidity both for ongoing cash needs and to fund a rebalancing overlay. Equities were a good target for liquidity because they remained relatively liquid during this period of market stress. While it may appear that this left investors with a more severe underweight to equities, the overlay program used this cash not only to replace the equity exposure that was sold but to also rebalance the overall portfolio exposures back to target. As a result, plans found themselves in a position to both create sufficient liquidity and maintain the desired asset allocation.
The goal of the rebalance in this example is simple: to reduce fixed income exposure and increase equity exposure. Assuming a portfolio has liquid equity exposure (passive exposure works well for this situation), an overlay program can achieve the goal in a capital-efficient manner while avoiding the discount associated with selling fixed income securities. Physical passive equity exposure can easily be substituted with equity futures without the need to fully fund the position. The illustration below gives you an idea of how this typically works.
Hypothetical. For illustrative purposes only.
In short, by selling passive physical equity exposure, adding synthetic equity exposure, and selling Treasury futures, institutional investors can rebalance in a capital-efficient manner and avoid forced selling of less liquid physical fixed income positions.
The bottom line
During the global financial crisis, institutional investors that made smart use of an overlay program found themselves able to generate liquidity to rebalance their portfolio in a way they may not have been able to independently. By selling out of liquid asset classes, they sidestepped the negative effects of selling assets at a discount and instead remained on target. As the coronavirus outbreak roils markets today, it’s an approach whose time may have come once again.