Illiquid assets

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GLOBAL INVESTOR 1.15 — 20 of USD 100 in the average hedge fund portfolio went to USD 132 (+32%). This is still a big difference, but it had gotten smaller. In the five years to December 2014, a USD 100 investment in US equities more than doubled to USD 205 (+105%). However, USD 100 in the average hedge funds portfolio “only” rose to USD 125 (+25%). As an investor, which sequence do you prefer: –11%/+2%/+105% or +41%/+32%/+25%? The second sequence is superior in two ways: higher-end return with less volatility. I like to think of the first sequence of returns as “nature.” That is what you get if you do not apply risk management: moderate overall return with high volatility. Hedge funds can improve this sequence with active risk management. The second sequence does not appear in nature, it is man-made. Hence the fees. Challenges big and small The biggest challenges hedge funds face today are linked to the smaller managers. First, they find it very difficult to raise capital because the financial crisis and the Madoff incident caused private investors to more or less disappear. They are coming back only very slowly. This means the main source of capital comes from institutional investors who have a more sophisticated decision-making process. They expect a hedge fund to have at least USD 100–150 million under management and three years of proven real returns. Furthermore, institutional investors conduct due diligence with their managers, because a lack of it was one of the sources of disappointment in 2008. Institutional investors also expect various layers of operational excellence, adding to the cost base of hedge fund operators. This means that the barriers for smaller, less-established managers have risen. Finally, regulation has intensified. Large hedge funds can deal with the added bureaucracy more efficiently than smaller managers. But large hedge funds also face challenges, and one of them is related to regulation. The financial crisis, and the regulation wrath that it triggered, resulted in investment banks downsizing their trading operations. Liquidity in many markets went down. Because of the winner-takes-all effect that resulted in large hedge funds getting larger and larger, these growing hedge funds see dwindling liquidity as a challenge. A less liquid market means diminished opportunity and is more prone to gap risk. Are hedge funds a good/bad investment? “Over the last decade or so, the conceptual arguments for investing in hedge funds have not changed by much. However, the market place has changed.” ALEXANDER INEICHEN I always recommended to everyone willing to listen that they move up the learning curve with respect to risk management, absolute returns and hedge funds. Knowledge beats ignorance every time. An educated investment is better than an uneducated investment. And education compounds. At the end of the day, an investment decision is binary: either a position is established or it is not. This means the various trade-offs, the pros and cons, need to be carefully weighed against each other. This requires an effort, i.e. learning. Whether a nice chap recommends hedge funds is not that relevant for most investors. An investor needs to reach a level of comfort before investing, and a conviction once acquired requires ongoing reconfirmation. Both are a function of learning and effort. The late Peter Bernstein, author of one of the best books on the history of risk, once wrote that “liquidity is a function of laziness.” What he meant is that liquidity is an inverse function of the amount of research required to understand the characteristics of an investment. As he put it: “The less research we are required to perform, the more liquid the instrument.” An investment in US Treasuries requires less research than an investment in US equities. An investment in US equities requires less research than an investment in hedge funds and so forth. In sum, hedge funds are not for the lazy. Why I want hedge funds in my portfolio Hedge funds originally marketed themselves as absolute return products that deliver positive performance in any market environment. Now, in the wake of the financial crisis, hedge funds focus on their diversification benefits and risk-adjusted performance. A portfolio of hedge funds does not obviate any alternative or “classical” way of portfolio construction. However, hedge funds have properties that you do not find in other areas of finance. For example, trend-following managers have had a positive return in 17 out of 19 major corrections in the equity market since 1980. This is unique. There is nothing else in finance that has such favorable correlation characteristics. Among other asset classes, measured low correlation more often than not turns into an illusion when it is most needed, somewhat akin to perceived liquidity. Over the last decade or so, the conceptual arguments for investing in hedge funds have not changed much. However, the market place has changed. For example: hedge funds as a group are larger; the largest funds are larger; some trades are more crowded; liquidity in some market areas is lower due to Dodd-Frank; yields are lower and IT is more important. But again, conceptually, an intelligently structured portfolio comprising independent returns and cash flows is as worth considering by every thoughtful and diligent investor as it was in 1949, when the first hedge fund was launched. If you know the future, invest in what goes up the most. If you do not, construct a portfolio where the source of returns and cash flows are well balanced and the risk is actively managed, while not forgetting that perceived liquidity can turn into an illusion.
GLOBAL INVESTOR 1.15 — 21 Hedge Funds Liquidity – a key to hedge fund performance Whether it’s related to an investor’s risk tolerance, or a fund manager’s decision on the appropriate trading strategy, the management of liquidity issues is a vital consideration when investing in hedge funds. And while illiquidity can be a source of risk, it can also be a source of additional returns. Annualized returns Liquidity is an important aspect to consider when investing in hedge funds. Liquidity issues have to be managed by both investors as well as hedge fund managers. While it is true that hedge fund liquidity has generally improved for investors since the global financial crisis, hedge funds are still less liquid investments than equities. To use Alexander Ineichen’s term, they can be called “quasi-liquid.” In the following, we take a closer look at the role liquidity plays for hedge funds and their investors. A key conclusion is that illiquidity is not only a drawback, but also a potential source of returns, which still has to be managed. <strong>Illiquid</strong>ity as a source of return Hedge fund returns can be divided into three components: (1) returns from general market performance (also called beta factors), (2) returns from exploiting risk premia, including illiquidity factors (alternative beta), and (3) returns related to manager skills (e.g. in selecting securities and timing entry and exit into an investment, called alpha.) The performance of equity and fixed income markets to which hedge funds have exposure are typical beta drivers. The sensitivity toward these drivers varies across hedge fund strategies. While long/short equity strategies (which belong to the fundamental style, see box) have a relatively high sensitivity to equity market performance, the influence on managed futures (a tactical trading strategy) or fixed income arbitrage (a relative value strategy) may be minor. Hedge funds provide advantages Tactical trading 5.5% Relative value –1.9% Event driven –2.6% Low liquidity decreasing Directional investing –4.6% Tactical trading 9.1% Directional investing 7.4% Event driven 7.3% Low liquidity increasing Relative value 5.8% Best trading strategy is a function of market liquidity In periods of low liquidity, tactical trading strategies have performed best. Particularly in an environment of low liquidity, this style stands out as the only one delivering positive returns. Source: Datastream, Credit Suisse Directional investing 15.3% Event driven 14.6% Tactical trading 11.9% Relative value 11.6% High liquidity decreasing Directional investing 18.5% Event driven 17.0% Tactical trading 13.6% High liquidity increasing Relative value 9.5% Generally, it is easy to gain exposure to traditional beta drivers. However, alternative sources of beta may not be as easily accessible through commonly traded instruments. Default risk and illiquidity premiums fall in this type of category, and hedge funds can be one way to access this type of return. For example, the distressed debt strategy in - vests in illiquid, distressed securities that are not commonly accessible to investors. In contrast, mutual funds have more stringent liquidity requirements and are usually restricted to invest at most in low-rated credit, while their structural setup allows hedge funds to take on such credit risk. Moreover, distressed debt hedge funds have a longer time horizon, which allows them to hold on to investments for longer and to wait until the company that issued the distressed security gets back on track. >
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