Illiquid assets

GLOBAL INVESTOR 1.15 — 23
er regulatory requirements, operating costs
have risen, which in turn has left some smaller
hedge funds unprofitable. Conversely, institutional
investors have been willing to sacrifice
high returns for lower risk as long as
their needs for liquidity and transparency are
fulfilled. For these structural reasons, we
think that the return potential of hedge funds
has generally decreased.
Liquidity drives our hedge fund strategy
The Credit Suisse proprietary Hedge Fund
Barometer is our main tool to assess the
broad investment environment for hedge
funds. The tool is an early warning framework
that should help avoid unnecessary risks. Besides
volatility, the business cycle and systemic
risk, the tool also assesses liquidity
conditions. While we have observed a general
increase in risk starting in late 2014,
tightening liquidity conditions began to draw
our attention in early 2015. As the second
chart shows, liquidity conditions deteriorated
around the turn of the year. While tighter liquidity
is generally a concern for hedge funds,
some strategies are less affected and can
even thrive in such an environment (see first
chart). Given the divergences in monetary
policies between the main regions and, in
particular, the likely approach of rate hikes by
the US Fed, we do not expect liquidity conditions
to improve materially in the near future.
Therefore, we adjusted our hedge fund strategy
in early 2015 and began to focus on
strategies that are less sensitive to liquidity
conditions, e.g. tactical trading strategies. At
the same time, our outlook worsened for
relative value strategies, particularly those
that are active in fixed income investments.
These strategies typically apply higher leverage
and/or invest in more illiquid securities,
and are thus at greater risk when liquidity
conditions tighten.
In sum, when investing in hedge funds,
investors should not just take traditional market
drivers into account, but also focus on
liquidity considerations. Illiquidity can be a
source of risk, but also a source of additional
returns for investors. Careful analysis of
the role of market liquidity in an investment
strategy can help avoid unnecessary risks and
lift returns.
Marina Stoop
Cross Asset and Alternative Investments Strategist
+41 44 334 60 47
marina.stoop@credit-suisse.com
The different hedge fund styles
and how they deal with liquidity
Tactical trading strategies are resilient when liquidity is scarce
Tactical trading strategies include global macro and managed futures.
In this style, managers try to exploit trends in equity, fixed income,
currency and commodity markets. Analysis of macroeconomic variables
rather than corporate transactions or security-specific pricing discrepancies
distinguishes tactical trading from other styles.
Tactical trading strategies trade in all major markets. However, one
major difference between managed futures and global macro is that
managed futures focus on trading futures contracts, the most liquid instrument.
In contrast, global macro managers have the widest investment
universe trading a broad range of different market instruments.
Another key aspect of the tactical trading style is that some strategies
are purely model driven. Within managed futures, trend-following strategies
are probably the best-known example of this strategy. A model generates
trading signals upon which trades are executed. Human discretion and
emotions are negated, which helps explain why tactical trading strategies
are well positioned to navigate through crisis periods. While discretionary
managers may rely to some degree on models, they can use their own
judgment when making investment decisions, and may be more prone to
making irrational decisions in a tough investment environment.
Fundamental strategies have various degrees of sensitivity to liquidity
Fundamental strategies focus on individual securities, mostly in the equity
and fixed income areas. While directional strategies usually build a broader
portfolio of more liquid securities and thus deliberately take directional
market exposure, event-driven strategies often build a more concentrated
portfolio of securities depending on a specific catalyst (event). Directional
strategies tend to take positions in more liquid publicly traded securities,
while event-driven styles often engage in illiquid securities (e.g. distressed
debt, special situations and activist investors with longer holding periods).
While liquidity sensitivity depends on the underlying investments, the
leverage applied is typically lower than in the relative value segment.
Relative value strategies depend on a favorable liquidity environment
Relative value strategies include fixed income arbitrage, convertible
arbitrage and equity market neutral strategies. They aim to exploit pricing
inefficiencies between related or unrelated securities and try to avoid
directional market exposure. Forgoing returns from beta drivers, returns
of these strategies would naturally be lower (yet more stable and with very
low correlation to movements in major asset classes). Leverage is a way
to enhance returns. It can be high, particularly for fixed income strategies
where targeted pricing inefficiencies can be small. But this makes the
strategy sensitive to liquidity conditions. While these strategies tend to do
well as long as markets move in their favor, volatile markets with scarce
liquidity can mean that positions need to be sold at unfavorable prices –
or worse, cannot be sold at all. This left many investors with large losses
during the financial crisis. It is thus vital to keep an eye on market liquidity.