Do Illiquidity Provisions Boost Hedge Fund Performance?

Retail investors who are ineligible to invest in quality hedge funds, in hard to access investment vehicles, either because they do not meet minimum levels of wealth or income standard, or the high subscription amounts often needed to participate in such funds gravitate to liquid alternative investments. The rise of liquid alternative investment funds, packaged in mutual fund formats over the past years, as the fastest growing category of “alternative investments” is now well documented. McKinsey & Company suggest “retail alternatives will be one of the most significant drivers of U.S. retail asset management growth over the next five years, accounting for up to 50 percent of net new retail revenues”.

With liquid alternatives beginning to find increasing traction in institutional portfolios too, the question is – are they an effective substitute for hedge funds and other illiquid structures? Little empirical fact based exists and opinions abound.

Our research at ActiveAllocator.com attempts to answer this question and concludes that they are not.

Retail investors in considering hedge funds immediately encounter a wide variety of strategies, organizations and structures. Indeed, hedge funds, rather than being an asset class, are broadly a collection of governance structures and investing techniques with many common structural features. Unfortunately, from an investor’s perspective, it is often difficult to decipher which structural features are useful, which imply tradeoffs and which are simply undesirable. The dearth of empirical research leaves investors to make intuitive judgments about what features they should favor.

We re-examined a sub-set of provisions governing fund investing- liquidity terms. In contrast to alternative mutual funds, which allow investors to redeem their holdings on a daily basis with little or no advance notice, hedge fund investors are subject to a variety of terms that may restrict their ability to access their capital. All things equal, investors prefer more liquid investments to less liquid investments. Liquidity provides investors with a valuable option – specifically the opportunity to trade in and out of investments in order to rebalance a portfolio, respond to unforeseen cash flow requirements or redeploy capital towards other opportunities.

While the benefits that liquidity offers to investors are clear, the costs associated with greater liquidity are less apparent. We explored two related questions:

•Do investors pay a price – in terms of lower investment returns – for better liquidity? In other words, do funds with more favorable liquidity terms underperform less liquid funds?

•If the answer to the question is yes, then what drives this cost? In other words how can one explain the under-performance of more “liquid” funds?

Our research finds that there has been a substantial performance cost from offering increased liquidity. The under-performance cannot be attributed to fee levels or the strategy pursued by a particular fund. We are unable to attribute the liquidity cost to differences in skill across managers; we do not find strong evidence that less skillful managers (whose performance is weaker) offer more attractive liquidity terms.

Instead, our results indicate that managers who offer more restrictive liquidity terms are able to outperform more liquid managers because they are able to pursue a broader range of attractive trading opportunities.

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Do Illiquidity Provisions Boost Performance

Author: Sameer_Jain

Partner. Sameer Jain is founder of FinTech ActiveAllocator.com, the world’s first portal that seamlessly integrates traditional, illiquid and alternative investments within portfolios. Prior to this he was Chief Economist & Managing Director at AR Capital. Before that he headed Investment Content & Strategy at UBS Alternative Investments. At UBS, he served as a non-voting member of the Wealth Management Research investment committee, and as a capital allocator was responsible for all illiquid investing including fund manager selection and due diligence across the platform. Prior to UBS he headed product development & investment research at Citigroup Alternative Investments that managed over $75 billion of alternative investments across hedge funds, managed futures, private equity, credit structures, infrastructure and real estate. Here he led a team that developed proprietary models for portfolio strategy and asset allocation with alternative investments, provided investment support and research to pension plans, sovereign wealth funds, endowments as well as internal clients including Citi Private Bank. Before this he was with Cambridge Alternative Investments and SunGard (System Access) where he travelled to over 80 countries for work across Europe, Asia, Middle-East and Africa. He has written over 30 academic and practitioner articles on alternative investments with thousands of downloads at SSRN, presented at over a hundred industry conferences and has coauthored a book, Active Equity Management. Mr. Jain has multiple degrees in engineering, management, public administration and policy and is a graduate of Massachusetts Institute of Technology and Harvard University. He is a recipient of the Alfred Sloan Fellowship and subsequently was a Fellow of Public Policy and Management at the Harvard Kennedy School of Government for a year. He holds Series 7 and 66 securities licenses.

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