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

Model Portfolios. One Size Fits All. Bad Bad Idea During Coronacrisis.

The notion of putting retail investors in cookie-cutter mass-produced standardized buckets of allocations, referred to as model portfolios, is remnant of antiquated ‘90s thinking. In 2020, during the coronacrisis it is akin to paying a doctor expensive (very typically over 1% of assets) fees for an over-the-counter pain medicine prescription.

Bespoke allocation goes far beyond conventional passive risk and return trade-off found in model portfolios. It personalizes for unique investor preferences including accommodating a desire or aversion to alternative investments, expressing preferences for desired levels of illiquidity, considering different investing horizons, incorporating time varying risk preferences as well imposing constraints on specific asset classes to reflect unique investor circumstances.

Departing from model portfolios has potential to foster greater transparency. Moreover, it raises the quality of discourse an advisor has with her client. It encourages a conversation not on historical, but around forward looking risk- return expectations. It also brings nuance in investment decision making, conspicuous by absence in model portfolios.

Rather than persist with the historical notion of putting clients in coarse model portfolios, a far better approach is to begin by analyzing the forward-looking statistical properties and expected behavior of a client’s existing portfolio. This helps to arrive at the best combination of asset sub-types that improve existing allocations on a variety of chosen metrics.

ActiveAllocator.com lets you create bespoke portfolios in 10 clicks, in 10 minutes and at 1/10th cost.

ActiveAllocator is a digital asset allocation platform with technology-enabled customized advice capabilities. It is the world’s first portal that seamlessly integrates traditional, illiquid and alternative investments within portfolios. It helps investors analyze existing allocations, discover inefficiencies and create bespoke portfolios in minutes.