Okay, the metaphors trip over themselves somewhat in this report. Road maps, barbells, a bucket, and one titular reference (“Liquidity Unbound”) that I believe is supposed to remind us of Prometheus.
But then, discussion of financial matters in prose is of necessity full of metaphors. A language’s reach must exceed its grasp, else what’s a meta … for? If you don’t want the metaphors you’ll be left with just equations full of Greek letters. And, if you can decode them, you’ll find metaphor there too.
Without further ado: Arden Asset Management has prepared a white paper on recent changes in the hedge fund industry. It focuses not on the fashionable issue of the “convergence” of traditional and alternative investing – a trend it acknowledges in passing – but on what seems a contrary trend, a matter of divergence.
Actual and potential investors in the space have experienced “a massive proliferation in hedge fund vehicles” aimed at solving “particular problems and [achieving] specific investment outcomes, such as generating income, dampening volatility or protecting against rising interest rates.” All this makes the hedge fund universe a much more complicated place than it was before 2008.
The real benefit of hedge funds remains the uncorrelated return they allow, justifying their name. But in order to achieve that benefit these days, an investor has to navigate through the newly-complicated landscape, and Arden is offering this white paper as a road map.
The Reason for Illiquidity
Liquidity is of course an important factor in making any such decision. Traditionally, hedge funds would allow for quarterly redemptions with 30 to 65 days’ notice, though some managers would require still longer notice periods. Now this sort of old-school arrangement has to compete with liquid alternative mutual funds with daily redemptions. Between those extremes there are customized accounts and registered investment companies. Also, a ’40 Act fund employing alternative strategies will be limited in its exposure to less-liquid instruments at the level of the portfolio: just 15%.
Fees differ in a way correlated with the differences in liquidity. The old-school funds charged and still charge both a management and an incentive fee. Customized funds, both those that offer daily liquidity and those that don’t go that far, will often charge a flat management fee, or a lower fee plus an incentive. But closed-end funds/RICs charge simply the flat management fee. A liquid alternative mutual fund registered under the ’40 Act will charge no performance fees.
Hold on, now. Some strategies, frankly, require illiquidity. The illiquid nature of those old-school funds didn’t come about by accident. It came about because the annoying lockups free the managers from the concerns that day-to-day redemptions impose, and thus allow for strategic thinking.
Arden cites a study on this point done by Cliffwater LLC, a hedge fund consulting firm, a little less than two years ago. Their empirical results support the a priori notion that imposing liquidity also imposes performance limits. Specifically (in Arden’s paraphrase), Cliffwater found “that the returns for liquid alternatives on average trailed private alternatives by approximately 1% annually, net of fees.”
Nonetheless, according to Morningstar, liquid alternatives are the fastest growing category of mutual fund at present. Arden’s white paper says, “Chief investment officers for pension plans or other institutions with liquidity needs can now allocate their entire hedge fund portfolio to alternative mutual funds should they want to.” They are now available through wirehouses and mutual-fund supermarkets.
Winners and Conclusions
All this is surely good for the mutual fund industry, as the long-only character of that industry has been seen as a significant shortcoming for years. Problem solved.
But what about investors? The white paper suggests that for many, the best way to get a lot of liquidity and a lot of exposure to the benefits of (sometimes illiquid) alternatives strategies is a barbell structure. An investor can simply allocate one portion of the alternatives sector of its portfolio to (illiquid) private placements, and another portion to more liquid alternatives formats that will necessarily pursue more liquid strategies.
Arden’s white paper closes with the sobering macro thought that “we are possibly nearing the end of bull run in equities that was in large part created by central bank policy.” The noun “we” here seems to refer to the whole western/industrialized world. If we are nearing the end of such a run, that makes the presence of less correlated investments in a portfolio that much more important.