Welcome to Efficient Flows, the fourth instalment in a series of papers written by the Alternative Investment Management Association (AIMA) and the Charted Alternative Investment Analyst (CAIA) Association for trustees and other fiduciaries.
The first paper in the series, The Way Ahead, explained the core value proposition of the hedge fund industry. The second paper, Portfolio Transformers, examined the return characteristics of different types of hedge funds. The third paper, Made to Measure, discussed how hedge funds use leverage.
This paper deals with another crucial concept in the hedge fund industry: liquidity. Liquidity is crucial for every investor to understand. In a time of ever-increasing disruption, investors need to know when they can access their capital, and under what conditions.
This paper explains the key concepts surrounding liquidity in the hedge fund space, from the different types of liquidity to the different liquidity levels offered by different types of hedge funds. Since hedge funds tailor their liquidity arrangements to their investment strategies in order to protect and grow the capital of their investors, these liquidity arrangements can vary quite drastically across the industry.
There is no one-size fits all approach to liquidity. Some investors prefer to have rapid access to their capital in order to meet their various obligations. Others (due to their liability structures) can lock up their capital for the longer term, which can represent an important source of competitive advantage for them, as they are able to harvest the potentially higher returns on offer from taking this approach. Accordingly, hedge fund liquidity arrangements are like the locks of a canal, ensuring that liquidity is present where it is needed or locked up when it is not.
We would like to thank our partners, the CAIA Association, for their continued help in developing this series of papers. We would also like to extend our special thanks to the members of AIMA’s Investor Steering Committee1 for their valuable insight and dedication. We trust you will find this paper useful.
Managing Director, Global Head of Research and Communications
Introduction from the CAIA Association
The CAIA Association is pleased to have participated in the research and findings in this latest installment of educational papers designed to equip trustees and other fiduciaries with the proper tools to assist them in their risk oversight responsibilities.
In this paper, appropriately titled Efficient Flows, we take a closer look at liquidity. We are at a very interesting inflection point in our capital markets and this subject matter is both timely and topical. We are now a full decade beyond the liquidity crisis that was the fuel to ignite the 2008 financial crisis and a lot has happened in those ten years. Of note, our friendly and very accommodating central bankers turned on the liquidity hose and pointed it directly at the capital markets to the tune of $20 trillion. Asset prices across the board have reaped the benefits and the deployment of leverage via access to very cheap financing has certainly been an incremental source of octane, but how will this end?
Regulators in some markets have looked for prescriptive ways to measure and disclose liquidity, and in periods of tranquility, that mostly works. Times of stress are quite a different story and it is here that liquidity measurement is more art than it is science. Anticipation and preparation are essential for all fiduciaries because there are seasons to our capital markets and perhaps the halcyon days that we have enjoyed for so long are beginning to wane.
This paper examines four facets of liquidity and how to think about them across various hedge fund strategies. It is important to approach liquidity in the context of your goals and those of the other LPs investing beside you. Hedge fund managers quite often provide for the use of gates, sidepockets or other restrictions to prevent the wholesale flight of capital at what might be the most inopportune times to seek liquidity.
Anyone who has tried to hail a taxi cab in London, Hong Kong or New York City in the height of an August downpour knows full well what an imbalance of supply and demand might look like. In this case, urgency will yield a soaking wet suit and a very uncomfortable remainder of the day. The more patient participants will find the less traveled side street or perhaps simply wait for the sun to come back out again.
Education is a powerful elixir for periods of market stress and our own well-intentioned but sometimes poorly-timed instincts. This paper is the latest dose and we are proud to be in the dispensing business with our partners at AIMA.
Author: William Kelly, CEO, CAIA Association
- Liquidity is an important, complex concept vital for every investor to understand. It plays an important role in asset allocation and the return characteristics of a portfolio.
- Hedge fund strategies span the entirety of the liquidity spectrum in all its dimensions. That is why investors need to understand (a) the liquidity of assets in which managers invest on their behalf, (b) the liquidity requirements for strategies pursued by managers, (c) the funding liquidity of such strategies as well as (d) the liquidity provided to investors by the fund vehicles themselves.
- The liquidity characteristics of the underlying assets and strategy within an investment portfolio (i.e. understanding the position size at least on an aggregated position level) should always be considered by investors before investing in any fund.
- Amidst an increasing set of demands from allocators and industry rule-makers, hedge funds have, on average, shortened the length of time it takes for investors to redeem from their investments.
- It is critical for investors to clarify and understand any arrangements relating to fund liquidity. The AIMA Due Diligence Questionnaire (DDQ) for Investment Managers contains questions relating to the liquidity of the underlying assets in the fund portfolio and how quickly the fund could be liquidated.
- Investors increasingly acknowledge that hedge fund managers should be compensated for offering greater levels of liquidity.
- The potential impact of fund liquidity risk should be regularly evaluated when estimating the market impact (or cost) of divesting the investor portfolio within a specific time and within specific market conditions.
- Depending on the investment plan’s liability structure and appetite for risk, long-term investors are best positioned to take advantage of the liquidity premium, if they manage their portfolio liquidity correctly. Typically, the more illiquid the asset, the greater the expected return on the investment.
Facets of liquidity
In broad financial terms, liquidity describes the degree to which an asset or security can be bought or sold in the market in a timely manner without having the price of the asset significantly change and without incurring costs related to the transaction. Money or cash is considered the standard for liquidity because it can be most quickly and easily converted into other assets.
On this basis, financial securities are more liquid than real estate and collectibles. Liquidity attracts investors to the market because it assures them that they have flexibility in exchanging their securities for cash and vice versa, enabling them to take swift advantage of any changes in market conditions that may result in a security becoming either more or less attractive.
Market liquidity has two important dimensions: breadth— the range of securities that are liquid, and depth—the amount of securities that can be bought or sold (including the transaction costs incurred) before the transaction itself influences the security’s value. These affect the ability of investors to achieve their objectives and crucially, all of which can at times be subject to drastic change.
A US Treasury bond (or its equivalent fixed income government security) is highly liquid as it can be easily sold within hours, transaction costs in selling it are nominal and there are many potential buyers who are willing to pay its market value. On the other hand, a house is a relatively illiquid asset since it can take months or even years to sell. Further, any sale will incorporate significant transaction costs and, depending on conditions in the market, the seller may have to take a reduced price to sell in a reasonable time.
There are three other liquidity factors to bear in mind when considering an investment in hedge funds or other similar strategies. For the purposes of this paper, liquidity has four facets:
• Market (or asset) liquidity;
• Strategy liquidity;
• Funding liquidity; and
• Investor (fund) liquidity
Investor liquidity for hedge funds
For investors, understanding the liquidity of hedge funds is a vital consideration in the structuring of any investment portfolio. This ensures that the necessary cash flow requirements of the investor can be fulfilled with minimal impact on its expected performance. Fund liquidity terms written into investor contracts by hedge fund managers can vary for several reasons, although the leading driver is the asset/market liquidity on offer when investing in the fund’s underlying strategy.
Hedge fund liquidity terms can be wide-ranging depending on the underlying positions in the fund. Some highly liquid strategies offer daily liquidity, while some of the more niche illiquid strategies require investor capital to be locked-up over a multi-year period. Most equity-focused strategies tend to offer shorter liquidity terms, as these assets can be more readily exited in broadly traded markets. By comparison, the terms being offered by the hedge fund manager extend out with investment strategies that invest in less liquid assets. For example, strategies that are heavily focused in less liquid private credit or distressed securities may be only offered in closed-end vehicles to ensure an orderly exit from the investments.
Hedge fund managers strive to match their liquidity terms to the investments in their portfolio. In some jurisdictions, this approach is also mandated by regulation. These terms dictate the minimum amount of time the money allocated to the fund must be left with the manager (the ‘lock-up period’), how frequently investors can redeem money out of the fund (the ‘redemption period’), and how far in advance of a redemption their investors must notify them of their intention to withdraw money (the ‘notice period’).
Hedge fund managers and investors have a set of tools at their disposal to efficiently manage withdrawals. These are often designed to ensure that investment strategies are capable of being carried out as intended. Certain restrictions are designed to avoid any occurrence of an asset-liability mismatch.5 Others exist to allow managers to withstand periods of significant market stress.
Gates and side pockets grew in prominence and controversy during the 2008 financial crisis. The liquidity that some hedge funds had been able to offer investors under normal market conditions was not available in times of market stress. Unable to meet a wave of redemption orders, many hedge funds imposed gates or separated illiquid or hard-to-value assets into side pockets. These contractual arrangements are not harmful to investors but investors need to understand them before committing capital. Having such redemption flexibility allows hedge fund managers to manage assets without being forced to prematurely close out their positions in less opportune times, to the detriment of their funds and their investors (for example, if a fund is forced into a fire-sale of its assets or if a run for the exit is permitted).