Alternative Investments: Diversifiers or Dangerously Illiquid?

(March 5, 2012) — Investors must remember that illiquid investments are not a substitute for liquid allocations, even if hedge funds are often sold as diversifiers, industry sources warn.  

“A fund of hedge funds approached me a few weeks ago. It had very nice, smooth returns, good protection in 2008, but it had a one year lockup! This is of no use to me!” Sam Kunz, the chief investment officer of Chicago’s Policemen’s Annuity and Benefit Fund, tells aiCIO. He noted that as his fund goes through volatile times and equities are hurt, for example, with such unfavorable conditions, he cannot use a fund of hedge funds allocation as a substitute to offset cash flow needs. “I’d still need to sell my equity,” he says, and “thus, the diversification benefits [of FoHFs] look good on paper, but in such instances they might not be very useful from a practical point of view.”

Two papers support these concerns — a 2007 paper by Emanuel Dermanan for the Journal of Investment Management and a 2011 article published in the Journal of Alternative Investments by Eric Hirschberg.

Dermanan’s paper — titled “A Simple Model for the Expected Premium for Hedge Fund Lockups” — notes that in recent years, hedge funds have tended to demand increasingly longer lockups. “This illiquidity comes at a cost: the inability to invest one’s money in other ways,” the paper says. 

It continues: “A fund with a lockup deprives the manager of this redemption option, and must provide a correspondingly higher expected return as compensation.”

Meanwhile, Hirschberg’s paper titled, “The Four Agreements of Terms and Conditions: Lockups and Transparency”, explains the conflict over lockups among hedge funds as follows:

“Providers of risk capital (‘investors’) and employers of risk capital (‘managers’) are often at odds over the terms and conditions that each party believes are in their best interests. Providers typically want high degrees of liquidity and transparency with compensation-based performance measures infrequent as possible. They believe that high degrees of liquidity protect them from manager-induced style drift, adverse market liquidity, and capital reallocation opportunity costs. Managers, on the other hand, typically want long periods of committed capital, minimal transparency, and frequent compensation-based performance measures. They believe that capital lockups let them provide liquidity when others are demanding it, allocate to investments more rationally, and maintain investment infrastructure and human resources during adverse investment periods. Minimal transparency aids in maintaining proprietary investment techniques.”

According to Hirschberg, while each participant’s desires are optimal for the role they have undertaken, it is far from clear that either is in the best interests of the capital itself.  

“Investors want one thing and managers want another. Hirschberg is absolutely right,” Ross Ellis of SEI asserts, noting that while, at the extreme, managers want to lock up money for as long as possible and give minimal transparency, investors don’t want to be trapped. “Lockups and infrequent redemption terms are off-putting to investors because they can’t control the exit strategies of their investments and some don’t want to take that risk.”

In response to Kunz’ concerns over illiquid investments, Ellis notes that a FoHF is typically just one portion of a portfolio. “If you want liquidity and are investing in FoHFs, you can use the rest of the portfolio to accomplish that — so the statement is correct if we’re talking about a large allocation to FoHFs, but probably not something to worry much about if it were 5% to 15%.” He adds: “It still doesn’t feel like we’re in a sustained recovery, so investors are forced to take risks in large part because we’re getting nothing on the fixed-income side. The nature of the beast right now is that you have to look at more illiquid investments and go further out with regard to lockup periods or expected payback in hedge funds and private equity.” Investors are more willing to give managers longer lockups – in exchange for lower fees – because it’s may be the only way to generate the returns they need , Ellis says.