Liquid Alternatives and the 'Illiquidity' Premium: Perception versus Reality

Liquid alternative strategies can deliver many benefits. Among them, as the name of the investment vehicle suggests, is daily liquidity, which traditional hedge funds do not offer. However, this benefit has sometimes generated criticism as well, such as the suggestion that the daily net asset value (NAV) structure may compromise return potential. This concept is often called the “illiquidity premium,” which refers to the perceived advantage that a traditional, presumably less liquid hedge fund has in its ability to lock up capital for longer, and consequently invest in longer-duration assets that may have an enhanced return profile. This notion of “illiquidity premium” raises the question of the extent to which the majority of traditional hedge fund models actually utilize their ability to invest in illiquid holdings, a capacity which underlies the theoretical advantage of the illiquidity premium. Based on our experience and analysis, while some strategies by their nature may lend themselves toward less liquid holdings than others—distressed debt for example—many hedge fund managers that we review trade in highly liquid securities most of the time. This analysis suggests that the capture of any presumed illiquidity premium would be limited in practice, based on the real-life investment behavior of the traditional hedge funds that we observe. Traditional Hedge Funds and Liquidity DataThe perception of traditional hedge funds being illiquid likely stems from the legal terms they function under, which require in most cases a one-month to three-month notice period prior to redemptions. This represents illiquidity at a structural level, but not at a holdings level, which we believe has a more direct impact on performance and is where the supposed illiquidity premium arises. Mutual funds are required to invest at least 85% of their portfolios in liquid assets; for an “illiquidity premium” to exist for hedge funds one would assume their allocations would differ substantially in terms of the illiquid exposure. On the contrary, our analysis of the hedge funds we follow indicates that very few are significantly different, with only a handful regularly allocating more than 15% of their portfolios to illiquid holdings for a lengthy period (greater than three months). Again, some traditional hedge strategies, by nature, may lend themselves toward less liquid holdings, but in general our analysis indicates that many traditional hedge funds may not have the suggested advantageous exposure to illiquid holdings that critics assume. In the following table we look at the 83 long/short equity funds that we monitor. As the exhibit indicates, roughly 71% of the aggregate holdings in these funds could be fully liquidated within one to five days, 83% within 10 days, and 91% within 20 days. ur analyses of other strategies generate similar results. For the event-driven funds we monitor, roughly 87% of the portfolios’ holdings could be fully liquidated within one to five days, 91% within five to 10 days, and 96% within 20 days. For the global macro funds we monitor, roughly 93% of the portfolios’ holdings could be fully liquidated within one to five days (all as of June 2016). As previously mentioned, some trading strategies are less liquid by nature, such as certain specialist credit funds, but in general our data suggests these represent the minority. Given this, we suspect the performance advantage of hedge fund illiquidity may in practice be limited. Performance of Liquid Alternatives Versus Traditional Hedge Funds While our data sample was limited as the majority of liquid alternative products are still relatively young, we did conduct a rough empirical examination of the actual performance of liquid alternative funds versus their traditional hedge fund counterparts. In the following chart, liquid alternatives are represented by a sample peer group of multi-strategy, multi-manager liquid alternative strategies, and traditional hedge funds are represented by the HFRX Global Hedge Fund Index. Based on this analysis, we observed that liquid alternatives actually outperformed traditional hedge funds over the historical one-, three- and five- year periods, by margins of 244, 161 and 366 basis points, respectively. Again, we feel it is important to note that the sample size in the analysis is small and the time period somewhat limited. Over longer horizons, we may expect results to vary, with quite a bit of return dispersion between the proxies included in the sample. Nonetheless, if there were a consistent drag on the performance of liquid alternatives associated with any sort of illiquidity premium, we would reasonably expect to see some degree of evidence of this in the data sampled. In fact, we observed the opposite. Conclusion Liquid alternative strategies have grown in popularity, with their ability to provide exposure to hedge fund strategies and potential returns with low correlations to stocks and bonds, plus the added benefit of daily liquidity. Critics have charged that liquid alternative funds have weaker returns due to their inability to invest in illiquid holdings. We suggest — based on our empirical analysis of the underlying holdings of the hedge funds that we monitor — that this assumption is not entirely accurate; that in fact many hedge funds holdings are not illiquid, and that liquid alternatives performance is often comparable to traditional hedge funds. While differences between the two remain, and while it is important to continue to monitor and study these differences over time, it is equally important to distinguish fact from mere perception.

The information provided is not a complete analysis of every material fact regarding any market, industry, security, asset class or strategy. Opinions expressed are as of the date specified on the commentary and can change without notice. A portfolio manager’s assessment of a particular security, investment or strategy is not intended as an investment recommendation; it is intended only to provide insight into the manager’s portfolio selection process. Past performance does not guarantee future results. Given the rapid changes that can take place in markets and economic conditions, it is often difficult to provide up-to-date materials that address the most current situations. The comments provided are valid only as of the date of publication.