Not least, investors are becoming increasingly savvy about whether they really need to take the risks associated with illiquid investments and pay the high costs associated with typical hedge funds structures for strategies that are liquid in nature.
“The theoretical arguments behind the illiquidity premium really are true in practice,” states Laurence Wormald, head of buy-side research for risk management technology provider SunGard. “You get more alpha if you are willing to give up some liquidity. It’s very real and you cannot get around it, but that doesn’t mean you should be overpaying for something that is liquid.”
Although the illiquidity premium is irrefutable, that doesn’t always translate into greater returns for investors.
As Annabel Gillard, director of fixed income at M&G Investments says: “There is an illiquidity premium, but it’s a question of who is getting that premium. Are investors taking the illiquidity risk without getting paid for it?”
Taking the example of equity long/short hedge funds, before the introduction of UCITS IV these strategies were predominantly offered through traditional hedge fund structures with their associated illiquidity and high fees. Yet the strategy is relatively liquid, making it well suited to a UCITS structure. In fact Deutsche’s research showed fundamental equity long/short to be the most popular strategy for investors allocating to alternative UCITS and US 40 Act mutual funds.
In this case, the illiquidity of a traditional hedge fund structure is less likely to fully reward investors for assuming that risk, especially net of fees.
“Investors should get a premium for giving up liquidity, but it depends if that illiquidity is necessary,” Wormald says. “Equity long/short portfolios are liquid so investors shouldn’t give up too much. Liquidity risk on equities usually accounts for basis points rather than percentage points in returns.”
‘SAVVY’ BREEDS EFFICIENCY
As investors’ understanding of hedge funds and the nature of their returns grows, it becomes increasingly difficult for managers to successfully impose less liquid structures on their clients.
“Over the last 10 years people have started to really understand the risks associated with hedge funds,” Viebig says. “They understand more now that a large component of hedge fund returns are not due to skill, but to the risks related to the strategy a fund manager is following.”
If a large proportion of returns are not due to alpha (manager skill) or illiquidity risk, then it is the manager, not the investor that is benefiting from an illiquid hedge fund structure. In that case, more investors should be allocating to liquid structures to increase the efficiency of the liquidity risks they are taking.
When hedge fund fee structures are brought into consideration, the arguments become even more compelling. Cost efficiency of alternative investments has become a priority for investors in recent years and particularly post-crisis.
Mutual funds generally charge flat fees, as opposed to the dual management and performance fees typical of the hedge fund sector and management fees also tend to be lower.
According to Fred Ingham, head of international hedge fund investments at Neuberger Berman: “Looking at the long term, performance fees have been a significant cost to hedge fund net returns. For example, if you take a hypothetical 10% gross return, net of a 2% management fee and 0.5% of expenses, you are left with 7.5%. If you then deduct a 20% performance fee, there is another 1.5% cost and the investor is left with a 6% net return – not far off the 10-year returns of the HFRI Composite Index in the decade to the start of this year. So stripping out the performance fee could be a material cost saving for alternative structures which adopt this approach.”
Considering the lower fees on liquid alternatives, by pushing for products in this area investors have significantly increased the cost efficiency of the risk they are allocating to some strategies by cutting unnecessary illiquidity risk and pushing for lower fee structures.
OPPORTUNITIES IN LIQUID ALTERNATIVES
In some cases liquid alternatives can also broaden out the opportunity set for investors, something that looks set to increase as the space develops and new financial markets emerge.
For long-term investors, there can be significant opportunities created in more liquid areas of alternative asset classes like private equity and infrastructure, which are still dominated by illiquid underlying assets, by allowing investors to respond with greater speed.
According to Tom Joy, director of investments at the Church Commissioners for England endowment fund: “Liquid alternatives potentially have a place in an investment portfolio. During a crisis, for example, the discounts on private equity secondaries widen enormously and this more liquid form can be the best thing to go into. You need liquidity and dry powder to be able to do that.”
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