HEDGE FUNDS INVESTORS LOOK FOR LIQUID ALTERNATIVES / THE FINANCIAL TIMES COMMENT & ANALYSIS

Smart Money

February 19, 2014 8:46 am

Hedge fund investors look for liquid alternatives

By Stephen Foley

Redeeming funds can be a problem and investors want quicker access

It’s MY money and I need it NOW! Anyone who has watched daytime television in the US will recognise the phrase. It is screamed by the actors in an irritating but effective commercial for JG Wentworth, a finance company that pays people an immediate lump sum in exchange for income they would otherwise receive over time from an annuity or court settlement.

“It’s my money and I need it now” ought to be a rallying cry for investors in hedge funds too.

Hedge fund managers are clinging to draconian restrictions that limit investor redemption requests to once a month or even once a quarter and then allow them to dawdle in meeting those redemptions.

Often these restrictions have not seemed justified by illiquidity in the funds’ underlying investments, a suspicion that is rapidly being proven by a new generation of hedge fund rivals.

In many ways, it is surprising that this should still be an issue, because there was the start of an investor revolt after the credit crisis.

As markets plunged in 2007 and 2008, hedge fund managers found clauses that allowed them to put up “gates” and bar redemptions. That left university endowments, pension funds and individuals unable to pull their money, even though they desperately needed the cash to plug holes that had opened up elsewhere in their portfolios.


Exiting illiquid assets


All told, about 30 per cent of hedge funds imposed some restriction on investor liquidity before the markets bottomed in 2009. That prompted an outcry, and many institutions went as far as changing their rules to say they would not put money with a manager that could erect gates, so hedge funds with such provisions are in a distinct minority today.

Certainly, the more complicated the hedge fund strategy, and the more esoteric the investments that managers are making, the more difficult and costly it is for them to unwind positions to meet redemption requests. An intricate bet on divergent price moves in illiquid markets such as asset-backed securities or other credit instruments, for example, could be ruinous to exit in a hurry.

Even in ultra-liquid equity markets, activist investors such as Nelson Peltz’s Trian Partners tie in their investors for years, because it can take a long time to pressure companies into strategic change.

Aligning the redemption windows with the underlying fund investments therefore makes sense, but progress has stalled.

The truth is that liquidity provisions reflect the balance of negotiating power between institutional investors and hedge fund managers, just like fee levels do. As the research group Preqin notes, the largest hedge funds have the longest initial lock-up periods, even though they would be least damaged by redemptions.

This is one of the many reasons to watch the rise of “liquid alternatives”, mutual funds that offer hedge fund-like strategies in a vehicle that has traditionally been used mainly for investing in equities and bonds and can be bought or sold any day of the week.

The growing availability of liquid alts could yet change the balance of negotiating power in investors’ favour.

It is no coincidence that the strategy that has existed in mutual fund form longest, managed futures, is also the hedge fund strategy that will respond to redemption requests most quickly, often within a week.

One of the most popular flavours of liquid alts funds in the past year has been equity long-short, the oldest hedge fund strategy of all, which places both positive and negative bets on listed shares. Long-short hedge funds still typically take 30 days to return client money after a redemption request; their liquid copycats prove it can be done in one-thirtieth of the time.

Relative returns

There is also a new breed of “funds of hedge funds” in mutual fund form that give exposure to underlying fund managers with none of the redemption restrictions they would impose on direct clients.

Those underlying managers would protest they are providing mutual fund investors with access to only a limited number of their most liquid investment ideas, but the differences may not be as stark as once assumed. Increasingly, seeing the vast retail investor market open up to them, hedge funds are considering launching their own low-cost mutual fund products directly, following a lead long ago established by Cliff Asness’s AQR.

With inflows of $4.8bn last month, the six main categories of liquid alts tracked by Morningstar remain small, but they brought in 61 per cent more money than they did in January 2013.

Most large hedge funds remain reluctant to jump in, fearing – probably correctly – that launching a mutual fund would cannibalise their existing business and lead investors to question their high fees. But smaller performers, and copycats inside traditional asset management groups, are crowding in.

The “alt” in liquid alts might soon mean “alternative to hedge funds”.

Ultimately, it will be the relative returns that will decide this race, but there may well be stars on both sides of the liquid/illiquid divide.

All else being equal, who would not choose a liquid vehicle over one with gates and redemption windows and long notice periods, just in case of another crisis? After all, it’s MY money and I may very well need it NOW.

Copyright The Financial Times Limited 2014.