JUNE 2011                                                                                                                                     Download PDF Version

End this Victorian Marriage


Liquidity remains a bone of contention between investment managers and clients, both of whom suffered, for different reasons, in 2008. Managers must seize the initiative and start to offer the correct terms without fear of losing their fee structures.

The relationship between alternative investment managers and liquidity can best be likened to a Victorian marriage. Both parties sleep in separate bedrooms and only meet when strictly necessarily and duty calls. The question is whether, in the 21st century, this relationship should not be modernized?

Broken Trust
Through 2008 investors often had portfolios of hedge funds which supposedly offered monthly or quarterly redemption. However, when the crisis hit a large number of funds could not meet their terms and locked up; some remain locked to this day. Investors were forced to manage their portfolios by raising cash from wherever they could. This meant that the managers who had performed well in the crisis and had maintained their liquidity profile were punished. 2008 produced this unfortunate double-whammy; the investors felt betrayed by the hedge fund community since their redemption terms could not be met; and the ‘successful’ hedge fund managers felt betrayed by investors who had ‘unfairly’ redeemed. 

Home Truths
Put at its most basic a fund’s redemption terms must mirror the liquidity of the investments into which it invests. The key question both investors and managers must now ask themselves is ‘What do we want?’. For the investors the answer seems to be that they want investments where the risks are visible and are no longer obscured by overly attractive liquidity terms. 

Misplaced Fear on Fees
For the manager the answer is the maintaining of their fee structure, the key pillar of their business. Investors are not yet querying the ‘traditional’ 2+20% fee structure and remain happy to pay for good performance. 2008 will have shaken out the mediocrity and those managers that remain and perform will enjoy these fees. Each party now has the opportunity to bring their Victorian marriages into the modern era and, as an example let us look at long-short equity managers, as they comprise the largest portion of the alternative industry.

The due diligence process for a long-short manager will no doubt cover all the appropriate areas; however, the decision on investment will hinge on whether the investor believes the manager is a first-class stock picker. Investors will invest because they like the manager’s best ideas not because they like his short positions. Also, when you analyse the majority of manager’s records they will have made the lion’s share of their return from the long book.

The fund manager, in most cases, spends a disproportionate amount of time and emotional energy on the short positions. They wrongly believe that the shorts allows them to justify their 2+20% fee, whereas investors might be happy to forego the short positions, retain the fee structure but enjoy greater liquidity. 

The truth is that long-short managers should certainly be able to give investors intra-month liquidity even if not running a long-only fund. Although their trust in their investors may have been shaken by 2008 investors generally suffered more. Managers should reward their investors for continuing to pay the fees by increasing their liquidity terms. Fees are only going to come into question if performance is disappointing and giving greater liquidity only increases the potential for a client to redeem, not the likelihood.

Stock Pickers Market
The current market is one where we at Clarmond believe active management will greatly outperform the passive strategies. Therefore forward-thinking managers should change their attitude to liquidity and give their clients what they want. If they do not they may find them having affairs with ETFs.

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