OCTOBER 2010                                                                                                                             Download PDF Version

Liquidity: time to evolve?


The fight for liquidity may not be a battle worth worth winning. Investors must not be blinded by the ‘liquidity terms’ apparently offered by new funds and should instead take a more strategic view. This may be the time to invest in longer lock-up funds and enjoy the ‘illiquidity premium’.

I had lunch last week with one of the doyens of the fund-of-fund world. His comment that resonated most was his assertion that “investors currently have an atavistic fear of illiquidity”.  This statement bothered me for a couple of reasons; first english was not this man’s primary language and he had used a word that sent me scurrying to the dictionary and, secondly, the requirement for liquidity may no longer be in investors’ best interests.

I had been considering the liquidity question since meeting with a family office which only invests in segregated accounts and investments with long lock-up periods. Although their portfolio had problems in 2008 there was very little they could do, instead they reminded themselves of the original rationales for making the investments. By 2009 and certainly when I met them in 2010 they were very happy that they had not had the ability to tamper with the portfolio which had withstood 2008 well and was now above its pre-crisis level.

A family office approach
While the above example is an extreme case there are good reasons why private investors should invest with the family office mindset. A family office will normally make a strategic investment with their holding period being a minimum of three years. This may not ever be explicitly stated but is implicitly understood both by the family office and the fund manager; this is the reason fund managers prize family offices above most other investor groups.

Such investments will have been made following considerable due diligence both into the asset class and the underlying manager. Investors smaller than family offices (most of us!) would do well to invest following the same principles as it has regularly been shown that portfolios with lower turnover but which are correctly allocated perform consistently better.

Why not lock?
If investors can admit to having a 3-year time horizon why would they not consider locking themselves into a fund for this period? 2008 clearly illustrated that one of the main and misunderstood risks of investing in funds was the irrational reactions of co-investors. Investors with shorter investment horizons can totally unbalance a fund, to the detriment of co-investors, by rushing to the exit at the worst possible moment.

A perfect example is the Asset Backed Lending space. This asset class is clearly illiquid and funds with monthly liquidity were never going to be able to meet this requirement should there be a mass exodus. In 2008 this is exactly what happened. If a number of these funds had been locked up and had investors not had the ability to try to redeem the subsequent collapse in this sector would have been avoided.

UCITS concerns
However, instead of the more sensible approach of matching investors who can handle illiquidity to suitable funds the industry is heading in the opposite direction by creating even more liquid structures; this is most clearly the case with the burgeoning UCITS universe.

UCITS are funds which mirror the strategy of their offshore fund counterparts, however, in all cases give investors intra-month liquidity. This liquidity is to be applauded if indeed the strategy itself can warrant it. However, it seems that less and less liquid strategies are being shoe-horned into the UCITS format just as a fund raising exercise. If a fund strategy can provide redemptions more regularly than once a month then the offshore counterpart should also offer this; if the fund strategy cannot then the investors in the UCITS fund must fully investigate how this liquidity is being provided.

In fact investors should actually be fearful of liquidity not illiquidity and they and their advisors should now be looking for the premium they can achieve for taking a longer-term view.

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