Editor’s Letter – January 2015

Issue 101

Originally published in the January 2015 issue

Liquidity is getting worse in the credit markets, so we constantly hear about banks, brokers, dealers and market makers that are unable to hold as much inventory as they once did, apparently due to new regulations. So bid-offer spreads are widening; some assets trade only by appointment or on a matched basis; normal market sizes are contracting; and the traded price can be much worse than the quoted price. Does this represent any threat to the explosive growth of liquid alternatives?

The phenomenon of liquid alternatives allows asset managers to attract the widest investor base using vehicles, such as UCITS or ’40 Act funds, that may offer daily liquidity – or even in some cases exchange-traded funds (ETFs) or exchange-listed closed end funds (CEFs) that can be traded intraday. But none of this means that liquidity has to be priced at zero.

Liquidity has always carried some cost, and often this cost has been opaque and hidden. For a few years the International Financial Reporting Standards (IFRS) made these costs transparent and explicit by requiring fund audits to estimate the impact on valuation of marking longs to the bid and shorts to the offer. This bid-offer spread adjustment sometimes approached 10% for leveraged arbitrage funds, for instance. Since 2013 IFRS has ceased to require this disclosure, and from 2014 audits onwards there is also no requirement to break down the valuation method employed, on a look-through basis.

Fortunately this information can be obtained in other ways. In response to investor pressures, some auditors may be adding appendices to audits that will continue to disclose valuation methods, and bid-offer spreads. The Global Investment Performance Standards (GIPS) will also still require disclosures of valuation methods that have a very close fit with the level 1/2/3 hierarchy. However, it does seem that investors need to be more vigilant in ferreting out information on the costs of liquidating portfolios, or how they are valued, if this can no longer be taken for granted as part of audits.

To protect longer-term investors from the frictional transaction costs associated with portfolio turnover, fund governance bodies, including directors, are usually empowered to impose, or increase, bid-offer spreads, or entry and exit fees, on fund vehicles. It would not be at all surprising if fund directors, and other governance entities such as depositaries, did indeed decide to start setting, or raising, bid-offer spreads on those collective investment vehicles that are incurring material costs in relation to turnover. But this need not threaten the growth of liquid alternatives – it is merely an honest reflection of the costs of trading in some financial markets. The obverse of those costs is that heightened volatility increases opportunities for skilled managers to extract alpha.