With hedge funds, two types of liquidity must be considered. One is position liquidity, the other is fund liquidity. On position liquidity, the issue is how readily can the instruments used in the strategy be converted into cash at a known value? Contrary to common expectations, good position liquidity cannot generally be expected to aid a manager in exiting a position quickly enough to avoid the bulk of a price movement when unexpected information comes into the market. However, there are significant benefits to trading in liquid instruments, including lower trading and shorting costs, ease of fund-level cash management, and generally smaller price movements for a given volume of selling or buying. Against these liquidity benefits, the costs of position liquidity must be weighed by the manager and the investor. The greatest of these is a price premium, and thus a return discount, that is often witnessed in more liquid assets (the price differential between on-the-run and off-the-run bonds is one example of this).

On fund liquidity, the issue is how quickly do stated terms allow an investor to exit a fund investment, what actions can a fund manager take to delay an exit beyond stated terms and what will the impact on market prices and remaining fund liquidity be in the event of other parties exiting the fund? It is particularly important to consider ‘remaining’ fund liquidity, as a fund with some liquid and some less liquid investments could sell off its liquid investments to meet early redemptions, leaving remaining investors with a lower liquidity profile.

Liquidity: the investor’s perspective
Theoretically, position and fund liquidity should be linked—the more liquid the underlying assets of the fund, the shorter the redemption notice period and lock-up (if any) should be; the less latitude a fund manager should have to gate or suspend redemptions; and the smaller the price impact and negative effect on remaining fund liquidity should be in the event of redemptions. Every asset allocator should take into account the balancing act between the often higher long-term returns of less liquid assets and strategies on the one hand, and the cost and cash-management benefits of highly-liquid assets and strategies on the other. A range of position and fund liquidity profiles have their place in investors’ portfolios. However, problems can arise when expected liquidity does not match actual liquidity.

This mismatch between actual and expected liquidity can occur for three primary reasons. First, changing market conditions can sometimes radically alter the position liquidity of previously liquid investments, as we saw in 2008. Second, a manager may, in normal market conditions, invest in less liquid positions than the strategy or stated redemption terms of the fund would seem to warrant, leading to problems when redemptions occur. Finally, the manager may unreasonably gate the fund or suspend redemptions. Whatever the source, mismatches can create problems in meeting obligations and can alter the liquidity of the fund for remaining investors. Ideally, investors should have the final say over the aggregate liquidity profile desired across their entire portfolio. To enable this, fund investments should provide liquidity in line with expectations. Transparency and control can help ensure this occurs.

Transparency, control and liquidity
The first component of good hedge fund liquidity management is position-level transparency—an investor or their agent should understand what is actually in the underlying portfolios of their hedge funds in order to get an accurate picture of liquidity. In normal market environments, transparency can give a picture of liquidity by analyzing trading volume or market depth at a particular point in time. This analysis should be accompanied by a more qualitative understanding of liquidity—utilizing knowledge of an asset class to form a forward-looking view of what depth looks like in times of market stress. This view can be formed by asking questions such as: how dependent is liquidity on intermediaries; who is the marginal buyer in the market; and how much leverage is typically inherent in the strategy? Timely knowledge of underlying positions can help monitor whether managers have strayed too far from an appropriate liquidity profile for their strategy and redemption terms, and can help investors understand how liquidity may change in times of market stress.

The second (and equally important) component is the ability to control investments as much as possible. Documentation that allows for unreasonable gates, suspensions or other liquidity-inhibiting measures can wreak havoc with an investor’s liquidity plans. It is important to note that gate and suspension provisions can be legitimately used to protect fund investors in the event of a radical change in market conditions. However, they should not be used to provide cover where a manager has overweighted securities that are less liquid than fund redemption terms would warrant. Rather, fund liquidity terms should be set up-front to appropriately reflect the liquidity of the instruments intended to be used in the strategy, and managers should not stray from that liquidity profile. Furthermore, gates and suspensions should be used for the minimum time necessary, and they should be avoided when their purpose is to keep investors locked into relatively liquid underlying investments solely because the manager believes those investments are undervalued and will later recover. Structures, such as separate accounts, that can enhance investor control over the fund; the presence of a strong, independent board; and the removal of gate terms in fund documents (unless absolutely necessary due to the liquidity profile of the strategy) can be important considerations for keeping actual redemption terms close to the stated liquidity profile of the fund.

The aggregate liquidity profile of a portfolio should be a top-down decision driven by the investor. Transparency and control can help ensure that investors’ liquidity is more closely matched by the actual liquidity of their hedge fund investments.

Clouding the liquidity equation

Lock-ups—provisions mandating a certain time period pass before redemptions can be requested—are puzzling aspects to the hedge fund liquidity equation. In cases where the underlying instruments are relatively liquid, investors should be reluctant to cede control of how patient they may be for a manager’s trade ideas to play out. While security price movements contain a significant amount of ‘noise’, and one can sympathize with a manager’s desire to guarantee a medium-term time window for trades to work, investors should be the final arbiters of when it is time to redeem.

If the central opportunity with a manager is to be in a less liquid universe, as that is where the manager’s strengths lie, it makes little sense to force the manager into more liquid investments over time. In such cases, investors should prefer a longer redemption notice period to a lockup.

Misha Graboi is an Associate Director working in Portfolio and Account Management in PAAMCO’s Singapore office.