Julie Cooling |Contributor
Jan. 12, 2023
The Liquidity Tradeoff
Written by: Keith Black, PhD, CFACFA 0.0%, CAIA, FDP, Managing Director, RIA Channel
Institutional Investors vs. Individual Investors
What practices of institutional investors could individual investors adopt to improve their investment outcomes? Diversify, rebalance, invest for the long run, and accept liquidity risk.
If Harry Markowitz, the Nobel Prize winning founder of modern portfolio theory, was an advisor today, he would be encouraging his clients to diversify and rebalance. “The chief mistake of the small investor is they buy when the market goes up…and they sell when the market goes down. There are these poor individuals who are buying at the top and selling at the bottom; and the institutional investor is on the other side. Everything the small investor loses the big investor gains.”
Markowitz’s key finding was that portfolios should be highly diversified. By adding assets to a portfolio that have low return correlation to other assets in the portfolio, the risk of the portfolio declines below the risk of the average investment in the portfolio. Ideally, some assets in the portfolio would have positive returns at times when other assets have negative returns. The gains help to offset the losses and the risk of the portfolio declines. Diversification improves as a greater variety of assets are added to a portfolio. That is, owning a large number of stocks and bonds from around the world does not comprise a fully diversified portfolio, as adding alternative investments such as real assets, hedge funds, and private equity can bring an even greater degree of diversification to a portfolio. Many of these highly diversifying alternative investments are available exclusively through less liquid long-term investment funds.
Studies show that investors who sell at the depths of the bear market stay out of the market too long and miss a substantial portion of the returns earned at the start of the next bull market. Morningstar estimates that poor market timing decisions cost individual investors about 50 basis points per year from 2005 to 2019. The time-weighted returns to buy-and-hold investors exceeded the dollar-weighted returns to investor inflows and outflows in the same funds. Investors were more likely to sell in times of declining prices and buy in times of rising prices when it is more profitable and less comfortable to do the opposite. Morningstar research also shows that investor flows to allocation funds have less of a return impact. Diversified portfolios with a rebalancing plan tend to have higher returns than when investors try to time their entry and exit in volatile asset classes.
Holding assets for longer periods reduces trading costs and current year tax burdens, while increasing the probability of returns more closely matching the predictions of the long-term models. Investors who hold a diversified portfolio for ten years or longer are likely to come much closer to the modeled ten-year return than are investors who panic and reduce risk in a bear market.
While spending needs are a key driver of the need for liquidity, portfolio rebalancing also requires at least some portion of the portfolio to be held in more liquid assets. In rebalancing, investors return their portfolio to the desired long-term strategic asset allocation weights by selling the asset classes with the highest past returns that have become overweight in the portfolio, while purchasing the assets classes with the lowest past returns that have become underweight in the portfolio. Systematic withdrawals from the asset classes with the highest return are also a form of rebalancing that can reduce the overweights in the portfolio.
Accepting Liquidity Risk
Many investors can benefit from holding alternative investments and less liquid investments in their portfolios. At the end of 2020, alternative investments comprised approximately 12% of global investible assets. While many pension plans have allocations to alternative investments between 10% and 25%, many of the largest college and university endowments have more than 50% of their assets committed to alternative investment funds. In contrast, many individual investors have between zero and 5% of their portfolio dedicated to alternative investments, which maximizes their liquidity and underweights the potential diversification and return benefits of alternative investments.
One key benefit of alternative investments is improved portfolio diversification. While stock and bond prices tend to suffer during higher inflation and rising interest rates, real asset investments such as commodities, infrastructure, and real estate may be able to benefit during times of higher inflation.
While individual investors have demonstrated poor market timing decisions, some alternative funds have proven to make profitable timing decisions. The largest managed futures funds earned average returns of 18% in the year-to-date 2022, taking advantage of the year’s weak stock and bond prices and well-defined market trends. Of course, stocks handily beat managed futures and commodities in the ten years ending in 2021.
If an investor had allocated to real assets or managed futures investments before the start of 2022, their portfolio losses in 2022 were moderated as the alternative investments posted gains while stock and bond holdings experienced losses.
Another key benefit of illiquidity is that illiquid investments may have the potential to outperform liquid investments over long periods of time. Using quarterly returns from January 2008-September 2021, we see that private infrastructure, private equity, and venture capital funds all outperformed the S&P 500 with lower measured standard deviation and maximum drawdowns, while private debt had higher returns and higher risk than the investment-grade bonds tracked by the Bloomberg Aggregate Bond Index. The Preqin Private Capital Index, which combines private investment asset classes on a dollar weighted basis, shows that there is a diversification benefit by diversifying across alternative investment strategies as the standard deviation of the private capital index is below the dollar-weighted average of the standard deviation of the private equity, venture capital, real estate, private credit and infrastructure indices.
While these illiquid assets have less apparent volatility risk, investors are accepting liquidity risk and should realize that the net asset value of alternative investment funds doesn’t necessarily reflect the liquidation value or risk of the fund, as there is often no immediate liquidity offered at the stated price.
Why do alternative investments need to be illiquid? The simple answer is that many investments take years to produce profits at a higher rate than the publicly traded stock market. Investing in private equity and venture capital funds often requires a ten-year holding period. During this time, the companies held in the fund can grow revenues, reduce debt, claim market share, and reward investors who can wait the necessary years for the market cycle to return to a point when mergers and IPOs are more plentiful and can be completed at higher levels of valuation.
Similarly, a real estate development fund may take many years to transform properties from vacant land to newly constructed buildings to fully leased buildings with substantial cash flows. Once the buildings have been fully occupied and have shown a track record of lease income, the properties may be able to be sold for a much higher price than the construction costs, especially when they are sold at a time when real estate valuations are high.
While in this building phase, the ability to exit investments in private equity and real estate is typically not accessible at reasonable cost, as the fund managers need investors agree to long-term holding periods to improve the probability of higher long-term returns from the fund. Investors who agree to invest for a full market cycle are giving their fund managers a highly valuable tool in the ability to exit investments at a time when the market is paying higher than average prices for the investments held in the fund. That is, sell high.
Illiquidity is measured as either the time to exit an investment or the cost to exit a position urgently. Positions are less liquid when they take greater time or cost to sell. Many alternative investments require substantial time to exit and the cost to exit positions, if even feasible, can be significant. Illiquid investments, however, can provide expanded diversification, including into assets and trading strategies that produced profits in 2022 while stock and bond markets posted their weakest combined performance since the 1930s. Accepting a multiple year lock-up period where investors don’t have the ability to liquidate alternative investments allows investors to stick with investments for the entire period of their strategic asset allocation plan or a full market cycle without succumbing to the temptation to liquidate their investments near the bottom of the market after most of the losses have already been sustained.
This tendency of investors to buy high and sell low conflicts with the long-term nature of many alternative investments. In order to protect investors and focus on long-term returns, some alternative investment funds may choose to gate withdrawals. When withdrawals are gated, which must be specifically allowed in fund documentation, the fund manager will temporarily suspend withdrawals. For example, a hedge fund may require a hard lock-up, or a minimum investment period, of two years. Once the investor has satisfied this minimum investment period, they will typically be allowed to request withdrawals on a specific schedule, such as at the end of a calendar quarter with thirty days’ notice. Many credit-oriented hedge funds chose to gate withdrawals, or deny redemptions, in December 2008 and March 2009, even for investors who had satisfied the lock-up period and provided timely notice of withdrawal. The funds’ decisions to suspend withdrawals were justified by later market action. By preventing investors from selling assets at crisis market lows, and allowing withdrawals in the third or fourth quarter of 2009 after credit markets had recovered, preserved significant value for investors. That is, focusing on long-term investments, even at the cost of denying investors liquidity when demanded, can substantially improve long-term portfolio returns, meaning that gates can be beneficial at times when market liquidity is constrained. Allowing some investors to demand liquidity at crisis market lows could damage returns for investors who choose to remain as long-term investors.
Structures of Alternative Investment Funds
Investing in alternative investments is more complex than investing in stock and bond funds, so substantial education and manager due diligence is required before investing. Many alternative investments require a multiple year investment horizon, while fee structures can be substantially higher than found in liquid stock and bond funds. The dispersion of returns is also higher in alternative investments, meaning that the potential for very large positive and negative alpha is more likely in alternative investments than in stock and bond funds.
Alternative investments are generally available in a variety of fund vehicles ranging from long-term limited partnerships to liquid alternatives, with tender offer funds and interval funds somewhere in between.
The alternative investment industry started with private placement limited partnerships. These funds may be designed to only be available for qualified purchasers who are investors with more than $5 million in investible assets. When limited partnerships are only sold to qualified purchasers or accredited investors, the SEC views these as private placements exempt from many of the requirements of the Investment Company Act of 1940. As such, many private equity and hedge fund vehicles do not offer transparency of positions and have no limits on the degree of liquidity, leverage, derivatives, or concentrated positions held in the fund. Due to the greater investment discretion afforded these managers by the private placement exemption, investors are encouraged to conduct expanded due diligence to understand both the risk and return potential of each individual fund where they are considering an allocation. Private placement limited partnerships can be highly illiquid, as investors typically commit assets to a private equity or venture capital fund for their full life of ten years or more, while many hedge funds require an initial lock-up period of one to three years. While private placement limited partnerships are highly popular with family offices and institutional investors, the minimum investment amount ranging from $100,000 to $5 million or more per fund is not feasible for most or all accredited investors.
Stock and bond funds are daily liquid vehicles, with prices fluctuating on a daily basis. It is imperative that stock and bond funds set their net asset value very carefully, as investors can buy and sell funds at the net asset value on a daily basis. In contrast, closed-end private equity, venture capital, real estate, and infrastructure funds typically do not offer investor liquidity until the fund manager has sold an investment or the fund is nearing the end of its stated life. While private funds may appear to be less risky in the sense of measured drawdowns or standard deviations, the net asset values of these funds are not set using daily market prices but on quarterly or annual appraisals that can be shielded from the volatility of the liquid public markets. Because investors have little to no ability to redeem their holdings in these private funds and fees are determined by the value of investments sold and not the investments held, the NAV of private funds do not necessarily closely track the liquidation value of the assets held in the fund and volatility may be understated due to the appraisal process.
While the history and growth of alternative investments has been focused on institutional investors in the private placement market, there has been substantial growth over the last decade in alternative investments available in fund structures designed in compliance with the Investment Company Act of 1940. As such, they may be available to accredited investors and, in some cases, even retail investors.
Funds registered under the Investment Company Act of 1940 have protections not required of funds organized as private placement vehicles. ’40 Act funds require a published prospectus, transparency of holdings, and governance structures including an independent board of directors while shareholder votes are required to change liquidity policies or investment objectives. In addition, ’40 Act funds typically offer tax reporting on Form 1099, which investors prefer to the K-1 tax reporting offered by private placement funds.
Interval funds provide limited liquidity at stated intervals, such as 5% of assets during each calendar quarter. Tender offer funds provide liquidity at the discretion of the fund manager, which might be more liquid than a private equity limited partnership but less liquid than an interval fund. Investors must realize that these liquidity facilities are not guaranteed, at least in full, and should be viewed as an emergency exit opportunity rather than a casual decision to exit a fund. Institutional investors more frequently exit funds when they have lost faith in the fund manager than when they have a short-term view on market performance.
Interval funds and tender offer funds are often organized as regulated investment companies (RICs) with pass-through taxation properties. If a fund earns at least 90% of its income from capital gains, interest, and dividends and distributes at least 90% of that income to shareholders, no taxes are charged at the RIC corporate level.
Many interval funds and tender offer funds are available at minimum investments between $10,000 and $25,000. Private equity limited partnerships draw down investor capital over a period as long as three years and only call investor capital when required to close on new portfolio company investments. In contrast, investors in interval funds and tender offer funds can invest the desired amount immediately, putting their money to work more quickly than is typical of private equity limited partnerships. Interval funds and tender offer funds are typically continuously offered closed-end funds. When a fund publishes a daily NAV, investors are allowed to buy into the fund at a time of their choosing.
While interval funds and tender offer funds share many characteristics, there is a key difference in the liquidity offered by the two structures. Common liquidity terms of an interval fund are that the fund agrees to provide liquidity to investors at stated intervals, such as 5% of the fund value on a quarterly basis. Once the interval fund has stated redemption intervals in its prospectus, it is mandatory for the fund to continue offering liquidity on that schedule. Interval funds are a popular way for investors to get exposure to less liquid asset classes such as private credit. Interval funds may be more liquid than tender offer funds, so investing in private credit loans offering regular interest payments may provide cash flow to fund investor redemptions. If an interval fund is offering to repurchase up to 20% of its shares during each year, liquidity must be maintained through interest payments, maturity of investments, lines of credit, fund purchases from new investors, or holdings in cash and shorter-duration fixed income investments.
It is important for investors to understand the meaning of 5% quarterly liquidity. An interval fund offering 5% quarterly liquidity is required to repurchase up to 5% of its shares on a regularly scheduled quarterly basis. In any calendar quarter when, say, 3% of shares are tendered for redemption, all investor withdrawal requests will be fully funded. However, when more than 5% of shares request withdrawals in any given quarter, investors are not guaranteed that their full redemption request will be satisfied. For example, when 10% of shares request a redemption in a given calendar quarter, an interval fund offering quarterly 5% liquidity will provide each investor with a pro-rated redemption of half of their requested withdrawal amount. Investors whose withdrawal requests were not completely fulfilled may continue to request withdrawals in subsequent quarterly liquidity windows until their desired withdrawal is fully funded.
In any illiquid fund, there is a cost to providing investor liquidity. Interval funds, then, must be viewed as semi-liquid, as investors are not guaranteed the ability to redeem their holdings in any specific calendar quarter, as the liquidity available is dependent on the number of withdrawal requests submitted by the fund’s investors. There is a cost to providing liquidity, as holding more liquid assets to fund withdrawals will cause a cash drag on the fund’s returns. Cash drag is experienced when a fund reduces its expected return to facilitate higher withdrawals by holding, perhaps, 70% in higher returning and less liquid private credit loans and 30% in lower returning and more liquid cash. A fund expecting lower withdrawals may have a less liquid portfolio that is expected to earn a higher return by investing 90% in private loans and 10% in cash.
Tender offer funds often invest in less liquid assets than interval funds, such as private equity or real estate. It is expected that tender offer funds may offer less liquidity to investors than is seen in interval funds. While a tender offer fund may have offered 5% quarterly liquidity in the past, there is no obligation that it will continue to do so. There is no legally required size or schedule of liquidity in a tender offer fund, as the fund’s board must vote separately each time that liquidity is offered to investors. There may be quarters, or even years, when the board of a tender offer fund may not offer to repurchase shares of the fund. Those may be times when the fund is fully invested and has not recently sold or exited any investments or when the market is in crisis and selling assets would likely take place at a significant discount to the NAV at which each investment is held in the fund. When a tender offer for shares of the fund is declared, the stated terms of the offer will include the repurchase price, the timing when the offering is available to investors, as well as the number of shares that will be repurchased. While tender offer funds can be less liquid than interval funds, the liquidity offered by tender offer funds may be greater than the liquidity offered by a private equity limited partnership.
The final type of alternative fund, often called a liquid alternative fund, is a daily liquid open-end vehicle. While interval funds and tender offer funds require minimum investments of $10,000 and more and are often limited to accredited investors and qualified purchasers, liquid alternative funds have no minimum investments or investor requirements. Liquid alternative funds may be structured as open-end mutual funds or exchange traded funds, allowing investors to buy and sell shares on a daily basis. Because liquid alternative funds are available to retail investors, they must follow all of the regulations of the Investment Company Act of 1940. Notably, liquid alternative funds are limited to hold a maximum of 15% in illiquid securities, which are defined as securities that can’t be sold in seven days for a price close to net asset value. Other key restrictions in liquid alternative funds are limits on position concentration or leverage used by the fund.
As a result, liquid alternative funds typically don’t have a primary objective of investing in illiquid categories such as private equity or private credit that are the domain of limited partnerships, interval funds, or tender offer funds. Liquid alternative funds provide investors exposure to highly liquid strategies such as commodities, currencies, or hedge fund strategies such as managed futures, long-short equity, or long-short credit. While the holdings in liquid alternative funds are highly liquid, the investment strategies may provide substantial diversification to investment portfolios. For example, many commodity and managed futures funds posted gains in 2022 at a time when inflation was rising and stock and bond prices were falling.
Whether investors are allocating to limited partnerships, interval funds, or tender offer funds, they must realize that these illiquid investments can be quite different than stock and bond funds or even liquid alternative funds. Investors in less liquid alternative investments do not have the ability to redeem at specific times, meaning that rebalancing typically takes place only in the liquid portion of the portfolio. The apparent low volatility of some alternative investment funds does not reflect the true risk of the investment, as the standard deviation, beta, and correlation risks are substantially understated in funds that value investment holdings using quarterly or annual appraisals or acquisition costs of specific investments. While this illiquidity may seem like a cost to some investors, there is a long-term benefit in the potential for higher returns and greater inflation protection.
Investors should allocate assets according to a long-term strategic asset allocation plan that carefully takes their liquidity needs into account. While highly liquid stock and bond funds form the majority of the asset allocation of most investors, there may be a value to investing in alternative investments and less liquid fund objectives. As demonstrated once again in 2022, stock and bond funds tend to suffer during times of rising inflation and tightening monetary policy. Investors seeking greater diversification and potentially higher returns may seek out less liquid and more alternative investment strategies. Investments in real assets, such as commodities, infrastructure, and real estate may provide investors protection against inflation that can ravage the value of stock and bond portfolios. Investors, especially those with the income or assets to qualify as accredited investors, may be able to earn higher returns in private equity and private credit than the returns offered in more liquid stock and bond investments.
While many investors can benefit from the greater diversification and/or higher return potential that may be available from investing a larger allocation of their portfolio in less liquid and alternative investments, they are highly encouraged to educate themselves on the different fund structures, fee structures, and the differentiated risks that are encountered in these investments. Because the range of risk and return in alternative investments may be much wider than found in stock and bond funds, investors are encouraged to make sure that substantial due diligence has been performed on each investment opportunity before they make a commitment to invest.
Finally, investors who choose to allocate to alternative investments to access the potential benefits of greater diversification, higher returns, and greater inflation protection must realize that there is a liquidity tradeoff. Alternative investments are less liquid for a reason, as many investment strategies require substantial time to come to fruition. Investors who can’t commit to a long-term investment program should consider whether alternative investments are right for them. Hedge funds gate withdrawals and interval funds offer limited redemptions in an attempt to protect investors from demanding liquidity at inopportune times and to facilitate investments in long-term and less liquid assets. Illiquidity is a feature of alternative investments, not a bug. Those investors who criticize fund managers for abiding by the terms of their prospectus or limited partner agreement by refusing to provide liquidity at a time when that liquidity is expensive may not have understood the rationale for investing in alternatives in the first place.
Julie Cooling | Contributor
© 2022 Forbes Media LLC. All Rights Reserved
This Forbes article was legally licensed through AdvisorStream.