Are all hedge funds illiquid and opaque?

Nov 2017 by Joe Burns

Transparency varies by investment strategy. At a minimum, investors should understand the primary return drivers and risk factors in each underlying investment. These can be analyzed qualitatively, statistically and operationally.

From a qualitative perspective, investors should understand the specific holdings (long and short, where applicable) along with the construction of the overall portfolio including position sizing; regional, sectoral and stylistic composition of the fund; and the liquidity, concentration, leverage and complexity of the overall strategy.

Statistically, beyond a simple assessment of historical returns, investors should feel comfortable with the risk-adjusted performance profile relating to their pre-investment and forward-looking expectations. This includes an analysis of realized volatility, drawdown potential (ex-ante and ex-post), market beta (dependency on broader markets driving returns), correlation with other holdings within their portfolio, and contribution to returns from alpha, or manager-specific performance above and beyond a relevant benchmark.

Investors should also assess the operational capabilities of each firm, regarding their internal policies and procedures, pricing and valuation methodologies, connection with top-tier service providers and commitment to institutional best practices in managing not only an investment fund, but an overall business. Too often investors rely upon realized performance and extrapolate future returns when making an investment decision. Drilling into the sources of return, the statistical robustness of the performance and the strength of each firm’s operational business processes is as important, and likely more predictive in assessing the future impact of each investment within a diversified portfolio.

When correlations compress and assets move in tandem, it stands to reason that investors prefer cheaper, more liquid alternatives. This phenomenon has given rise to the trillions of dollars allocated to passively managed index-tracking ETFs and the like. Consequently, many investors effectively barbelled their portfolio into (daily) liquid funds and long-dated private markets, in large part due to the relative underperformance of hedge funds during that high correlation market of 2009-2015. Over much of the 2016-2017 period however, hedge funds have benefitted an increasing opportunity set, with many strategies offering monthly or quarterly liquidity to investors.

Hedge funds are illiquid as compared to mutual funds, as they should be. They are also far more liquid (in most cases) than other alternative investment strategies. The key for investors is to assess the liquidity of their overall portfolio, with the ability to make informed decisions via access to detailed market-level information and fund-specific due diligence that certain advisory firms can provide. Accessing high-quality, high-performing funds that are comparatively liquid and transparent can result in higher returns, and improve risk-adjusted performance over the long term.