It is generally assumed that, if all investors play by the same set of rules, markets are highly efficient and therefore alpha opportunities are scarce.  But what happens when one group of investors faces artificial constraints such as liquidity requirements or cap size?  These exogenous variables can pervert market processes and create (repeatable) out-performance opportunities for those players with greater flexibility.  For example, some commentators have argued that the large cap bias of most pension funds creates a market inefficiency that under-prices small caps until their expected return beats large caps (or vice versa – that large caps are bid up to a point where there return drops below their “fair” price).  Others have argued that the long-only constraint artificially supports stock prices by preventing the downward pressure of short-selling.

Tim Price, CIO of Global Strategies at UBP and part-time blogger makes a similar case in his commentary this month.  He says that hedge funds’ obsession with short term liquidity perverts markets, creating an alpha opportunity for long term investors.  Says Price:

“…hot money investors with constraints over liquidity and a limited short-run tolerance for loss are handing alpha opportunities over to long-term investors with emotional discipline. Given the $2 trillion now widely accredited to hedge funds (and the likely associated leverage), ‘crowding out’ and hyper-competition within the short-run trading community (or at least those managers offering apparently attractive liquidity terms) may now represent a compelling opportunity for longer term real money investors with a reasonable sense of patience and emotional discipline.”

While this may sound like another case of hedge funds missing the forest for the trees, both of these situations (crowding of large caps and crowding of short term trades) can also be viewed as the result of differing utility curves.  One could argue that all investors actually receive the same level of utility – even if one group is racking up financial gains at the expense of others.  In other words, the large-cap-loving pensions are perfectly content to watch small cap opportunities pass them by because they receive utility from the (perceived) stability of major corporations.  Turns out, the guy in the sideshow carnival booth was right, “Everyone’s a winner!”.

Arguing that one group of investors (of the short or long term persuasion) represent the sane majority may be a mug’s game.  While short-term investors may face fewer great investment opportunities, they achieve what they set out for: liquidity.  Sure, you could argue that desire for liquidity is poorly-founded, but it exists nonetheless (as expressed by asset flows into hedge funds).  After all, interest rates themselves are an expression of the market’s arbitrary desire for liquidity now vs. liquidity later.  Those investors who happen to want more liquidity now can’t really be described as falling victim to those who use their capital to invest at higher rates and take liquidity later.  Indeed, the short-term crowd elected to sacrifice returns in favour of liquidity by investing for the short term.

Or did they?  Sacrificing returns for liquidity might be an active decision in aggregate, but an accidental one for individual investors.  So perhaps the more salient questions for hedge fund investors are: “Does a particular fund actually address the utility preferences of its investors?”, or “Is ‘crowding’ causing the return potential of a short-term fund to degrade to a point where even liquidity-seekers aren’t getting the (lower) minimum returns they require?”.

- Alpha Male