Is illiquidity really all that bad?
Aug 9th, 2007 | Filed under: Hedge Fund Industry TrendsAs a recent Fed report and a recent book have pointed out, forced liquidations can often propagate a death spiral for leveraged investors as more and more assets are dumped to meet margin calls (see related posting). The Bear Stearns situation is a living case study for this phenomenon.
At the same time, commentators have derided hedge funds for investing in illiquid securities. By doing so, they say, hedge funds are setting themselves up for just such a situation. Liquid assets: good, illiquid: bad, they argue.
But is there anything inherently wrong with investing in illiquid securities? After all, private equity funds have done so for years. In fact, such investments are considered the key behind the success of university endowments (see related posting).
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Liquidity is overrated. Like David Swensen once said, “its never there when you need it, anyway”.
IMO, from what I’ve experienced and read, its not the illiquid instruments that matters during times of crisis; its whether the clients can tolerate the volatility in performance.
Clearly, the onus is on the manager to not overly focus his/her portfolio in an illiquid market, unless he/she can be nimble enough and have the foresight to see the crunch coming. Looking at past experiences, it is clearly not possible to see the crunch coming. So what should a manager and its investors do? a) Not be overly focused, b) have clients which understand the intricacies of the hedge fund’s operation, so come crisis time they don’t panic and press the sell button; much to the benefit of Citadel in Sowood’s case.
You gave good examples of Warren Buffett and Julian Robertson, which illustrate that investors in Buffett’s fund were smart and patient enough to weather the storm based on Buffett’s track record and investment style. But what happened to Julian, wasn’t his record superb too? Sure it was. But, during the last few years of operation the Tiger fund had a lot of issues on the operational and personnel level multiplied by the raging bull market of the 99’s. To learn more of the short comings at Tiger, I’d advise reading the biography on Julian Robertson.
Yaser
[...] All About Alpha writes “So it’s not illiquidity per se that causes financial distress, its a liquidity mis-match between two parties in the financial chain that can cause market dislocations.” [...]
The life insurance industry has been through all of this. This is what kills life insurance companies most of the time: illiquid assets, and liquid liabilities. There is a yield premium to illiquidity, which tempts companies to invest there, but when too many assets are illiquid, and liabilities are not, unfavorable credit market performance can lead to the insolvency of firms.
Regarding the FT article citing hedge funds investing in illiquid assets with short term funding…..hmmmm…sounds a bit too similar to the S&L debacle….borrowing short and lending long in a short term rising rate enviroment…
[...] Ein Beitrag zum Thema Illiquidität und Auszahlungen (Redemptions) bei allaboutalpha.com: Is illiquidity really all that bad?. [...]