Study finds many hedge funds simply hold back liquidity to power returns
Nov 26th, 2008 | Filed under: Performance, Analytics & Metrics, Today's Post
With hedge fund redemption gates now being shut with increasing frequency, it has become vogue to question the ethics, if not the very legality, of “not giving investors their money back.” But holding onto investors’ capital – assuming such a possibility is included in the fund’s O.M. – is actually neither bad nor good on its own. In fact, this illiquidity might actually have a fair market price according to a Swiss study.
After all, when a bank takes a term deposit, investors don’t get their money back for several years. Yet few people complain that these guaranteed investment instruments won’t give investors their money back. Instead, they simply demand (and receive) a higher return from these illiquid instruments.
A hedge fund O.M. with an optional redemption gate clause is analogous to a hybrid between a term deposit and a more liquid demand deposit. The price an investor should be willing to pay for that fund (or put another way, the return they should expect from it) should therefore reflect the possibility of the “demand deposit” essentially becoming a “term deposit”.
Although the likelihood of the manager shutting a redemption gate is a function of the size of investors’ redemption requests, the illiquidity of many hedge fund portfolios makes them more exposed to possible gate closures than more liquid traditional portfolios.
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For more on the topic of the impact of (i)Liquidty on risk please see the discussion and associated papers and spreadsheets on the discussion forum for Carol Alexander’s new four volume set at
http://www.carolalexander.org/phpBB/viewtopic.php?f=6&t=2
This incudes both the normal (‘gaussian’) and Cornish Fisher (‘modified’) VaR and CVaR numbers for simple returns at different holding horizons. Whilst it does not directly answer the question of liquidity premium it does give you a better idea of what the drawdown at risk or liquidity VaR you might be exposed to over a longer time horizon, also for the non-normal case, than simply scaling by the square root f time rule.