New study on redemption gates requires a closer look
Dec 15th, 2008 | Filed under: Hedge Fund Industry Trends, Today's Post
Academic research on hedge funds can be tremendously valuable to investors. But with increasing complexity, comes a greater chance that research conclusions can be interpreted in many different unintended ways. For example, a widely publicized study released last week by Andrew Ang and Nicolas Bollen was presented by some as evidence that gating provisions themselves have a certain calculable cost.
As Reuters reported:
“In a paper titled “Locked Up by a Lockup: Valuing Liquidity as a Real Option,” Mr. Bollen and Columbia Business School’s Andrew Ang show that a manager’s right to block redemption requests “generates an implied cost of between 5% and 15% of the initial investment.”
This claim was likely based on the following statement in the introduction to the paper:
“…we show that a manager’s discretion to block redemption requests using gate restrictions or suspension clauses generates an implied cost of between 5% and 15% of the initial investment.”
Gate Provisions vs Gate Closures
Like Reuters, we read this to mean that the manager’s right (option) to cease redemptions was worth the equivalent of 5-15% of the value of the fund. But a more detailed reading of the paper left us with the understanding that the manager’s actual decision to halt redemptions - not simply their option to do so - had the effect of immediately decreasing the value of the fund by 5-15%.
Ang and Bollen put a price on the investor’s option to redeem at their freedom. The following table shows the value of a fund with a given volatility, a given likelihood of failure, and various expected mean returns (6%-14% per annum) under 5 separate liquidity regimes (columns from left to right: no liquidity, 2 yr lock-up + 3 month notice, 2 yr lock-up only, 3 month notice only, no restrictions at all). The numbers represent the fair value (in dollars) for a fund with a $100 NAV on the day of its launch (i.e. at “Age=0″).
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