How to face liquidity risks across alternatives

Our panel weighs up the liquidity risks in hedge funds (An investment fund that uses alternative strategies to make a return).

Our panel:

Kelli Byrnes – Vice President within BlackRock’s Portfolio Analysis and Solutions team
Shane Balkham – Chief investment officer at Beaufort Investment
William Dinning – Chief investment officer at Waverton Investment Management

Alternative strategies, such as hedge funds, are considered to be the liquid end of the alternative-investment spectrum. This is as opposed to privately traded alternative assets, such as private equity and property.

Since the 2008 financial crisis, European investors have increasingly moved away from traditional fixed income and towards liquid alternative strategies that bring greater diversity to their portfolios (Citywire, October 2019). Rather than chasing returns, investors have shifted focus towards creating resilient portfolios that are perceived to be more equipped to withstand uncertainty. But are investors being overwhelmed by the choices available, the due diligence involved and some high-profile cases that have damaged public trust?

How easy is it to find the right liquid alternatives?

The investment toolbox available to retail investors has expanded enormously in recent years and continues to do so. The growth in passive alternative investments and the increasing growth in illiquid alternative assets (private equity and real assets, such as infrastructure) are two of the standout trends.

But liquid alternatives have fallen out of favour somewhat, despite hedge funds’ potential for low correlation to equity markets, which can minimise market exposure in uncertain times. Some of the public trust in liquid alternatives has been eroded by a series of high-profile cases where funds have apparently failed to adequately consider their liabilities and have been far more illiquid than advertised.

Risk. Due to its investment strategy an 'Absolute Return' fund may not move in line with market trends or fully benefit from a positive market environment.

Kelli Byrnes, Vice President, BlackRock’s Portfolio Analysis and Solutions team, has both a possible explanation and solution. “Finding strong and consistently outperforming alternative managers can be challenging,” she says. “The skill, time and cost associated with carrying out due diligence on such investments must not be underestimated. Retail investors can alleviate some of the cost and time demand in other areas of the portfolio, by using cost-effective, passive index strategies to invest in traditional equities and bonds.”

“This also allows investors to manage risk and use their risk budget for sourcing truly uncorrelated returns through alternative investments.”

Risk. While the investment approach described herein seeks to control risk, risk cannot be eliminated.

There are benefits to illiquidity

While liquidity could become an issue for alternative strategies considered liquid, many experienced investors point out that such issues are just as present in many traditional markets, such as the European corporate credit market (Citywire, October 2019). In addition, much of the press coverage tends to ignore the potential benefits that can be achieved through investing in alternatives.

“Funds doing things that people arguably wouldn’t expect them to do have definitely hit the headlines recently,” says Shane Balkham, chief investment officer at Beaufort Investment. ‘So now someone does a bit of research and goes: “These funds have a high level of unquoted stocks,” or “they’re highly illiquid,” and that’s damaging for the industry as a whole. Illiquidity, however, doesn’t have to be a bad thing. If you can get that income stream and potential return on capital and invest for the long term, you benefit from the higher returns that come with an illiquidity premium.”

Because of the potential returns from the premium offered by illiquid alternative assets and the opportunities they offer in unstable markets, investors feel there is an important regulatory balance that needs to be reached between preventing extreme scenarios and becoming overly stringent.

“One of the attractions of alternative assets is that they provide the potential for good returns, both in terms of income and capital, that, in my opinion, you don’t find in traditional assets,” says William Dinning, chief investment officer at Waverton Investment Management. “Whether it’s a pension fund, an individual systematic investment plan (SIP), or whatever it is, we need to encourage investors to be able to access that opportunity, rather than discourage it. So, I hope the industry doesn’t end up being overzealous. A lot of it perhaps comes down to education, and perhaps the regulator has a role to play there, rather than just saying no.”

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One of the attractions of alternative assets is that they provide the potential for good returns, both in terms of income and capital, that, in my opinion, you don’t find in traditional assets.

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William Dinning, chief investment officer at Waverton Investment Management

Understand the liquidity of your fund investments

Successful alternative investing is about striking a balance between maximising illiquidity premiums and the number of liquid vehicles required to offset this. For new investors, BlackRock’s team believe the process of identifying the right funds and minimising risk comes down to regularly communicating with fund managers and finding those who weigh up the need for liquidity both from their underlying investments and liabilities.

Risk. A Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair.

“Just knowing what your fund’s actually doing is ever more important,” says Byrnes. “If all of the funds’ money is held up with a couple of investors, their potential demand on liquidity could be much larger than if there’s a very diversified set of investors who are holding that fund.”

BlackRock’s alternatives team believes liquid alternatives may offer substantial benefits from a risk management perspective and an absolute return (a positive return regardless of an index return), as their low market correlation means they minimise market exposure. However, they feel it is vital for investors to look beyond the Undertakings for the Collective Investment in Transferable Securities (UCITS) stamps and conduct their own research into whether a fund has the appropriate liquidity.

“This is definitely something we spend a lot of time thinking about,” says Alex Orr, a director within BlackRock’s alternatives specialists team. “Within that comes the capacity of these strategies as well. Not just to make sure that you’re running these funds at the right size so you can deliver the right returns, but that you have the right levels of liquidity.”