Liquidity Buckets, Liquidity Indices, Liquidity Durations and Their Applications to Hedge Funds
Ranjan Bhaduri & Christopher Art, AlphaMetrix Alternative Investment Advisors, LLC, Chicago.
Liquidity risk is the financial risk due to not being able to pull one’s money out of an investment instantaneously without market impact (ie, not having perfect liquidity).
A well-established fact from classical finance is that investors expect a premium, or liquidity premium, for investing in more illiquid assets [Damodaran 2002]. Hedge funds should not be exempt from providing a liquidity premium and one should not mistake the liquidity premium for alpha (Bhaduri, AllAboutAlpha.com 2007).
Mistaking illiquidity for alpha
Consider the following:
• Hedge Fund A has a two-year lock-up with annual redemption and trades in illiquid instruments.
• Hedge Fund B has no lock-up with monthly redemption and trades in liquid instruments.
• Both hedge funds have a five-year track year.
It is incorrect to merely compare the statistics (return, volatility, skew, kurtosis, omega, etc) of these two funds. Hedge Fund B allows the investor to get out of the investment sooner and this has a value that does not appear when one calculates the statistics. Due to the illiquidity and lock-up, Hedge Fund A should be furnishing a better statistical return. One needs to quantify the value of liquidity in order to make a fair statistical comparison. Otherwise, it really is comparing apples to oranges. One should not mistake the illiquidity of Hedge Fund A with alpha. Portfolio managers must ensure that they are being properly compensated to take on the illiquid assets.
Portfolio managers who merely compare statistics of Hedge Fund A and B are essentially giving the liquidity premium a value of zero. While one knows (or should know) that liquidity has a value, Bhaduri and Whelan demonstrated via the ‘Balls in the Hat’ game, that it is easy to underestimate the value of liquidity (Bhaduri & Whelan 2008).
In Emanuel Derman’s August 2006 paper ‘The Premium for Hedge Fund Lock-ups’, he calculated that the risk premium for a two-year lock-up over a one-year lock-up is approximately 1% and approaches a constant of 3% for longer lock ups (Derman 2006).
One may apply an option-pricing methodology into portfolio management in order to try to take liquidity differences into account (Krishnan & Nelken 2003 and Whelan & Bhaduri 2008). However, these techniques, though useful, can sometimes be difficult to implement.
President's Working Group Recommends Best Practices for US Hedge Fund Industry
Keith T. Robinson & Derek B. Newman, Dechert LLP, Hong Kong.
On 15 April 2008, two private sector committees established by the US President’s Working Group (PWG) on Financial Markets1 — the Asset Managers’ Committee and the Investors’ Committee — released separate but complementary reports setting out proposed sets of best practices for US hedge fund managers and investors. The report by the Asset Managers’ Committee is intended to set standards for hedge fund managers that are designed to reduce systemic risk and foster investor protection.2 The report by the Investors’ Committee, which is divided into a ‘Fiduciary’s Guide’ and an ‘Investor’s Guide’, is designed to set practice standards and guidelines for fiduciaries and investors considering, or already investing in, hedge funds on behalf of qualified individuals and institutions.3 These reports, working together, are meant to implement the PWG’s Principles and Guidelines Regarding Private Pools of Capital, issued on 22 February 2007 (the ‘Principles and Guidelines’).
These reports build on existing industry initiatives and draw upon insights from both US and non-US professional associations, financial services professionals and a wide range of institutional investors. For example, the committees consulted with the Managed Funds Association, Alternative Investment Management Association, major accounting firms and others during their drafting process. As such, many of the recommendations are already practiced by well-managed US and non-US hedge funds and sophisticated, diligent investors. However, as highlighted below, some of the recommendations involve novel and far-reaching practices that exceed current industry standards. Some of these recommendations may appear especially unfamiliar to non-US managers, as they draw from the principles applicable to US public companies and investment advisers.
In addition, it is important to note that these best practice recommendations are not binding and do not have the force of law or regulation. Rather, these recommendations represent the position that discipline on the part of all market participants (ie, hedge fund managers, investors and counterparties), not new regulations, is the most effective means of protecting investors and guarding against systemic risk. For example, in the Principles and Guidelines, the PWG recognised that ‘in our market-based economy, market discipline of risk-taking is the rule and government regulation is the exception’, while a senior Treasury Department official involved in the drafting of the principles noted that any new regulations would discourage innovation and risk-taking.4
Nevertheless, despite the voluntary nature of these recommendations, prior experience has shown that best practice recommendations such as these ultimately may serve as the basis for a subsequent legal and/or regulatory framework. As the former Securities and Exchange Commission (SEC) commissioner, Harvey J. Goldschmid, has warned, the industry may only be ‘two serious scandals away’ from vigorous legislation.5 Moreover, the standard of reasonable practice for hedge fund managers applied for purposes of regulatory or civil liability may change to reflect these best practice standards if a sufficient number of hedge fund managers ultimately implement the recommendations. Although non-US investment managers may fall outside the scope of any future US legal or regulatory framework, a strong market impetus to follow these best practices may develop if the reports have the intended effect of influencing investor behaviour. The reports place significant emphasis on roles of investors and counterparties, and pressure from these parties to hold US and non-US managers to the best practice recommendations may have an immediate impact on a manager’s operations.
Hedge Fund Legal Structures and Their Impact on Performance
Bhaswar Guptha and Edward Szado, CISDM, Isenberg School of Management, University of Massachusetts.
While there is a plethora of research on investment strategies, asset allocation and risk management, one area where academic research is scarce is the legal structure that a fund employs and the resulting differences in performance and risk. Hedge funds may be set up using a variety of legal structures and among the more common ones are open-ended investment companies, limited liability companies, partnerships (3C1), partnerships (3C7) and corporations. This article bridges the gap by examining performance from the perspective of the legal structure of the hedge fund. Using the Morningstar database, legal structures are examined at the strategy level. A probit model is formulated to examine whether or not performance and level of assets are influenced by the legal structure. The results show that while there are no uniformly significant differences between the performances and assets of funds using various structures, certain patterns hold as to the level of assets and legal structures.
Introduction
The hedge funds industry has evolved tremendously in recent years. According to the CASAM CISDM Industry Report1, assets under management in hedge funds have grown from less than US$50 billion at the end of 1990 to over US$2.2 trillion at the end of 2007. Much of these flows have come from institutional investors. According to Pensions & Investments magazine2, direct hedge fund investments as of September 2007 increased 67% from the year earlier, while investments in fund of funds increased 38% during that same period. With this asset flow, the hedge fund industry has received increased scrutiny in academic and practitioner research. While there is a plethora of research on investment strategies, asset allocation and risk management, one area where academic research is scarce is the legal structure that a fund employs and the resulting differences in performance and risk. This article bridges the gap by examining performance from the perspective of the legal structure of the hedge fund.
The choice of legal structure is certainly a critical decision. The general partner may choose to set himself/herself up as a limited liability company3 or corporation to limit personal liability. The rules on such choices vary from state to state. Offshore hedge funds are typically organised as corporations in the respective domiciles (such as the Bahamas, British Virgin Islands, etc). Offshore funds generally manage assets of investors who reside outside the US or the US tax-exempt organisations. If managers wish to cater to both US and non-US investors, a master-feeder structure may be the structure of preference. The US investors in a master-feeder fund typically invest in a domestic feeder fund which may be a limited partnership fund. The non-US and US-tax exempt investors generally invest in an offshore feeder fund which may be organised as a corporation. Both feeders invest directly into the master fund. An alternative to the master structure is a side-by-side structure or parallel structure. In this type of structure, the US investors typically invest in a limited partnership organised in the US and offshore investors invest in an offshore corporation. A major disadvantage to this type of structure is that it is more costly to operate and may not have as much leveraging power, since the total assets are separated into two pools. These different types of structures raise numerous tax, legal and other accounting and operational issues that are of immense interest to academics, practitioners and investors, but have only recently begun to be addressed in the literature available.
Shari'ah Compliant Hedge Funds: Commencing With First Principles
Michael J. McMillen, Fulbright & Jaworski LLP, New York.
Introduction and some initial considerations
Whenever, in response to inquiries as to my then-current product development efforts, I replied that I was working on a hedge fund that was compliant with the principles and precepts of Islamic Shar?cah (the ‘Shari’ah’)1, the immediate, usually unconsidered, response was, ‘it is not possible under the Shari’ah; this is one type of venture that will be eternally absent from Islamic finance’. This response stands in sharp contrast to the pervasive admonition so common in the Middle East that ‘all things are possible’, which is often uttered with a tone that is either immediately contemplative or denotes a strong possibility of future contemplation. The ‘not possible’ response was received from a broad range of business people, financiers, lawyers, accountants and others involved in Islamic finance. Importantly, however, this has not been the response of the Shari’ah scholars that will determine, ultimately, whether Shari’ah-compliant hedge funds will be implemented (or, restated, and presaging the analysis, when they will be implemented) and how hedging mechanisms used by Shari’ah-compliant hedge funds will be structured. In fact, a limited number of Shari’ah-compliant hedging mechanisms have been approved by prominent Shari’ah scholars for use by Shari’ah-compliant hedge funds.
What is the basis for the ‘impossibility’ response? Analytically, it must relate to:
(a) some essential objective or characteristic of hedge funds;
(b) the strategies used by hedge funds;
(c) the mechanisms used by hedge funds to conduct their business; and/or
(d) the manner in which hedge funds are operated in practice. This chapter will survey each of those bases.
Looking at the last basis first, it is clear that there is some negative sentiment based upon publicity with respect to the failures of, or misjudgments by, specific hedge funds and to recent regulatory efforts directed at hedge funds and fund managers. The concerns are exacerbated by the increasing size of hedge funds, with particular reference to the systemic effects of the failure of a large hedge fund. Yet, the amount of money under management has continued to increase dramatically, now reaching approximately US$2 trillion, with the fastest and most significant investor base growth being institutional investors, such as pension funds, endowments and foundations. The number of hedge funds has increased to approximately 9,000. Clearly, a large number of sophisticated investors perceive a positive benefit in the existence and activities of hedge funds. A survey of the popular press reveals recognition of the fact that abuses and misjudgments are uncommon as a relative matter. My discussions with those proclaiming ‘impossibility’ reinforce the assessment that their response does not relate to these infrequencies or related regulatory issues.
Skipping to the first basis, what are the objectives and benefits sought by hedge funds? Are those a cause of concern for the Shari’ah-compliant investor?