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.