The CIO of a European family office talks about the world of "liquid alternatives" and how investors should address this corner of the investments universe.
Liquidity comes at a price: we can see how investors are piling into private equity, debt and other non-public markets to obtain a premium for having money locked away for months or years. But there is a crop of funds playing in the hedge funds and private equity space that offer relatively high liquidity, such as pan-European UCITS funds which offer daily liquidity. To achieve this, the underlying strategies of such funds must be fit for purpose – some hedge fund strategies, such as distressed debt ones which take months to execute, are going to be difficult to fit in. Matching liquidity to risk tolerances is made even harder these days in a world of low or negative interest rates. Yields on conventional listed markets such as equities are squeezed. Citi Private Bank, for example, has recently stated that it is urging clients who want income to shift into dividend-paying stocks because bonds are such a poor investment.
So can the circle be squared? To answer that sort of question is Christian Armbruester, chief investment officer of the European firm Blu Family Office, who regularly airs views in these pages. The usual editorial disclaimers apply; readers who want to dive into the debate are most welcome. Email firstname.lastname@example.org and email@example.com
The very term 'alternative' has an inherent negative connotation. After all, it is not the first choice: it is more like another option, a detour so to speak, or something to consider as we already have something in place. Why would I want an alternative, if I already have what I want? Because it is always good business to consider all the available possibilities, particularly if it helps us to manage our investment risk in a more efficient way. So, here is a closer look at the investment universe defined as anything other than (listed) stocks and bonds. Clearly, art, cars, property, commodities, private equity or debt and anything held in hedge funds, aptly called alternative investment funds, is a big universe. Which is why it does not make any sense to categorise all of these different investments, strategies and products into one asset class. So, the first step is really understanding where the differences between the various types of investment possibilities lie.
One of the great things about stocks and bonds, is that they are traded on exchanges, which means that the investors can buy and sell them at any time. This is called liquidity, and it is what makes the difference from almost everything else we are going to explore. Buying a house cannot be completed within a day, as there are surveys that need to be done, contracts to be negotiated, and numerous documents that are required to be signed. Neither can we expect to make a profit by acquiring a company or a piece of art and trying to sell it the next day. One could argue that buying stocks is also a long-term game, but we are talking about risk here. So, leaving our investment horizon aside, we can persuasively conclude, that there is a premium being placed on liquidity. In other words, there is a value to being able to get our money back in an instant. Ergo, if we are willing to accept illiquidity, we should get paid for it. And this is where the cookie crumbles. By buying anything other than liquid stocks and bonds, we diversify our performance profile as we are getting paid for taking on a different type of risk.
Wonderful, but there are many other ways to make money or take on different risks in an investment world as large and unconstrained as it is. By shorting financial securities or using financial derivatives, we can play the market from both sides. This allows us to capture potential returns that are not accessible to everyone else. Foremost, those people who only buy things (as in stocks and bonds), and that’s part of the reason we make money. However, most of the returns that can be achieved by investing in so called market-neutral strategies, are a function of the inherent inefficiencies in the market.
Prices of financial securities go up and down on daily. It is part of the price discovery process as buyers and sellers determine the “market price”. In the past, we had auctions in town squares or specialised warehouses to sell our cows or other goods to willing buyers. Now, we have global financial exchanges. It’s all very efficient, you can do it from anywhere and it is entirely electronic. Whatever we make of the frantic changes in prices of the S&P 500, oil, or Tesla, clearly markets do not move up and down in straight lines. There are patterns, trends, reversals, squeezes, and many inefficiencies, as the markets find the equilibrium price (fair value) between supply and demand.
All of which means, there is money to be made. The only problem is, of course, if we get caught up in the same risk that most other people are taking. Which is why the only way to make these strategies work is by eliminating market risk, so that every individual mispricing can be extracted in isolation. Commonly known as alpha, or that which our financial textbooks cannot explain, it is the excess return and an excellent way to diversify our overall portfolio risk. But beware the pretenders, as there is a big difference in the price of alpha and beta and the last thing we want to be doing is taking on the same risk we already have, at a higher cost.
Everything else is just that, and entails taking disproportionate risks on very specific investment opportunities. The risk of so-called venture capital, special situations or event-driven strategies is simply that we get it wrong. However, we do receive a big payoff if what we think will actually come to pass. Putting it all together, we can categorise our alternatives investment universe into illiquid, market neutral and speculative. That’s great and makes perfect sense, but what of so-called liquid alternatives? That would mean that we get our diversification from stocks and bonds, we get the excess returns, and those risk premiums we are to receive for taking illiquidity risk. Yet we can still get out whenever we want, akin to the proverbial “free lunch”, and we would all like a bit of that. Unfortunately, whereas it has become quite chic to wrap everything and anything in so called UCITS funds, which offer daily liquidity, but you get what you pay for.
Think of it this way, if you buy and hold Tesla, you have to do a lot of research. But for the most part, once you have made your decision, the stock kind of sits in your portfolio until further notice. If you are trading Tesla against BMW, you have to time your entry and exit points precisely. It is very difficult to make money every day, and then there is the technology, infrastructure, leverage, borrow, margin, costs and fees that work against you as you try to make money from extracting tiny inefficiencies from the markets. To make this work, it is literally like inventing a money printing machine. So why on earth would you give it away? Why put yourself at risk of having people redeem on you, just as you are making your best trade? Why pay for more inefficiencies that the UCITS regulations impose on you, and why go to the extra expense of having to offer daily liquidity, when you don’t have to? There is a large difference in returns of strategies wrapped into alternative investment funds with monthly liquidity to those wrapped in UCITS funds offering daily liquidity, and there is a reason for that.
And what about listing private equity or private debt funds on exchanges? Yes, that would create liquidity from third parties, even though the underlying investments are illiquid. However, the basic problem still remains: market risk. The whole idea of making money in private transactions comes from investing for the long term. Whatever liquidity we may get in the short term, it comes at a price.
If you look at the performance of these types of funds during the crisis, they were down just like everything else and in line with the markets upon which they were listed. Wasn’t the whole idea to diversify this risk, as we already have that in abundance in our stocks and corporate bonds?
In summary, it is a big world out there. Don’t limit yourself to stocks and bonds, but don’t group everything else together and try to make sense of it. Always bear in mind, that risk is very efficiently priced in the market, there are no short cuts, and we are not going to re-invent the wheel. If there is a premium to be had for making illiquid investments, then we can’t expect to get paid the same returns for making liquid investments. Having said that, there are many ways to make money from these markets and this amazingly diverse and wonderfully opaque investment universe. Happy hunting!