Liquidity drain: How to face liquidity risks across alternatives
Although investor sentiment has recently shifted away from liquid alternatives, their low market correlation can minimise market exposure.
Since the financial crisis, European investors have increasingly moved away from traditional fixed income and towards liquid alternative strategies as a portfolio diversifier. Rather than chasing asset class returns, investors have shifted focus towards creating resilient portfolios that are perceived to be more equipped to withstand uncertainty.
The investment toolbox available to investors has also expanded enormously in recent decades, and continues to do so, as Kelli Byrnes, consultant within BlackRock’s portfolio analysis and solutions team, points out. The growth in index instruments, as well as an increasing growth in alternatives allowing access to illiquidity premia, are two of the standout trends.
‘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. If there is limited capacity for this in the investment process, we encourage clients to seek efficient alternative fund-of-fund or multi-strategy investments, or alleviate some of the cost and time demand in other areas of the portfolio, by using cost-effective index strategies within the long-only equities and fixed income sleeves.
‘This also allows investors to manage risk and use their risk budget for sourcing true uncorrelated alpha through alternative investments.’
But in recent years, 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, particularly in liquidity terms.
Jessica Milsom, Senior Associate at Stonehage Fleming
Benefits of liquidity
However, while there are risks associated with liquidity, many experienced investors point out they are just as present in many traditional markets, such as the European corporate credit market. In addition, much of the press coverage tends to ignore the potential benefits that can be achieved through investing in alternative assets.
‘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,” or “they’re highly illiquid,” and that’s damaging for the industry as a whole. Liquidity 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 illiquidity premium.’
Because of the potential returns from illiquidity premiums 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 they provide the potential for very good returns, both in terms of income and capital, that I think traditional assets aren’t able to do,’ says William Dinning, chief investment officer at Waverton Investment Management. ‘Whether it’s a pension fund, an individual SIP, or whatever it is, we need to encourage investors to be able to access that opportunity, rather than discouraging 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 in terms of educating, rather than saying no.’
‘One of the attractions of alternative assets is they provide the potential for very good returns, both in terms of income and capital, that I think traditional assets aren’t able to do.’
William Dinning, chief investment officer at Waverton Investment Management
Balance and flexibility
Being a successful alternatives fund is always going to be a balancing act between maximising illiquidity premiums and the amount of liquid vehicles required to offset this. For investors, BlackRock’s expert team believe the process of identifying the right funds and minimising risk, comes down to regularly communicating with managers and finding those who weigh up the need for liquidity from both an asset and a liability perspective.
‘Just knowing what your fund’s actually doing is ever more important,’ says Byrnes. ‘If all of the fund’s 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. Funds need to be responsible, and if there’s a potential mismatch in the liquidity they’re offering in the underlying, that has to be noted, and you need to be aware of it.’
Because of such mismatches, analysts believe it is crucial to conduct regular due diligence on whether a fund’s structure is appropriate and challenge managers on why they think adjustments may be necessary.
‘We have been concerned for a number of years that a lot of strategies are being pushed into daily dealing vehicles,’ says Jessica Milsom, senior associate at Stonehage Fleming. ‘So we do our own independent checks of the portfolio. At the moment we’re in conversation with a weekly dealing fund that is potentially looking to move to a daily dealing structure, and we’re putting some of our concerns forward. From their perspective, they think the portfolio can handle daily dealing, but we’re asking them: “Why do you think investors actually need that? Why not give yourself a little bit more flexibility of the weekly structure?’’.’
BlackRock’s alternatives team believes liquid alternatives can offer substantial benefits from a risk management perspective as well as absolute return, as their low market correlation means they minimise market exposure. However, they feel it is vital for investors to look beyond Ucits stamps and conduct their own research into whether a fund has the appropriate liquidity and terms for the underlying investments.
‘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 from a liquidity perspective as well.’