Liquidity When You Need it - How Much is it Worth?
Locked-Up Money and Sailing Boats
It’s a bright day outside, and while you walk along the beach next to your new retirement home, you think about how much you will be enjoying the summer on the sailing boat that you are about to buy. When back home, you make a phone call. Your capital was locked up in a closed-end fund, and you need to get it out to make the payment for your long-dreamed sailing boat. The fund is quite illiquid, so at least 3 months will pass before the money is transferred to you, but that is alright, you were expecting it.
What you might have forgotten, is that such illiquid characters of an investment, require an expected return premium over that of liquid investments.
A few days pass, and the market for some reason collapses on itself. Worried, you call the fund manager. Losses are being incurred, but the rules remain unchanged: you will receive your money in 3 months. In the meanwhile, your investment is worth less and less by the day. So long for tanning on your sailing boat, you quietly accept that for another year you’ll be blocked on the beach.
Why is liquidity relevant to the current market?
We are currently experiencing unusual market circumstances. A large sell-off followed by an also quite large bull market, all within a period of 2 months. This had amazingly relevant impacts on the liquidity of various assets. We can see it for example in the graphs of the bid-ask spreads (the green lines) of Gold Futures (which skidded upwards by around 183%), and through those of the E-mini S&P500 Futures (with a spike of 160%).
This is true also for past disruptions and crises, for example in the fixed income market: the following chart shows the credit spread from 2007 to 2017, with clear increases in 2009 (following detailed market events as the Lehman Brothers collapse), with the subsequent liquidity freeze and European sovereign debt crisis in 2012.
It is also worthy of mention that central bank quantitative easing has caused an increase in liquidity, and therefore a fall in credit spreads at the root of the stabilization that can be seen in the graph from 2013 onwards.
Credit spreads are a strong indicator of the changes in market liquidity during a crisis. While this might not seem relevant when investing in a hedge fund (where the money is not managed by you), it is relevant for the fund manager in making his investment decisions, but also in financing his trading positions.
Introduction To The Paper
The authors: Gagnon, Lacroche, & Rémillard published the paper in 2011, fresh from the financial crisis. The academic paper shows us how much of an expected return premium the fund manager should gain when investing in illiquid assets. This is extremely important when we know that our money, could be locked up in such an investment for prolonged periods. This focus on the fund manager’s perspective is interesting and at the time very innovative. It makes the research gain a game theory aspect, as the choices made by the fund manager will be considered by the investor too.
They did this by creating a hypothetical world where hedge fund managers can choose to invest in either liquid or illiquid securities. At the same time, they apply a constraint: investors will redeem their money from the fund after a certain “stop-loss” is reached in their position’s value.
Their framework is straightforward:
- In a situation of market crisis, the fund manager invested in liquid securities can quickly exit the position and invest in the risk-free rate, thereby not reaching the stop loss level.
- Contrarily, the fund manager invested in illiquid securities will find it difficult to exit his position and this causes investors to redeem their investments as the minimum value limit is breached.
The models and parameters used
Firstly, the hedge fund returns for those invested in liquid securities were constructed through a normal distribution with the parameters we will discuss soon.
Secondly, the stop-loss barrier investors were predicted to redeem their funds from the hedge fund at between 80% and 90% of their position’s value. These values were consistent with the benchmark of “of knockout levels of most constant proportion portfolio insurances for structured products.”
Now the parameters:
- The expected return and volatility of the liquid hedge fund strategy were set arbitrarily by the authors. The returns were set at 8% (which at the time was considered a 4% to the Libor) and the volatility values remained between 4% (a stable market) and 20% (a volatile market).
- The returns of the hedge funds invested in illiquid securities though, were modelled as the sum of the liquid returns with a “liquidity risk premium”. Throughout their analysis, it was this liquidity risk premium which the researchers tried to estimate.
- The volatility of the illiquid strategy was modelled in an “autoregressive” form. While there is no need to understand this econometric term, it’s relevant to explain that the illiquid strategy’s volatility was structured by multiplying the liquid strategy’s one by a value greater than 1. The higher this value, the more the securities invested in were assumed to be illiquid.
- Three investment horizons were considered: 12, 36, and 60 months.
- Finally, the researchers assumed that the assets under management of the hedge funds were identical for both the liquid and illiquid strategies. This allows to construct a real-life scenario: the fund manager’s fees depend on the size of their AUM, therefore the identical AUM assumption served to annihilate any incentive the fund manager might have had to take on one strategy over the other. The model, therefore, searches for the liquidity risk premium that satisfied this equilibrium.
It is also assumed that once redemption takes place, the AUM falls in a straight-line manner and reaches 0 at the end of the liquidity lock-up period.
To the right are displayed one of the sets of results that the researchers reached. The values found are represented in basis points per year, and show the liquidity risk premium that should be expected given:
- The “Barrier” (the stop loss value we talked about earlier).
- The volatility of the liquid strategy (“unadjusted volatility”).
- The “AR(1) Coefficient” (this is inserted into the formula to derive the illiquid strategy’s volatility, the higher the more illiquid).
- An investment horizon of 3 years, and a liquidity lock-up timeframe of 3 months.
The two values highlighted in yellow show us two different scenarios that can be of interest. Within a stable market, for a highly illiquid strategy, a 4% premium is justified. On the other hand, at a very unstable market (which is what we have experienced in the last months), the illiquidity premium should be around 49%. That just comes to show how valuable liquidity can be in periods of crisis, under “turbulent market conditions”.
The researchers go further by explaining that liquidity risk premiums have option-like characteristics. Once the strike price is reached (the barrier), the quicker the investors can gain access to their capital, the lower the loss they expect to have. This justifies the fact that, as illiquidity and lockup time increase, so does the premium they require in their expected returns.
Understanding liquidity premiums is very useful, yet many inexperienced investors throw themselves into illiquid investments without such knowledge. While investing in securities one knows little about or doesn’t fully understand is certainly not the way to go, illiquid securities may be advantageous for these kinds of investors. Put simply, unknowledgeable often exit their positions too early: this is a behavioural/psychological issue. A contrarian view is that illiquid securities might not allow for this mistake to take place, as the investor remains locked into the investment for often long periods of time.
Through this academic paper, we have walked through the process of modelling liquidity premiums. Many factors influence these premiums, namely: volatility, lock-up time, maximum drawdowns before redemption, illiquidity of the asset, and investment horizons. It is clear that as circumstances change, so does the premium. Liquidity premiums must, therefore, be considered dynamic as factors such as volatility change constantly in the market, particularly in times of crisis. The investor must, therefore, be very considerate of how long he is willing to lock up his money, and what kinds of returns he should expect from illiquid hedge fund strategies. This said, the industry must find ways to render hedge funds more liquid, as this would benefit greatly the investment community, and allow for greater efficiencies in the market.
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