Years of record low yields on fixed income investments and frothy equity markets have led investors to stretch their risk tolerance in pursuit of higher returns. [1] Many investors have extended the maturities of their bond portfolios, for example, and ventured into credit with “junk” ratings. They have increased their allocation to equities to a percentage beyond their normal comfort zone. These shifts have yielded mixed results thus far and offer uncertain prospects for future returns. For a high net worth investor who can forfeit access to some of their cash for a preset period of months or years, private funds may offer the ability to enhance returns, in exchange for reduced liquidity. * 1
Over the past five years, it has not benefited investors on a risk-adjusted basis to invest in longer-dated or higher-yield bonds. Long-term Treasuries have returned only 1% more than short-term Treasuries in the past five years [2,3], and high yield bonds outperformed investment grade by a similar amount. [4,5] In both cases, the riskier approach experienced far more volatility including significant declines in asset value during market shocks such as the 2013 “taper tantrum” and the 2014-15 energy rout.
Market conditions have improved since then, of course, and it is easy to get caught up in the exuberance of the “risk-on” Trump trade, which in the past few months has rewarded high yield credit and pushed equity markets to record highs. But when the next pullback comes— and they always do — an investor will likely be exposed to more than just declining asset values. They will also be vulnerable to the emotions and actions of the other investors in their funds. For example, when high yield credit pulls back, many investors in open-end high yield bond funds tend to quickly redeem their shares, causing fund managers to have to rush to sell securities to raise cash. This hurts all the investors in those funds - not just the redeeming investors, but also those that remain invested.
Investors in private funds, and more specifically in limited partnerships that are open only to Qualified Purchaser investors, can gain access to the same underlying assets. Private funds are often less liquid than daily liquidity mutual funds. Hedge funds, for instance, may allow redemptions monthly, quarterly, or annually — it depends on the securities and the underlying strategy. Private equity funds, including buyout, real estate and venture capital, as well as private credit funds engaging in strategies such as direct lending, typically have a much longer lockup, ranging from 5-10 +years. ** 2
Why would an investor choose to invest in a less liquid fund vehicle to access a similar underlying asset? One reason might be access to a particularly talented hedge fund or private equity fund manager. Another reason might be that very illiquidity -- for investors who do not need immediate access to the capital they are deploying here, choosing an illiquid vehicle can confer significant advantages.
Structures with long lockups can appropriately match the term of the fund to the length of time required to cultivate and dispose of assets in a value-maximizing way. Unlike in a daily liquidity vehicle, these structures allow fund managers to run their portfolios more fully invested, with less cash on hand on a regular basis, which can reduce the “cash drag” on a fund's performance. Lockups also forestall panic-driven redemptions and protect investors from not only their own potentially self-defeating behavior in times of market stress, but also from that of their fellow fund investors. Private funds that trade actively, i.e. hedge funds, impart to their investors an additional benefit by being a source of patient capital in an otherwise impatient market. Returning to the example of the high yield bond mutual fund that is forced to liquidate bonds during a market sell-off, it is worth noting that hedge fund managers are often standing by, waiting to buy those securities at discount prices, enhancing returns over time for their investors. These are some of the reasons why funds with long lockups are believed by many to offer an “illiquidity premium,” or a higher expected return than their more liquid counterparts, in exchange for this reduced liquidity.
Investors should weigh their individual needs for cash flow and liquidity, and neither undervalue liquidity (i.e. invest more heavily in illiquids than is prudent, given their preferences and financial situation) nor overvalue it (prize liquidity for its own sake more than needed). Financial advisors can help their clients to find the right balance.
FOOTNOTES:
1) Alternative investments are not suitable for all investors. Incorporating alternative investments into a portfolio involves significant risks including the possibility of significant losses which, in some cases, can exceed the principal amount invested. Some alternative investments have experienced periods of extreme volatility. Asset allocation and diversification strategies do not ensure profit or protect against loss in declining markets. You should consult your personal investment professional before considering any investment strategy.
2) Private funds are far less regulated than mutual funds, and their managers have more freedom to concentrate capital in high-conviction positions and to introduce leverage. Due diligence is of great importance in private partnership investing, as these provisions introduce the prospect of both increased returns and heightened risk.
[1] https://www.bloomberg.com/view/articles/2013-01-29/lower-rates-push-yield-seekers-to-higher-risk OR http://money.usnews.com/investing/articles/2016-10-19/death-of-the-saver-how-low-interest-rates-are-punishing-the-risk-averse
[2] https://www.ishares.com/us/products/239452/ishares-13-year-treasury-bond-etf
[3] https://www.ishares.com/us/products/239456/ishares-710-year-treasury-bond-etf
[4] https://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf
[5] https://www.ishares.com/us/products/239566/ishares-iboxx-investment-grade-corporate-bond-etf Mercury Text G1 Roman in font size 11 is appropriate for this document.
James Waldinger is CEO of Artivest, a tech-driven investment platform expanding access to private equity and hedge funds for financial advisors and their HNW clients.