Global Investor 1 15 en (1) Credit Suisse

8/21/2019 Global Investor 1 15 en (1) Credit Suisse

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Global Investor 1.15, May 2015

Expert know-how for Credit Suisse investment clients

INVESTMENT STRATEGY & RESEARCH

Illiquid assetsUnwrapping alternative returns

Roger Ibbotson Are investors rewarded or penalized for holding illiquid stocks?Sven-Christian Kindt Exploring the upside of new illiquid alternatives.

Alexander Ineichen Hedge funds overcome recent challenges. Carol Franklin Trees represent a growth opportunity for the patient investor.


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u r e s a r e f o u n d i n t h e D i s c l o s u r e a p p e n d i x

C r e d i t S u i s s e d o e s a n d s e e k

s t o d o b u s i n e s s w i t h c o m p a n i e s c o v e r e d i n i t s

r e s e a r c h r e p o r t s .

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o n l y a s i n g l e f a c t o r i n m a k i n g t h e i r i n v e s t m e n t

d e c i s i o n .

F o r a d i s c u s s i o n o f t h e r i s k s o f i n v e s t i n g i n t h e s e c u r i t i e s m e n t i o n e d i n

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GLOBAL INVESTOR 1.15 —03

Standard financial theory tells investors to carefully assess the trade-

off between return and r isk. Liquidity is a third key consideration. This

Global Investor (GI) is about the liquidity and illiquidity of individual

assets and overall financial markets. Just as risk and return are un-

certain before the fact, so is liquidity. Some assets may appear high-

ly liquid, only for their liquidity to suddenly vanish. Moreover, changes

in liquidity often correlate with shifts in risk. As our article on fixed

income (page 62) points out, some more exotic bonds become very

hard to sell just as their perceived risk increases, and when less liquid

assets are pooled in typical (open-end) funds, such difficulties can

be amplified (see page 24).

This does not imply at all that we would advise against investing

in illiquid assets. In fact, assets that eventually generate high returns

are very often highly illiquid. Those who invested in Apple, Google

or Microsoft when they were small (unlisted!) ventures run out of

“garages” garnered huge returns. Apart from private equity, this GI

covers a broad range of other more or less illiquid assets – ranging

from forests to farmland to infrastructure, and from real estate, the

most common of illiquid assets, to the most exotic “passion” invest-

ments. We also look at the pros and cons of investing in hedge funds,

which a re not necessarily pa rt icu lar ly ill iquid, bu t where the sources

of return are often harder to identify than those of other more visible

illiquid assets.

Adr ian Orr, CEO of the New Zealand Superannuation Fund, known

for its innovative investment philosophy, points out (page 26) that

even investors with long horizons should gauge the liquidity of their

overall portfolio carefully: investments in illiquid assets should be

balanced by some that can be easily sold. This rule is of even great-

er importance for private investors whose investment horizon is

typically shorter and where the potential for a drastic change in

personal circumstance (and thus need for liquidity) is that much more

pronounced. The temptation of abandoning such caution seems par-

ticularly high at a time when both nominal and real expected returns

on the most liquid of assets are so meager. Conversely, investors

should avoid overpaying for liquidity: Professor Ibbotson (page 10)

argues that investors tend to overrate (and thus overpay for) the

benefits of owning large cap stocks. The fact that these assets can

be traded in almost any circumstance may not only render them

more expensive but also prone to excessive price gyrations. In sum:

make sure that the analysis of risk and return is complemented with

a careful review and “stress test” of the liquidity of assets and

investment vehicles.

Giles Keating, Head of Research and Deputy Global CIO

P h o t o s : M a r t i n S t o l l e n w

e r k ,

G e r r y A m s t u t z

Responsible for coordinating the focus

themes in this issue:

Oliver Adler is Head of Economic

Research at Credit Suisse Private Banking

and Wealth Management. He has a

Bachelor’s degree from the London

School of Economics, as well as a Master

in International Affairs and a PhD in

Economics from Columbia University

in New York.

Markus Stierli is Head of Fundamental

Micro Themes Research at Credit Suisse

Private Banking and Wealth Management.

His team focuses on long-term invest-

ment strategies, including sustainable

investment and global megatrends. Before

joining the bank in 2010, he taught at

the University of Zurich. He previously

worked at UBS Investment Bank. He

holds a PhD in International Relations

from the University of Zurich.


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What do we knowabout liquidity?

A particular focus of this Global

Investor is on market liquidity.

By this we mean the presence –

or absence – of the ability to

sell (liquidate) an asset quickly,

without impacting the market

price significantly, and without

institutional constraints.

Measuring marketliquidity

For many asset classes, bid-ask spreads are

a convenient and straightforward way to mea-

sure market liquidity, with declining (tighten-ing) spreads indicating greater liquidity, and

vice versa. The spread is simply the cost that

you would incur if you were to sell an asset

on the market and immediately purchase it

back. But, as we will discuss throughout this

Global Investor, the concept of market liquid-

ity is more complex than that. To star t with,

the bid-ask spread is not easy to measure for

many assets, such as real estate. Moreover,market liquidity typically varies dramatically

across the cycle. Some as-

sets are highly liquid in

the upswing or the top of thecycle, but become less liquid

in a downswing. Lastly, instru-

ments matter. For example,

closed-end funds can deviate

from the value of the underlying

assets, which is bad in some ways,

but may also help protect long-term

investors. Some vehicles, such as private

equity funds and hedge funds, may impose

so-called “gates” on their investors to limit

redemptions.

Liquidityhas manymeanings

In the wake of the financialcrisis, the liquidity of the

financial system became

synonymous with its “life-

blood.” Large injections of

liquidity by central banks (the

ultimate creators of liquidity)

were necessar y to save those who “bled”;

the provision of liquidity to safeguard the

economy has remained paramount ever since.In this context, macroeconomic liquidity does

THE ALLURE OFLIQUIDITY

CURSE OR BLESSING?TEXT MARKUS STIERLI Head of Fundamental Micro Themes Research ILLUSTRATION FRIDA BÜNZLI


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not really refer to

the availability of cash

in the economy, but rather

to the smooth functioning of financial markets

and thus the economy as a whole. To a finan-

cial firm, liquidity refers to the ability to meetits debt obligations without becoming insol-

vent. While cash holdings (a liquid balance

sheet) provide a buffer against losses, the

ability to convert assets into cash to meet

current and future cash flows – its funding

liquidity – can prove critical for survival in the

event of stress. Therefore, funding liquidity is

now a key regulatory imperative. Neverthe-

less, central banks ultimately will always need

to act as a backstop to commercial banks; as

the role of commercial banks is typically to

invest clients’ liquidity (deposits) in less liquid

assets, they would structurally not have suf-

ficient liquidity to withstand a bank run.

On premiums and risk

Investors and firms share a common problem:liquidity risk premiums are hard to gauge, both

across different types of assets and over time.

Liquidity does not manifest itself in standard

measures of risk, such as price volatility. In

fact, in normal times, illiquid investments are

not necessarily more volatile than liquid ones.

Of course, price volatility may simply be hid-

den because illiquid investments are priced

at lower intervals – turnover is itself a defini-tion of liquidity. However, even in equity mar-

kets, as we learn from Yale’s Roger

Ibbotson (see page 10), lower turnover

stocks actually proved more resilient

(and less volatile) during the financial

crisis in 2008 than their highly liquid peers.

Bringing it all together

While the different concepts of liquidity are

often treated in isolation, it is essential to try

to understand how they interact. We know

that liquidity black holes wiped out entire

markets, such as the junk bond market in

the mid-1990s, and the subprime mortgagemarket more recently. We understand that the

deterioration of balance sheets forced banks

to cease lending, resulting in a vicious liquid-

ity squeeze that required significant policy

intervention to restore confidence so that the

financial system could fulfill its most basic

purpose. The most challenging part of the

liquidity discussion is that it depends heavily

on circumstances. The financial crisis was

such a profound event that it still has a sig-

nificant impact on investors’ attitudes toward

illiquid investments. Consequently, entire as-

set classes are being shunned, sometimes

unjustifiably, and genuine opportunities will

be exited prematurely or missed altogether.

In other cases, investors may actually end up

paying too much for liquidity. If history has

taught us one thing about liquidity, it is that it

is often self-fulfilling, and at times a mirage.


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Contents Global Investor 1.15

10Psychology and (il)liquidityLiquidity has its price. But, says RogerIbbotson, with equities the popular choice

has a premium that may be too high.

16Liquidity trends in illiquidalternatives

Amid rising interest in less li quid a lterna-

tives, Sven-Christian Kindt points out the

reward for sacricing unneeded liquidity.

18On doing your homeworkIf you’ve first done your research, says

Alexander Ineichen, hedge funds maybring higher end returns with less volatility.

21Liquidity – a key to hedge fundperformanceIt’s a key factor. Marina Stoop examines

the role that liquidity plays in hedge funds

and for their investors.

24Open-end versus closed-end fundsThe right investment, say Giles Keating

and Lars Kalbreier, is a function of the

underlying asset type and the kind of fund.

26 Attractively consistent At the helm of the New Zea land Super-annuation Fund, Adrian Orr talks about

patience, opportunity and very long horizons.

30Talking teak She has branched out. Carol Franklin has

a diverse background including language,insurance and plantation ownership.

39Institutional investmentin timberlandIt’s not easy going green. Gregory F leming

explains why institutional i nvestors

see timberland as a growth opportunity.

42Farmland – a fertile investmentWith dairy farming interests, and over 20 years in asset management, Griff Williams

knows plenty about farmland investment.

44Ins and outs of real estateIt’s an illiquid asset, but real estate isattracting growing interest. Philippe

Kaufmann offers his insights and advice.

48Infrastructure on the riseInstitutional investors are ocking toward

infrastructure. Robert Parker explains whybuilding for the future is a big deal today.

52Looking beyond liquidityFelix Baumgartner and Patrick Schwyzer

reect on client perspectives of the illiquidasset landscape.

56In passion we trust

Art, antiques and collec tibles: Art Market

Research and Development looks ata different kind of alternative investment.

58From illiquid assets to profitableinvestmentsThe European Central Bank is working

to restore the European securitizationmarket, report Christine Schmid and

Carla Antunes da Silva.

62No exit?There’s lower and more volatile liquidity in

the corporate bond markets. Jan Hannappeloutlines the causes and the implications.

Disclaimer > Page 65


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Roger Ibbotson, founder, chairman and CIO of Zebra Capital Management.

P h o t o

s : R o b e r t F a l c e t t i


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>

INTERVIEW BY OLIVER ADLER Head of Economic Research, JOSÉ ANTONIO BLANCO Head Global MACS, SID BROWNE CIO and Head of Research Liquid Alternatives

Liquidity premium

Psychology and (il)liquidity

Sid Browne: Economic theory states that

there should be a premium available for

accepting illi quidity. You’ve studied premi-

ums – and associated risks – attached to

both illiquid and liquid assets. What can you

tell us about your findings in general wi thin

a portfolio context? How should institutional

and private investors invest?

Roger Ibbotson: Let me start off by

saying that the stocks that I study are actu-

ally publicly traded stocks. They may be less

liquid than the most liquid stocks, but they’re

all liquid stocks. There’s a strong theoretical

reason why you’d expect less liquid s tocks,

in fact less liquid assets of any type, to be

lower valued. People want liquidity, and

they’re willing to pay for it. They pay a higher

price for the most liquid assets, and there-

fore the less liquid assets sell at a discount.

That discount means that, for the same

where there is mispri cing because they get

to be “too” popular, as measured for exam-

ple by their heav y trading. Interestingly, our

measures of stocks that trade less show

lower volatility. So these stocks don’t really

seem more risky. Therefore I don’t really

like calling the extra return a risk premium.

Sid Browne: What about in the event of a

squeeze, when all of a sudden you want

liquidity and rush to sell your illiquid stocks?

Isn’t there that flight-to-quality risk?

Roger Ibbotson: There could be the risk

of having to sell quickly. In actual experience,

though, for example in 2008 when you had

a kind of a liquidity crisis, it was the most

liquid stocks that were sold and dropped the

most. So even in a nancial crisis, the less

liquid stocks do relatively well compared to

the more liquid stocks. Now it is true that it

is more difcult to sell the less liquid, and

cash flows, you pay a lower price and

subsequently you get higher returns. Now,

what ’s especially interesting in liquid mar-

kets is that giving up a little bit of li quid-

ity actually can have a surprisingly big

impact – by buying stocks that trade every

hour, say, as opposed to every minute.

José Antonio Blanco: From an investor’s

perspective, could you call the effect you’ve

just described a risk premium, or is i t

instead the result of market inefficiency in

the sense that investors focus on certain

companies and disregard the rest?

Roger Ibbotson: It could be both.

You can create a risk factor from a liquidity

premium. But I am rather thinking of

something I call a “popularity” premium,

which I’ve expanded on in recent papers.

The stocks that trade the most a re the

most popular. And those are the ones

Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tendto pay up too much for it while underestimating the extra returns from holding illiquid assets.The overpricing of liquidity seems to be greater in equities than in bonds, in part because

in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics.


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people chose not to sell them. But it is still

a fact that their prices fell much less than

those of more liquid stocks.

Sid Browne: So would it make sense to

have a very la rge exposure in your portfolio

to these types of stocks?

Roger Ibbotson: If you’re a day trader,

you don’t want to buy these kinds of stocks

because they’re going to have higher trad-

ing costs. It really depends on your horizon.

If you have a longer horizon, then buying

less liquid stocks can make sense.

Oliver Adler: Could you discuss the paral lels

in the bond market, or segments of the

bond market, in terms of what those

liquidity or illiquidity premiums would look

like there?

Roger Ibbotson: Well, first of all, bond

markets are in the fortunate position of

having yields to maturity that you can actu-

ally see. You know that if the bond doesn’t

default, you’re going to get a specific return

in that particular currency. And you know

it in advance.

In the equity market, you can’t see the

forward returns in the same way. You only

see the result. And since returns them-

selves are very volatile, it’s hard to discern

what the resul t really is. Moreover, the re-

turn measures differ strongly over different

periods. That’s why we can debate which

of these premiums really exist and how high

they are. This is quite dif ferent in bond

markets where maturities are normally xed.

Oliver Adler: Would you say that the stock

market gives rise to more irrational behavior

in some sense than the bond market?

Roger Ibbotson: I’m sure there is irratio-

nal behavior in the bond market, too. But

yes, there is behavior in the equity market

where essent ial ly people are at tracted to

stocks that trade a lot. And they’ll pay more

for them, just as you would do with brands

in the consumer market. Consequently,

the return structure is going to be dif ferent

among the less popular and the more popu-

lar, and that leads to mispricing. Of course,

you’re also going to see mispricings in

the bond market, but they may be smaller

there and they’re more visible and thus

easier to take advantage of.

Sid Browne: You’re saying that something

could be more popular in the equit y market

than it would be in the bond market.

So Apple stock, for example, could go

“hot” and ver y, very liquid, but the debt,

because it’s traded less and because

it is a discounted flow of more certain

cash payments, would actually not be

impacted by this popularit y phenomenon.

Roger Ibbotson: It could be affected,

but it would not be affected by as much

because you can see the pricing exactly in

a yield spread. And so you know exactly

what you’re paying for.

José Antonio Blanco: Are you saying that

we have more serious information issues

in the equity than in the bond market?

If you compare t wo bonds, it’s relatively

easy to find the one that is paying too

much, or too little. Whereas, for a stock,

you might look at the past, but the future

is much more difficult to assert. So, as

an investor, you tend to grab things that are

a bit easier to recognize, like brand names,

along the lines “if something is popular,

it’s probably better.”

Roger Ibbotson: Yes. In the equity

markets, you can tell stories about

the stock. And the stories can be very inter-

esting. And you can pay a lot for stories.

That’s why, for example, value tends to

have higher returns than growth. Growth

gets highly priced because growth

companies have much more interesting

stories than value companies. In the bond

market, all these same phenomena may

exist, but there is more information.

It’s much more mathematical. The spreads

are visible.

Oliver Adler: How about areas like private

equity, or hedge funds, where you need

a lot of knowledge and can’t easily

tell stories? Might it therefore be fair to

say that mispricing phenomena occur

less frequently here?

Roger Ibbotson: Well, mispricing can

be pretty frequent in private equity as well

because there’s actually less information

for the buyer. You need more specialized

expertise to understand the specific stocks.

Also, in private equi ty, the presumption is

that the private equity manager not only

identifies undervalued stocks, but actually

changes the company in some way to make

it more valuable, perhaps by getting tax

benefits, restructuring management or

altering incentives. So there are potentially

more possibilities for profit if you’re really

good at doing that.

Hedge funds typically buy publically

traded equities or bonds – more or

less liquid securities. When you invest in

a hedge fund, you are essentially buying

the manager who is buying liquid

securities.

“What’sespecially

interesting inliquid marketsis that givingup a littlebit of liquidityactuallycan have asurprisinglybig impact.”Roger Ibbotson

continue d on page 14 >


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How Moody’s

measuresliquidity stress

In periods of market stress, investor scru-

tiny often moves onto lower-rated finan-

cial instruments that have been issued

with a premium yield level at tached.

Concerns about the abilit y of issuers to meet

ongoing cash obligat ions for coupon payments

can lead to investor flight from speculative

bonds, just at the moment when those issuers

most need to shore up their finances to remain

in business. Classic examples might be riskier

consumer finance companies, smaller oil and

gas firms, and heavily leveraged property

developers. If the stress period persists, such

issuers are often unable to raise sufficient

short-term debt to maintain their trading

activities and, if undercapitalized, they may

even fail.

Defaults in this riskier zone can prove con-

tagious, both because of the effect on other

parties exposed to a given sector or deal, and

due to the psychological effect on the gener-

al investing public. A vicious illiquidity circle

can develop, as occurred in real estate loans

in 2008–2009, and may require government

intervention and ultimately debt write-downs.

Liquidity, a key element of credit analysis

In order to provide additional transparency in

its existing liquidity assessment process and

arm investors willing to hold speculative-grade

debt against falling foul of rapid shifts in mar-

ket sentiment, the rating agency Moody’s

began assigning Speculative Grade Liquidity

(SGL) ratings in 2002. Loss of access to fund-

ing remains a risk criterion in any assess-

ment. Defining speculative-grade liquidity

risk as “the capacity to meet obligations,”

SGLs describe an issuer’s intrinsic liquidity

position on a scale of 1 (very good) to 4 (weak).

Assignment of a rat ing is car ried out under

detailed criteria for measuring a company’s

ability to meet its cash obligations through

cash, cash flow, committed sources of exter-

nal cash, and potentially available options for

raising emergency cash through asset sales.

SGLs are a measure of issuers’ intrinsic

liquidity risk – meaning Moody’s assumes

companies do not have the abilit y to amend

covenants in bank facilities or r aise new cash

that is not already committed. Such conditions

are not t ypical in normal market environments,

but can occur in periods of economic and

credit market stress when companies need

liquidity support the most to avoid default.

Because Moody’s factors market access and

the ability to amend covenants into its long-

term ratings, the assumptions utilized in ana-

lyzing liquidity are more stringent.

One proviso that Moody’s noted from the

outset is that liquidity assessments focus on

corporate capacity to meet obligations. Will-

ingness to default remains a management

issue that is not factored into SGL ratings, but

is separately evaluated as part of the long-

term ratings analysis. Ratings are dynamic and

may be modied ad hoc, as with bond ratings.

Art icle by

John Puchalla , Seni or Vice Pres ident,

Corporate Finance Group at Moody’s

Co-Author

Gregory Fleming

Senior Analyst

+41 44 334 78 93

[email protected]

To date, Moody’s assigns SGL ratings to

US and Canadian issuers alone, although

the framework is used in most other regions

as well. Moody’s maintains SGL ratings on

approximately 840 issuers, with USD 1.8 tril-

lion in rated debt.

Index summarizes the market conditions

Moody’s also created the Liquidity Stress

Index (LSI) to provide a broad indication of

speculative-grade liquidity. The LSI is the per-

centage of SGL issuers with the weakest

(SGL-4) rating. Changes in corporate earn-

ings, borrowing costs and ease of new debt

issuance are critical drivers of changes in the

LSI over time. Credit cycles tend to lead the

economic cycle because will ingness to lever-

age into expanding economic activity has to

occur before the activity itself gets underway

in the real economy.

Speculative-grade companies do not have

access to the commercial paper markets, so

they are generally unable to quickly raise new

financing in crisis moments. Measuring their

riskiness essentially boils down to gauging

the free cash flow from operations, cash on

hand, and committed financing from other

sources such as revolving credit facilities (the

latter is not part of the SGL analysis.)

More than 12 years after the introduction

of SGLs, the track record now includes both

extended periods of more-than-ample liquid-

ity and phases of unprecedented risk and

market stress. The LSI ’s long-term average

value since inception is 6.8%, with a record

high reading of 20.9% in March 2009 at the

height of the financial crisis in the US. The

lowest level reached by the index was 2.8%

in April 2013, with default and illiquidity risks

exceptionally low. At the start of 2015, the

index was still very benign at 3.7%, indicating

a below-average forecast of the default rate

of speculative-grade companies in the course

of this year. Higher risks from falling oil pric-

es were balanced against the steady earnings

gains from US consumer spending.


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Oliver Adler: What sorts of issues come

up in terms of liquidity and premiums

wi th some of the more obscure asset

classes, like infrastructure, or the

not-so-obscure ones, like real estate?

Roger Ibbotson: Well, of course, some-

thing like real estate is by its nature very

illiquid. But there are structures that you

can buy, like REITs (real estate investment

trusts), that make it more liquid. If you put

real estate into a structure that makes it

more liquid, it tends to be more highly val-

ued. A REIT is a more expensive way to buy

real estate, but of course it has the benefit

of being liquid. On the other hand, if by

buying real estate you actuall y get involved

in managing it, it’s a much more complicat-

ed thing. That’s more like private equity.

All of these things are less liquid, and they

all should have illiquidity premiums. I sus-

pect that a lot of the return from real estate

comes from its illi quidity premium.

Oliver Adler: Given that the different asset

classes seem to have different characteris-

tics, how do you deal wi th the liquidity

issue when you put everything together

into a portfolio?

Roger Ibbotson: People need a certain

amount of liquidity. If you’re going to have

a lot of illiquid assets, you also need some

liquid assets to meet your liquidity needs.

On the one hand, people should not pay

for liquidity they don’t need. On the other

hand, they may need more liquidity than

they think.

There’s a danger in going into too many

illiquid assets, like real estate and infra-

structure and private equity. Some of

the universities, for example, did get into

a bit of a squeeze in the financial crisis.

They could not get very good prices for

their private equity investments. One of the

benefits of the kinds of stocks I’ve been

talking about is that they can easily be

sold in any crisis wi thout paying much of

a discount at all.

Oliver Adler: But might it be possible

to argue that illiquid assets could help to

put a break on investors’ impulses

to sell at the wrong time and save them

from making mistakes?

Roger Ibbotson: That’s an interesting

argument. And, of course, there is evidence

that overall stock market trends go in the

opposite direction of what retail investors

do: retail tends to sell after the crash and

buy after the rise. So if retail investors were

somehow prevented from overtrading, they

Roger IbbotsonThe founder of Zebra Capital Manage-

ment in 2001, Roger Ibbotson is also

Professor in the Practice Emeritus

of Finance at the Yale School of

Management. He has written numerous

books and articles, including “Stocks,

Bonds, Bills and Ination” with Rex

Sinqueeld (updated annually), which

serves as a standard reference for

information on capital market returns.

might perform better. But the truth is that

people want liquidity even though it some-

times leads them to take the wrong actions.

José Antonio Blanco: Once you know

what your liquidi ty needs are, is there a fair

reward for real illiquidity? Or could you

also achieve a higher return by structuring

liquid assets, for example by exploiting

anomalies or special effects, as you’ve

described (I don’t want to call i t risk

premiums)? In other words, do you think the

illiquidity premium is overestimated?

Roger Ibbotson: I think one aspect

of what you are speaking about is the ability

to achieve “alpha” (a measure of outperfor-

mance relative to some asset class or

benchmark). To get a lot of alpha, you may

need to do a lot of trading. People are

overconfident, of course, of their ability to

achieve alpha. But the more you believe you

can create alpha, the more you want liquidi-

ty because it is the lower-cost assets that

may allow you to achieve alpha.

In contrast, if you have long horizons,

then you’re the natural type of investor

to go af ter illiquidity premiums. The fact is,

though, many people believe they can

create alpha – some legitimately, and others

who just think they can – and they wil l pay

up for it. I don’t see that going away. So,

the market will tend to pay too much for

liquidity, and conversely underestimate the

illiquidity premium.


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India4

5.5

China

6.9

15.7

South Africa0.3

1.5

Russia0.1

2

Brazil

1.5

2.7

Nigeria

0.1

0.6

Private equity

in emergingmarkets

High expectationsIn the USA , private equity achieved annual returnsof around 16% over 2009–2014. Only 39% oflimited partners surveyed expect that the USA will be able to sustain that level in 2015. 57% of limited partners expect emerging market privateequity portfolios to achieve net returns of 16%or greater in 2015. Historical annual returns foremerging market private equity were around13% over 2009–2014. Emerging market equities

only returned around 4% over the same period.In comparison, US private equity trailed US equitymarkets in terms of returns.

In search of exit Asian venture cap ita l investment s have s tar tedto find viable exits through IPO routes. Theaggregate value of venture capital exits quadrupledover 2013–2014 to reach USD 38 billion.

Moving up the value chain Afr ican pr ivate equit y is moving up the va lue cha in,away from extractive industries.

Private equity capital invested

in key emerging markets, USD bn Number of Asian venture capital exits

Global opportunity At USD 29 billion, emerging market private equityfund-raising has been concentrated in emerging Asi a, b ut growth has been the fas tes t in Afr ica .

Not all markets are equalPrivate equity investments expanded rapidlyin China, Brazil and Nigeria, shrank slightly inIndia and collapsed dramatically in Russiaand South Africa between 2009 and 2014.

The untapped potentialof emerging markets

Emerging markets make up:

The promise of venture capitalEmerging market private equity investmentsincreased by 60% in value between 2009 and2014. In the same period, venture cap ital invest-ment value increased sevenfold, now making upmore than 20% of total private equity investmentsin emerging markets. Technology investmentshave more than tripled in the same period.

3

6 7

2

5

1

4

Markus Stierli

Fundamental Micro Themes Research

+41 44 334 88 57

[email protected]

Nikhil Gupta

Fundamental Micro Themes Research

+91 22 6607 3707

[email protected]

Financials

Telecoms

Oil and gas

Basic

materials

USD 9 bn USD 38 bn

Consumer

goods

PE investments in 2014,

USD mn

454

415

242

119

42

PE investments in 2009,

USD mn

253

126

63

539

458

39%of global output

18%of global stock market capitalization

14%of global private equity fund-raising

11%of global private equity investments

Aggr egate e xit value

Trade sale IPO

Write-off Sale to GP

3%5%

50%65%

40%22%7%8%

2014145 exits

200783 exits

USD 4 bn

+327%*

USD 29 bn

+97%*

D a t a s o u r c e s u s e d f o r t h e a r t i c l e : D a t a s t r e a m , E m e r g i n g M a r k e t P r i v a t e E q u i t y A s s o

c i a t i o n , P r e q i n

* 2014 vs 200 9

2009 2014

Buyout Growth PIPE Venture capital

4030

20

10

0

2009 2014

Emerging market private equity by strategy, USD bn

20.8

33.8


16/68


Investors are increasingly showing appetite to commit to less-liquid alternatives. This includesinvestment opportunities in areas such as private equity, private debt and real assets. Accordingto a recent study, shifting from liquid assets in which the primary investment return resultsfrom the market’s (or benchmark’s) movements to less liquid investments in which the primarysource of the return is due to a fund manager’s skill at navigating an investment to a successfuloutcome typically results in a median return premium of 20%–27% over a fund’s life, andmore than 3% per year. This illiquidity premium can be further enhanced by investing with the

best-performing managers. These managers typically generate top-quartile investment returnsand outperform the median performance benchmark by as much as 20 percentage points.Despite the opportunity to enhance overall portfolio returns (while reducing exposure to dailymarket volatility), individual investors tend to be under-allocated to illiquid alternatives relative toinstitutional investors. One oft-cited reason is the restriction on withdrawals of ten years orlonger before fully returning capital and prots to investors. However, the recent growth of shorterduration and yield-producing investment strategies, such as direct lending to small and medium-sized enterprises, coupled with the emergence of a secondary market for early liquidity,may result in greater comfort with and more appropriate allocations to illiquid alternatives.

Liquidity

trendsin illiquidalternatives

AUTHOR SVENCHRISTIAN KINDTHead Private Equity Origination & Due Diligence, Credit Suisse

P h o t o : B i w a

S t u d i o / G e t t y I m a g e s


17/68


Liquidity optionsHistorically, illiquid investment propositions such as venture capital and pri vate equity funds required ten years or longer before fully returning capitaland profits to investors. However, the growth of shorter-duration and yield-producing investment strategies and a secondar y market for early liquidity mayresult in greater comfort with allocations to illiquid alternatives. The strategies outlined below are only a small subset of more liquid options available tothe investment community. These, and others, should make it easier for individual investors to sacrifice liquidity that they do not need in order to capture(some of) the illiquidity premium.

Private debt strategiesThe private debt market has seen strong growth since 2008, primarilydriven by direct lending funds. According to alternatives data provider P reqin, over 200 private debt funds have raised in excess of USD 100 billion ofnew capital commitments in 2013–2014. Private debt is characterized byshorter investment duration relative to venture capit al and private equityfunds, and in the case of direct lending, funds can be combined with regularyield payouts to investors. The outlook for investing in the direct lendingspace remains positive due to persistent structural factors preventing middlemarket companies from accessing the broader traditional credit markets.While credit supply remains tight, demand for middle-market credit remainsstrong due to the expected deployment of committed, uninvested capital

(also referred to as “dry powder”) and the refinancing overhang of middle-market companies.

Secondary strategiesThe secondary market in illiquid alternatives has been fueled in the re centpast by new regulations (e. g. the Volcker Rule), by record amounts ofdry powder and by improving economic conditions. A record USD 42 billionof assets have traded on the secondary market in 2014, up from USD 9 billionin 2009. Investors increasingly see secondaries as a viable channel togenerate liquidity before fund lockups expire. They are using the secondarymarket to rebalance their illiquid port folios, exit poorly performing invest-ments, reduce capital costs or comply with new regulations. In order toincrease liquidity for investors, some managers are now proactively offeringthe possibility of exiting their funds early. For example, in its latest flagshipfund, a US buyout manager committed to selling fund stakes twice a

year to a preselected group of pr eferred buyers. Other managers havestarted to provide interested sellers with a list of potential buyers.

The illiquidity premiumThe term “liquidity” refers to the ease with whichan asset can be conver ted into cash. Assetsor securities that can be easily bought and sold,such as bonds and publically traded sto cks, areconsidered liquid. Private equity, private debtand real assets, in contrast, are said to be illiquid.Investment returns tend to increase with thedegree of illiquidity of the asset. A recent studyof nearly 1,400 US buyout and venture capitalfunds found that the aggregate per formanceof these funds has consistently exceeded theperformance of the S&P 500 by 20%–27% overa fund’s life, and more than 3% annually.

The manager premium An i ncrease in i lliquidi ty shif ts the primar y sourceof the investment return from movements ofthe market itself (or beta) to a fund manager’sknowledge or skill at navigating an investment toa successful outcome. Manager skills influencethe returns of illiquid alternatives primarilythrough strategic and /or operational improvementsbrought to por tfolio companies. For example,a manager may be particular ly able to increaseport folio company sales, reduce operating expenses,optimize asset utilization or exploit leverage.The potential for upside in illiquid alternatives istherefore driven not only by exposure to a specificilliquid category but also by investing with thebest-performing managers. This is evident in thegraph below, which shows that the return differ-ence between top and bottom quartile managerscan be over 30 percentage points in pr ivate equity.

Individual investor allocationRelative to individuals, many institutional inves-tors with long investment horizons, such aspension plans (with their liabilities for retirees)and endowments (with their ongoing operatingbudgets), have built up significant allocationsto illiquid alternatives, as shown over the lasttwo decades. In 2013, the average US endowmentheld a portfolio weight of 28% in alternativeassets, versus roughly 5% in the early 1990s. A sim ila r trend is evident among pension p lans.In the early 1990s, pension plans held lessthan 5% of their port folios in less liquid alter-natives; today the figure is close to 20%.Having a long-term investment hor izon may givemore patient investors an edge in har vestingthe illiquidity premium. They can be rewarded forsacricing liquidity that they do not need.Investment returns generally

increase with illiquidity

Illiquidity estimates

Private equity

Deposits

US fixedincome

Venture capital

Small equity

High yield

Real estate

Hedge funds

18

16

14

12

10

8

6

4

2

61 2 3 4 5

Globalgovernmentbonds

Compound gross annual returns in %

% of investment portfolio

Allocation to alternatives

Pension EndowmentsIndividualinvestor

19.4%

28%

2%

Source: Illiquidity estimates taken from “Expected Returns” by

Antt i Illmane n, 2011. 1994–2014 re turn dat a taken from Bloo mberg,

Citigroup, Barclays Capital, J. P. Morgan, Bank of America Merrill Lynch,

NCREIF, Hedge Fund Research, Cambridge Associates, Russell 2000.

Source: Taken from “Patient Capital, Private Opportunity” by The

Blackstone Group, Private Wealth Management, 2013. Return data drawn

from Lipper, Morningstar, Preqin and Tass.

Source: Allocation data drawn from Cerulli Research, National

Assoc iation o f Colleg e and Unive rsity B usines s Of cers 2013/14

Studies, Pensions & Investments 2013 Annual Plan Sponsor Survey.

Manager dispersionincreases as illiquidity grows

40

30

20

10

Median

–10

–20

Return differential vs median in %

Long-onlyfixed income

Long-onlyequity

Hedgefunds

Privateequity

Top decile

bottom decile

2nd quartile

3rd quartile


18/68


Hedge funds

On doing your homework TEXT BY ALEXANDER INEICHEN


19/68


>

Recent skeptical reports in the press abouthedge funds, and a high-profile divestmentor two, have prompted speculation that hedgefund returns are in “structural” decline. Notso fast, says Alexander Ineichen. For investors

willing to get off the couch, a careful study

of hedge funds shows that they actually deliverhigher-end returns than US equities do, with less volatility.

P h o t o : G e r r y A m s t u t z

Many seasoned investment professionals argue that liquid-

ity is an illusion. It is something you think you have, and

can measure in good times, but it vanishes immediately

during a perfect storm. It is a bit like your path toward

the emergency exit in a concert hall: under normal circumstances you

can run toward the exit within seconds; when fire breaks out, you

cannot. Liquidity is something everyone seems to require at the same

time. The financial crisis of 2008 is a good example. Markets literally

disappeared for a while. So-called market makers would delete their

prices on their screens and not pick up the phone, even in markets

that were considered liquid prior to the market disturbance. Another

example is the more recent decision by the Swiss National Bank to

drop its quasi-peg to the euro in January 2015. For a short time, the

foreign exchange market – considered as the most liquid market in

the world – stopped functioning properly.

Hedge funds – a “quasi-liquid,” superior return profile

In his 2000 book “Pioneering Portfolio Management”, David Swen-

son, the CIO of Yale University’s endowment fund, distinguishes be-

tween liquid and illiquid. But, for hedge funds, he creates something

in between that he calls “quasi-liquid.” This is a very elegant turn of

phrase. Hedge funds are indeed not as liquid as US large-cap stocks,

but are also not as illiquid as, say, private equity or real estate.

In the last couple of years the gloss has come off hedge funds.

Earlier, the high returns had turned a niche product into a flourishing

industry. For example, an investment of USD 100 in the S&P 500

Index at the beginning of 2000 was at USD 89 (–11%) five years later,

including full reinvestment of the div idends. The same investment of

USD 100 in an average hedge fund portfolio, after all the fees every-

one complains about, stood at USD 141 (+41%) five years later. This

is a big difference.

Hedge funds did well in the second part of the last decade too. In

the five years to December 2009, a long-only investment in the S&P

500 went from USD 100 to USD 102 (+2%), whereas an investment

Alexander Ineichen Alexander Ineichen s tar ted his nancial

career in derivatives brokerage and

origination of risk management products

at the Swiss Bank Corporation, UBS

Investment Bank and UBS Global Asset

Management. In 2009, he founded

Ineichen Research and Management

AG, a research boutique focusing

on absolute returns, risk management

and thematic investing.


20/68


of USD 100 in the average hedge fund portfolio went to USD 132

(+32%). This is still a big difference, but it had gotten smaller. In the

five years to December 2014, a USD 100 investment in US equities

more than doubled to USD 205 (+105%). However, USD 100 in the

average hedge funds portfolio “only” rose to USD 125 (+25%). As an

investor, which sequence do you prefer: –11%/+2%/+105% or

+41%/+32%/+25%? The second sequence is superior in two ways:

higher-end return with less volatility. I like to think of the first se-

quence of returns as “nature.” That is what you get if you do not ap-

ply risk management: moderate overall return with high volatility.

Hedge funds can improve this sequence with active risk management.

The second sequence does not appear in nature, it is man-made.

Hence the fees.

Challenges big and small

The biggest challenges hedge funds face today are linked to the

smaller managers. First, they find it very difficult to raise capital

because the financial crisis and the Madoff incident caused private

investors to more or less disappear. They are coming back only very

slowly. This means the main source of capital comes from instituti onal

investors who have a more sophisticated decision-making process.

They expect a hedge fund to have at least USD 100–150 million un-

der management and three years of proven real returns. Furthermore,

institutional investors conduct due diligence with their managers, be-

cause a lack of it was one of the sources of disappointment in 2008.

Institutional investors also expect various layers of operational excel-

lence, adding to the cost base of hedge fund operators. This means

that the barriers for smaller, less-established managers have risen.

Finally, regulation has intensified. Large hedge funds can deal with

the added bureaucracy more efficiently than smaller managers.

But large hedge funds also face challenges, and one of them is

related to regulation. The financial crisis, and the regulation wrath

that it triggered, resulted in investment banks downsizing their trad-

ing operations. Liquidity in many markets went down. Because of the

winner-takes-al l effect that resulted in large hedge funds get ting

larger and larger, these growing hedge funds see dwindling liquidity

as a challenge. A less liquid market means diminished opportunity

and is more prone to gap risk.

Are hedge funds a good/bad investment?

I always recommended to everyone willing to listen that they move up

the learning curve with respect to risk management, absolute returns

and hedge funds. Knowledge beats ignorance every time. An edu-

cated investment is better than an uneducated investment. And ed-

ucation compounds. At the end of the day, an investment decision is

binary: either a position is established or it is not. This means the

various trade-offs, the pros and cons, need to be ca refully weighed

against each other. This requires an effort, i.e. learning. Whether a

nice chap recommends hedge funds is not that relevant for most

investors. An investor needs to reach a level of comfort before invest-

ing, and a conviction once acquired requires ongoing reconfirmation.

Both are a function of learning and effort.

The late Peter Bernstein, author of one of the best books on the

history of risk, once wrote that “liquidity is a function of laziness.”

What he meant is that liquidity is an inverse function of the amount

of research required to understand the characteristics of an invest-

ment. As he put it: “The less research we are required to perform,

the more liquid the instrument.” An investment in US Treasuries re-

quires less research than an investment in US equities. An invest-

ment in US equities requires less research than an investment in

hedge funds and so forth. In sum, hedge funds are not for the la zy.

Why I want hedge funds in my portfolio

Hedge funds originally marketed themselves as absolute return prod-

ucts that deliver positive performance in any market environment.

Now, in the wake of the financial crisis, hedge funds focus on their

diversification benefits and risk-adjusted performance. A portfolio of

hedge funds does not obviate any alternative or “classical” way of

portfolio construction. However, hedge funds have properties that

you do not find in other areas of finance. For example, trend-follow-

ing managers have had a positive return in 17 out of 19 major correc-

tions in the equity market since 1980. This is unique. There is noth-

ing else in finance that has such favorable correlation characteristics.

Among other asset classes, measured low cor relation more often than

not turns into an illusion when it is most needed, somewhat akin to

perceived liquidity.

Over the last decade or so, the conceptual arguments for invest-

ing in hedge funds have not changed much. However, the market

place has changed. For example: hedge funds as a group are larger;

the largest funds are larger; some trades are more crowded; liquidity

in some market areas is lower due to Dodd-Frank; yields are lower

and IT is more important. But again, conceptually, an intelligently

structured portfolio comprising independent returns and cash flows

is as worth considering by every thoughtful and diligent investor as it

was in 1949, when the first hedge fund was launched. If you know

the future, invest in what goes up the most. If you do not, construct

a portfolio where the source of returns and cash flows are well bal-

anced and the risk is actively managed, while not forgetting that per-

ceived liquidity can turn into an illusion.

“Over the last decadeor so, the conceptualarguments for investing

in hedge funds havenot changed by much.However, the marketplace has changed.” ALEXANDER INEICHEN


21/68


Best trading strategy is a function of market liquidityIn periods of low liquidity, tactical trading strategies have performed best. Particularly in an environmentof low liquidity, this style stands out as the only one delivering positive returns. Source: Datastream, Credit Suisse

T a c t i c a

l t r a d i n g

5 . 5

%

T a c t i c a l t r a d i n g

9 . 1

%

D i r e c t i o n a l

i n v e s t i n g

7 . 4

%

E v e

n t d r i v e n

7 . 3

%

R e l a t i v e v a l u e

5 . 8

%

D i r e c t i o n a l i n

v e s t i n g

1 5 . 3

%

E v e n

t d r i v e n

1 4 . 6

%

T a c t i c a l t r a d i n g

1 1 . 9

%

R e l a t i v e v a l u e

1 1 . 6

%

R e l a t

i v e v a l u e

9 . 5

%

R e l a t i v e

v a l u e

– 1 . 9

%

E v e n t d r

i v e n

– 2 . 6

%

D i r e c t i o n a l i n v e s t i n g

– 4 . 6

%

T a c t i c a l t

r a d i n g

1 3 . 6

%

E v e n

t d r i v e n

1 7 . 0

%

D i r e c t i o n a l i n

v e s t i n g

1 8 . 5

%

Low liquiditydecreasing

High liquiditydecreasing

Low liquidityincreasing

High liquidityincreasing

Liquidity is an important aspect to con-

sider when investing in hedge funds.

Liquidity issues have to be managed

by both investors as well as hedge fund

managers. While it is true that hedge fund

liquidity has generally improved for investors

since the global financial crisis, hedge funds

are still less li quid investments than equities.

To use Alexander Ineichen’s term, they can

be called “quasi-liquid.” In the following, we

take a closer look at the role liquidity plays

for hedge funds and their investors. A key

conclusion is that illiquidity is not only a draw-

back, but also a potential source of returns,

which s til l has to be managed.

Illiquidity as a source of return

Hedge fund returns can be divided into three

components: (1) returns from general market

performance (also called beta factors), (2)

returns from exploiting risk premia, including

illiquidity factors (alternative beta), and (3)

returns related to manager ski lls (e.g. in se-

lecting securities and timing entry and exit

into an investment, called alpha.)

The performance of equity and fixed in-

come markets to which hedge funds have

exposure are typical beta drivers. The sensi-

tivity toward these drivers varies across hedge

fund strategies. While long/short equity strat-

egies (which belong to the fundamental style,

see box) have a relatively high sensitivity to

equity market performance, the influence on

managed futures (a tactical trading strategy)

or fixed income arbitrage (a relative value

strategy) may be minor.

Hedge funds provide advantages

Generally, it is easy to gain exposure to tra-

ditional beta drivers. However, alternative

sources of beta may not be as easily acces-

sible through commonly traded instruments.

Default risk and illiquidity premiums fall in

this type of category, and hedge funds can

be one way to access this type of return. For

example, the distressed debt strategy in-

vests in illiquid, distressed securities that are

not commonly accessible to investors. In

contrast, mutual funds have more stringent

liquidity requirements and are usually re-

stricted to invest at most in low-rated credit,

while their structura l setup all ows hedge

funds to take on such credit risk. Moreover,

distressed debt hedge funds have a longer

time horizon, which allows them to hold on

to investments for longer and to wait until the

company that issued the distressed security

gets back on track.

Hedge Funds

Liquidity –a key to hedge fund performanceWhether it’s related to an investor’s risk tolerance, or a

fund manager’s decision on the appropriate trading strategy,the management of liquidity issues is a vital consideration

when investing in hedge funds. And while illiquidity can be asource of risk, it can also be a source of additional returns.

>

Annualized returns


22/68


Investments in more illiquid securities on the

side of hedge fund managers have implica-

tions for investors too. Since the forced sell-

ing of securities can mean selling at unfavor-

able prices, hedge fund managers can set up

a range of provisions to avoid losses due to

this. Liquidity provisions can take the form of

redemption restrictions, lock-ups, gates, side

pockets or a combination thereof (see glos-

sary at the left hand side). It is no surprise

that the strategies investing in the most liquid

assets (managed futures and global macro)

tend to be the strategies that offer the highest

liquidity for investors. As a result of the bad

experiences made during the financial crisis,

with many investors not full y aware of such

provisions, investors now desire a higher de-

gree of liquidity. Consequently, more liquid

strategies as well as structures like UCITS

(undertakings for the collective investment in

transferable securities), which are designed

to accommodate this desire, have attracted

more inflows.

While barriers of withdrawal can protect

investors from redeeming funds at the most

unfavorable terms, there can also be argu-

ments raised against such policies. Investors

may get the impression that hedge funds are

using such provisions as an excuse to earn

further fee income before their capital is even-

tually returned. It is thus important that inves-

tors are assured that long lock-up periods are

well just ified – e.g. because the hedge fund

is holding illiquid investments such as over-

the-counter-traded distressed debt securities.

Generally, investors eager to benefit from il-

liquidity premia should be prepared to take a

longer investment horizon and be willing to

accept more stringent liquidity provisions. In

any case, it is import ant that investors clear-

ly understand the fund terms in order to avoid

unpleasant surprises later on.

Liquidity requirements and return potential

As Alexander Ine ichen point s out , hedge

funds used to be known as an asset class that

delivers superior returns at lower volatility.

However, our view at this time is that lower

expected upside from traditional asset class-

es (i.e. weaker beta drivers) in combination

with structura l changes is likely to dampen

the return potential of hedge funds. With re-

gard to structural changes, the investor base

of hedge funds is increasingly made up of

institutional investors, while private investors

previously played a larger role. Tougher re-

quirements regarding liquidity and transpar-

ency have made it easier for institutional in-

vestors to include hedge funds in their

portfolios. Further, the shift toward a more

institutional investor base has increased the

focus on the role of hedge funds in a port fo-

lio context: low correlations with other asset

classes and more stable return patterns have

become the key dif ferentiating feature rather

than the delivery of high returns. With tough-

Glossary of liquidity provisionsRedemption notice period Minimum period foradvance notice prior to redemption.

Redemption period Frequency with whichinvestors can withdraw their funds.

Lock-up Time period from the initial investmentuntil it is possible to make a f irst withdrawal.

Gates A gate limits withdrawals to a certainpercentage of assets under management duringany redemption period.

Side pockets A provision that allows the managerto keep particularly illiquid holdings in a separateaccount. There is usually no liquid mar ket forthese holdings. It may be difficult to establish theholdings values and may be difficult to sell

them. Hence, if an investor places a redemptionrequest, the manager does not need to liquidatepositions in a side pocket immediatel y. Pro rataproceeds of these holdings are only distributed toinvestors once these holdings have been sold – which can be long af ter an inve sto r ha s w ithdrawnhis capital.

Hedge Fund Barometer variables: LiquidityHedge funds thrive when liquidity conditions improve and are exposed to liquidity shocks when cond iti ons tighten. Source: Credit Suisse/IDC

1.00

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0

Liquidity composite 13-week moving average composite

Jan. 96 Jan. 00

Percentile rank value

Jan. 04 Jan. 08 Jan. 12 Jan. 92

Liquidity tight

Liquidity plentiful


23/68


The different hedge fund stylesand how they deal with liquidity

Tactical trading strategies are resilient when liquidity is scarceTactical trading strategies include global macro and managed futures.

In this style, managers try to exploit trends in equity, fixed income,

currency and commodity markets. Analysis of macroeconomic variables

rather than corporate transactions or security-specific pricing discrepan-

cies distinguishes tactical trading from other styles.

Tactical trading strategies t rade in all major markets. However, one

major difference between managed futures and global macro is that

managed futures focus on trading futures contracts, the most liquid in-

strument. In contrast, global macro managers have the widest investment

universe trading a broad range of different market instruments.

Another key aspect of the tactical trading sty le is that some s trategies

are purely model driven. Within managed futures, trend-following strategiesare probably the best-known example of this strategy. A model generates

trading signals upon which trades are executed. Human discretion and

emotions are negated, which helps explain why tactical trading strategies

are well positioned to navigate through crisis periods. While discretionary

managers may rely to some degree on models, they can use their own

judgment when making investment decisions, and may be more prone to

making irrational decisions in a tough investment environment.

Fundamental strategies have various degrees of sensitivity to liquidity

Fundamental strategies focus on individual securities, mostly in the equity

and fixed income areas. While directional strategies usually build a broad-

er portfolio of more liquid securities and thus deliberately take directional

market exposure, event-driven strategies often build a more concentrated

portfolio of securities depending on a specific catalyst (event). Directional

strategies tend to take positions in more liquid publicly traded securities,

while event-driven styles often engage in illiquid securities (e.g. distressed

debt, special situations and activist investors with longer holding periods).

While liquidity sensitivity depends on the underlying investments, the

leverage applied is typically lower than in the relative value segment.

Relative value strategies depend on a favorable liquidity environment

Relative value strategies include fixed income arbitrage, convertible

arbitrage and equity market neutral strategies. They aim to exploit pricinginefficiencies between related or unrelated securities and try to avoid

directional market exposure. Forgoing returns from beta drivers, returns

of these strategies would naturally be lower (yet more stable and with very

low correlation to movements in major asset classes). Leverage is a way

to enhance returns. It can be high, particularly for fixed income strategies

where targeted pricing inefficiencies can be small. But this makes the

strategy sensitive to liquidity conditions. While these strategies tend to do

well as long as markets move in their favor, volatile markets with scarce

liquidity can mean that positions need to be sold at unfavorable prices –

or worse, cannot be sold at all. This left many investors with large losses

during the financial crisis. It is thus vital to keep an eye on market liquidit y.

er regulatory requirements, operating costs

have risen, which in turn has left some small-

er hedge funds unprofitable. Conversely, in-

stitutional investors have been willing to sac-

rifice high returns for lower risk as long as

their needs for liquidity and transparency are

fulfilled. For these structural reasons, we

think that the return potential of hedge funds

has generally decreased.

Liquidity drives our hedge fund strategy

The Credit Suisse proprietary Hedge Fund

Barometer is our main tool to assess the

broad investment environment for hedge

funds. The tool is an early warning framework

that should help avoid unnecessary risks. Be-

sides volatility, the business cycle and sys-

temic risk, the tool also assesses liquidity

conditions. While we have observed a gen-

eral increase in risk starting in late 2014,

tightening liquidity conditions began to draw

our attention in early 2015. As the second

chart shows, liquidity conditions deteriorated

around the turn of the year. While tighter li-

quidity is generally a concern for hedge funds,

some strategies are less affected and can

even thrive in such an environment (see first

chart). Given the divergences in monetary

policies between the main regions and, in

particular, the likely approach of rate hikes by

the US Fed, we do not expect liquidity condi-

tions to improve materially in the near future.

Therefore, we adjusted our hedge fund strat-

egy in early 2015 and began to focus on

strategies that are less sensitive to liquidity

conditions, e.g. tactical trading s trategies. At

the same time, our outlook worsened for

relative value strategies, particularly those

that are active in fixed income investments.

These strategies typically apply higher lever-

age and/or invest in more illiquid securities,

and are thus at greater risk when liquidity

conditions tighten.

In sum, when investing in hedge funds,

investors should not just take traditional mar -

ket drivers into account, but also focus on

liquidity considerations. Illiquidity can be a

source of risk, but also a source of addition-

al returns for investors. Careful analysis of

the role of market liquidity in an investment

strategy can help avoid unnecessary risks and

lift returns.

Marina Stoop

Cross Asset and Alternative Investments Strategist

+41 44 334 60 47

[email protected]


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Open-end versus

closed-end funds

Average discount to net asset value for US closed-end investment fundsThrough the worst of the Global Financial Crisis, the average discount on closed-end funds dipped from roughly – 7% to –11% in January 2008 before rebounding shar ply, but briefly – after which it fell t o –18% before recovery at the start of 2009. Source: Bloomberg, Credit Suisse

MSCI World Average discount 3m MA (rhs)

01.05 07.05 01.06 07.06 01.07 07.07 01.08 07.08 01.09 07.09

800

600

400

200

000

00

00

Making what turns out to be the right investment

decision can hinge upon the underlying asset

type, and understanding the fundamental

differences between open-end and

closed-end funds.

In times of crisis

The discount of closed-end funds mirrors thedevelopment of the overallmarket. The discountincreases as the crisisunfolds, but is quick torevert again as recoverybegins to take hold.

–11%

In good timesOn the upward trend,investors see the discountnarrowing noticeably for

closed-end funds as theeconomy strengthens.

– +

0

–2

–4

–6

–8

–10

–12

–14

–16

–18

–20

–7%


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Investors have many choices when select-

ing a pooled investment fund: regional

versus global, active versus passive, bonds

versus equities, famous manager versus

start-up, and so on. But one choice can be

overlooked: open-end versus closed-end

funds. On occasion, this may be the most

important i ssue.

As we wil l show, the practical dif ference

for investment returns may not be great under

normal market conditions, but can become

significant at times of market stress, espe-

cially for funds investing in illiquid assets such

as real estate, small caps, or specialized cred-

its. In such cases, a closed-end fund may be

the better structure.

Key differences

Closed-end funds have a fixed asset pool.

This can grow (or shrink) due to good (or bad)

investment performance, but normally no ex-

tra capital is added from investors or paid out.

An existing investor who wants to exit must

sell on the open market to another investor

who wants to put money in. In contrast, the

assets in open-end funds can change be-

cause of shifts in market prices as well as due

to net inflows or outflows of capital from in-

vestors. When net new money comes in, the

manager invests in extra underlying assets,

whi le exit ing investors sell unit s back to the

fund manager, who disposes of underlying

investments to meet net redemptions.

Operation under normal market conditions

Investors in open-end funds buy and sell units

at a level equal to the underlying asset value

(subject to enough liquidity, see below). By

contrast, the price of closed-end funds is typ-

ically at a premium or discount to the underlying

assets, reecting the balance between the sup-

ply from exiting investors versus demand from

those entering. Academic studies have argued

that a premium might reect the skill of the

manager or the rarity of the underlying assets,

while a discount might indicate lack of con-

dence in the manager. Morningstar data shows

that, over the long term, closed-end US funds

have on average traded at a slight discount.

This tends to deepen when markets go down,

while it narrows or moves to a premium when

markets go up and investors become more

optimistic.

Some closed-end funds buy back their

own shares to try to narrow the discount, en-

hancing value for remaining investors. Some-times, external predators try to gain control

and liquidate the fund at the market value,

Giles Keating

Head of Research and

Deputy Global Chief Investment Ofcer

+41 44 332 22 33

[email protected]

Lars Kalbreier

Head of Mutual Funds & ETFs

+41 44 333 23 94

[email protected]

thus effectively eliminating the discount.

Despite these measures, discounts and pre-

miums rarely disappear completely, perhaps

because demand for most closed-end funds

is dominated by retail investors who tend to

be procyclical.

When money ows in or out of open-end

funds, the dealing costs are in many cases

spread among all investors. The impact of these

costs may be negligible in large funds with

little movement, but can be a noticeable burden

on performance in small, fast-growing funds.

Perhaps, more importantly for an open-end

fund with specialist strategies in relatively il-

liquid assets like small-cap or frontier-market

stocks, a good performance in the early years

when the fund is small may be difcult to rep-

licate later if large amounts of new money are

attracted by the good results, but are not eas-

ily investible in the same way. So many suc-

cessful open-end fund managers in specialist

areas close their funds for new investments to

protect existing investors as they approach

capacit y limits. If a manager does not do this,

there can be style drif t, making the track record

of a fund manager less relevant.

Operation in stressed markets

When markets become stressed, such as dur-

ing the financial crisis, some assets may be-

come illiquid, while others remain easy to sell.

When this happens with an open-end fund,

the first investors to exit will tend to receive

cash obtained by the manager from sales of

the more liquid assets. While this is good for

these faster-moving investors, slower-moving

investors are left with units in an imbalanced

fund that holds mainly illiquid assets that can-

not be readily sold and for which the theo-

retical valuation may fall further than the more

balanced portfolio existing before the stress

began. Well-known examples in recent years

include some frontier-market, real estate and

credit funds. Fund managers may have some

ability to restrict (“gate”) withdrawals. If this

is done early in the stress situation, it in effect

temporarily makes the fund closed, protecting

remaining investors. But in a worst-case sce-

nario, this closure happens after the faster

investors have left, which leaves remaining

investors trapped with a pool of illi quid under-

lying assets that may then eventually be sold

as soon as some limited liquidity reappears,

which unfortunate ly is likely to be near the

bottom of the market.

Clearly, this process simply cannot happen

in a closed-end fund. Faster investors who

try to exit will likely find few buyers, forcing

the fund price down to a substantial discount

to the apparent net asset value. In the middle

of the financial crisis in early 2009, the aver-

age discount of the largest US-listed closed-

end funds rose as high as 25%. But the fund

manager is not forced into selling the under-

lying assets to meet withdrawals. Investors

who are prepared to hold their nerve through

the phase of stress will still own a share in

the balanced pool of assets selected by the

manager, with a good chance of recovery af-

ter the stress has passed, and they will not

be forcibly liquidated near the bottom of the

market by the selling actions of other investors

in the fund. Indeed, after the financial crisis,

the average discount narrowed quickly as

markets recovered, providing an additional

return driver for these funds on top of the rise

in price of the underlying assets.

Conclusion: Horses for courses

The conclusion is that investors should choose

between open-end and closed-end funds

largely on the basis of the underlying asset

type. For investments in mainstream, liquid

markets like developed economy large-cap

equities, an established large open-end fund

is probably the better choice in most cases.

It avoids the fluctuating premiums/discounts

of closed-end funds and should be large

enough to avoid issues of dealing cost attribu-

tion, although it would likely not have leverage

capability.

In contrast, closed-end funds are likely to

be the better choice for underlying assets

such as real estate, frontier markets, small

caps and low-grade credit, since these are,

or are at risk of becoming, illiquid with all the

potential issues described above (see ar ticle

on Swiss real estate funds on page 47 for

more details).


26/68


Oliver Adler: From the point of view of

a private client, what’s special about

the New Zealand Superannuation Fund

(NZ Super Fund), as a national

sovereign wealth vehicle?

Adrian Orr: We are a “buffer” fund.

Our aim is to smooth the increasing finan-

cial burdens for future generations. For

that reason, we have a very long-term

investment horizon: no money will come out

of the fund until at least 2031. That pro-

vides us great certainty around our invest-

ment horizon and our li quidity needs. These

“endowments,” as we call them, together

with our governance and our ownership

(i.e. our control over our capital) allow us a

very high level of risk appetite and also

the ability to invest in what can be called

illiquid assets.

Oliver Adler: How do you decide

your investment strategies?

Adrian Orr: We have a number of

investment beliefs against which we contin-

uously test ourselves, for example, that

there is some concept of fair value for an

asset, and that prices may deviate from

fair value, but should also revert to it over

time. These beliefs give us the confidence

to pursue contrarian strategies, as well

as illiquid strategies, if we think the price is

right. All potential investments, regardless

of asset class, are measured in terms of

their attractiveness – either as a diversifier,

or as a (mispriced) opportunity – and, more

generally, their consistency with our beliefs.

Oliver Adler: Isn’t that what the vast

majority of funds do?

Adrian Orr: Most funds have specific

strategic asset allocations (SAA s) to which

they are always rebalancing, whereas

we are oppor tunistic: we are cont inuously

shifting from the least attractive to the most

attractive asset classes or assets, based

on our confidence in our strategies. We are

least invested in black-box hedge-fund-type

strategies that are purely skill-based. We

have low confidence in skill as a basis for

adding investment value because we really

struggle to be able to assess it, and we

also have low confidence in its consistency.

José Antonio Blanco: What kind of horizon

do you use to estimate the attractiveness

of an asset mispricing? How much do

you want to have in illiquid assets? And how

much in liquid ones?

Adrian Orr: We define a long-term in-

vestor as someone who has command over

the capital. So at any point in time, we

Liquidity issues in an institutional portfolio context

AttractivelyconsistentPatient, yet opportunistic. Those are two key characteristicsof the New Zealand Superannuation Fund, whose very long-terminvestment horizon allows it to pursue contrar ian and illiquidstrategies if the price is right, all while managing liquidity at the

whole-fund level.

INTERV IEW BY OLIVER ADLER Head of Economic Research JOSÉ ANTONIO BLANCO Head Global MACS

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