Alternatives’ Lack-quidity Problem

Question: When is a liquid asset not a liquid asset? Answer (possibly): When it’s a liquid alternative.

UBS saw it coming five years ago. As providers and investors alike were drawn to regulated structures for hedge funds, the Swiss financial giant warned in a 2011 report that “many hedge fund strategies cannot be successfully implemented in the open-end format, such as global macro, fixed-income arbitrage, or distressed investing.” 

The problem? Liquidity.

However, providers had already put together regulatory changes, such as new UCITS (Undertakings for Collective Investment in Transferable Securities) mutual fund rules in Europe, with the flood of distressed debt that emerged as banks sought to offload high-risk assets. 

One such provider was Third Avenue Management. Its Focused Credit fund peaked at more than $3.5 billion in 2014, according to a Wall Street Journal report, all in illiquid and distressed debt, as investors piled into the asset class.

But the good times did not last. Demand for credit-focused hedge funds “evaporated” in the second half of 2015, stated data firm eVestment in January.

By this time, the effect of this evaporation was all too clear. Third Avenue Management abruptly closed the doors on the Focused Credit fund in December following a spate of withdrawals, and was soon forced to unwind its portfolio and return cash to investors. 

Lutetium Capital, which ran a similar strategy, shut its doors in January and handed back money to investors after clients withdrew the majority of its $150 million in assets. Agreeing to liquid alts terms, Co-Founder Michael Carley told CIO at the time, was “a good way to get assets under management. The money came in very quickly, and rolled out even faster.”

The US Securities and Exchange Commission is paying close attention. Commissioner Kara Stein told a think tank last year that liquid alts funds operate in a regulatory “gray area.” The trend “should give everyone pause, and regulators and the public need to be asking questions about this development.”

An example of one liquid alts provider’s (PIMCO) disclaimer should be enough to make investors aware of what they are getting into: “There is no guarantee that a security will be able to be liquidated in a timely fashion or when it would be most advantageous to do so.”

You can’t say you haven’t been warned.