Herding behavior is draining hedge funds of liquidity, data firm Novus has found.
Although hedge funds appear to be fairly liquid when examined on an individual basis, the industry as a whole tells a different story, argued Stan Altshuller, co-founder and chief research officer at Novus.
Liquidity, he explained, boils down to how much time it takes to sell an investment without adversely impacting its price.
“Clearly, managers that own large portions of shares outstanding of thinly traded companies can’t normally unload their full investment at once, and must do so over a number of trading days so as not to drive down the price,” he wrote.
Based solely on its own portfolio, the average hedge fund should have been able to liquidate about 92% of its equity holdings in 30 trading days without affecting prices in 2015, Altshuller said—a level of liquidity that had remained constant over the last five years. In reality, however, hedge funds don’t operate within a vacuum.
“Calculating liquidity strictly based on the manager’s own holdings is deceiving,” he wrote. “What if many managers were to try and sell simultaneously as they often do?”
Working under the assumption that managers move in lock step—“Not too far-fetched, as some investors would agree after the most recent de-risking cycle,” Altshuller quipped—Novus aggregated the equity investments of all the hedge funds in its data universe.
This time, 30-day liquidity in 2015 was just 25%—a steep drop from 2009, when managers could have liquidated half of their portfolios in 30 days even if they sold all at once.
“This trend is a direct result of more hedge fund dollars chasing the same ideas,” Altshuller wrote.
This crowding, he explained, is in part a result of the industry growing, with rising numbers of hedge fund assets making it more difficult to find unique investments. Herding also stems from converging research and investing philosophies, as well as the tendency of managers to share stock picks and copy their most respected peers.
The other reason for illiquidity, besides herding? It’s “where the money is.”
“Given that managers find alpha in less liquid securities and the long-term growth trajectory of hedge fund assets, it’s likely the illiquidity risk will only grow in the near future,” Altshuller concluded.
Source: Novus’s “The Liquidity Deception”
Related: Liquidity Is Top Concern for Health Care Funds & Hedge Fund Herding, and How to End It