| Fund of hedge funds face growing liquidity mismatch |
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| 02/09/2007 | |
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Common wisdom may hold that a number of fund of hedge funds (FOHF), most of which do not have lock up provisions, may be facing a liquidity crunch at the moment. At the core of such an argument is the fact that most FOHFs are invested in less liquid underlying assets such as individual hedge funds, many of which have liquidity constraints or lock up provisions. The result is what industry experts refer to as a liquidity mismatch. This begs the question: how does a FOHF, invested in a less liquid pool of funds, respond to redemptions during sharp market downturns? bfinance spoke to a number of fund-of-funds to see how they are coping in the current volatile environment. Their comments suggest that many of the larger FOHFs are dealing better than expected, and while most FOHFs do not have lock up provisions, one has actually seen net inflows in the month of August, a difficult one for the broader market. Moreover, many FOHFs have a host of defences to resort to should redemptions accelerate. A gate feature, for example, can restrict outflows and facilitate orderly unwinding in times of extreme market stress. The €7bn Gottex Market Neutral Fund has a 10% gate feature. It can be triggered when the fund sees redemptions in excess of €700m. Put differently, the fund manager does not have to meet redemptions in excess of €700m for any notice period. Gottex gets is One of the largest fund-of-funds, Gottex is far from such a scenario. Its assets actually grew in August, says Max Gottschalk, partner and senior managing director. It saw $400m in net inflows in the midst of a volatile environment. "What we are seeing is that our underlying managers may take a little longer to pay, so we make sure that the investments we have match the liquidity needs of our clients. We typically try to avoid hedge funds with lock ups. More than half of our investments are monthly liquidity hedge funds." Gottex, which has a 35-day redemption notice, returned about 4% year-to-date at the end of August compared to 6.25% at the end of June, says Gottschalk. Yet it experienced net inflows during the turbulent period partly because of the diversification attributes of its underlying hedge funds. "Investors have come to recognise that hedge funds have a different risk profile than equities and bonds, and institutions are consciously changing allocations to different asset classes." Indeed, the year-to-date returns achieved by Gottex are in excess of most equity market indices. A number of studies have explained this out-performance partly due to the illiquidity premium associated with the lock ups and share restrictions of hedge funds. "The annual returns on funds with lockup provisions are approximately 4% higher than those of non-lockup funds," concludes George Aragon in one study titled "Share Restrictions and Asset Pricing: Evidence from the Hedge Fund Industry." The results are consistent with previous findings, though a May 2007 study by Bing Liang and associates concludes: "Although the behaviour of mutual fund flows is well-documented, hedge funds have proven much more elusive. Besides the difficulty in obtaining complete hedge fund data that is free of reporting biases, hedge funds exhibit many complex features that impact flows, relative to mutual funds. Common hedge fund characteristics include restrictions on lock up periods, forced redemption, capacity constraints, asset illiquidity and required delay periods for subscriptions and redemptions." Lock me up The liquidity mismatch between FOHFs and their underlying assets has been growing in the last three years. Historically, hedge funds had shorter redemption notice periods, ranging from 35-45 days. Lock ups have become more common in recent years. One recent driver was the adoption of SEC rules requiring certain hedge funds to register as investment advisors. One way for hedge funds to sidestep registration was to put into place two-year lock ups. The SEC later dropped their no lock up requirement from their definition of what constituted a hedge fund, but many kept the lock up anyway. A managing director at an offshore fund-of-fund told bfinance that a year or two ago an increasing number of activist hedge funds, most with lock ups, came on the scene. "Many FOHFs have been investing in them," he says. "In the current environment a FOHF wants to have lock ups, because in times like this, most investors become short-term. You have a month like August come along and you want to change your allocation. But as a FOHF manager you have to think two, three, six months out and ask 'how am I going to decrease my credit exposure?' If in February or March you picked up on warning signs and wanted to take down your subprime exposure, you could not have in a hedge fund with a quarterly redemption notice. You could not have changed course until June or later." The fund, which has a redemption notice of 36 days, has seen net outflows equal to less than 1% of assets in the past three months. "The outflows have been normal, the inflows have slowed." Similar to other FOHFs this one market neutral fund has a 15% short-term borrowing facility in place to meet redemptions, but it has not drawn on the facility in the current downturn and does not forsee this happening today. For redemptions to accelerate you probably need to post three or four consecutive months of negative performance, he says. "I have read thousands of prospectuses. They are all written with the spirit of defending the investors of the fund. The Board has the obligation and responsibility to protect the fund's investors." VB |
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