The New York Times recently published an insightful article (If a Fund Turns on a Dime, Watch Your Dollars, by Gretchen Morgenson) that highlights, among other things, the importance of liquidity and transparency when investing in alternative investment funds. By default, alternative mutual funds, ETFs and publicly traded closed-end funds provide daily liquidity and no-less-than quarterly transparency. Most private investments funds, such as hedge funds, don’t provide that same level of liquidity for investors.
The article focused on a fund (described as a “closed-end fund,” likely an interval fund, which is a non-publicly traded form of a closed-end fund) distributed by UBS that had its principal investments in distressed investments. Investors could redeem their assets only once per year – each December. In 2012, the fund suffered an 89 percent decline and, not surprisingly, shut down in 2013.
A few lessons learned (these principles apply to any investment, not just to the fund noted in the article):
- First, when a fund manager changes what appears to have been a successful investment approach, and deviates from the objectives of the fund (in this case, one objective was low volatility,) buyer beware. Most of the best investors do one thing, and do it very, very well. They stick to their knitting. Changes in their investment approaches don’t happen very often, and certainly don’t happen without a lot of thought and discussion with investors.
- Second, transparency is critical. Having a clear understanding of the investment approach, as an investor, and the fund’s underlying portfolio, is critical for the ongoing evaluation of an investment in a fund.
- Third, liquidity is king. The less liquidity offered by a fund, the more trust an investor needs to have in the fund manager and the investment strategy. In other words, once you’re on that ship, there are limited opportunities to get off.
A quote from an investor in the fund highlights the importance of liquidity:
“I knew I was in trouble but there was nothing I could do about it.”
Here are a couple of ways to the think about the liquidity and transparency issues when evaluating a potential fund investment:
Liquidity – The terms of the fund around investor liquidity (especially the ability to make withdrawals) should be consistent with the liquidity of the underlying assets. If the assets of the fund are highly liquid (as is the case with most stocks, futures, options, and high quality fixed income securities,) then the investor’s liquidity terms should be pari passu.
- Highly liquid fund assets should result in the fund providing daily or weekly availability of monies for investors.
- Less liquid fund assets, such as investments in distressed debt, real estate, private investments (private equity and venture capital,) timber, land, etc. should have less frequent availability of investor assets.
Funds with just a few large investments, such as that in real estate or private equity funds, will have long-term lockups of investor principal (5-7 years or more.) More diversified funds investing in semi-liquid assets, such as distressed debt, will have shorter withdrawal provisions (quarterly, semi-annually or annually.)
Transparency – This can come in a couple forms, but some level of transparency around holdings, valuation and the current investment thesis or strategy is critical. Great fund managers keep their investors well-informed of what they are doing (and why) through their monthly or quarterly letters, and also provide details about the portfolio (statistical information, position summaries and position details) that back up their written word. Some private funds (hedge funds for example) provide regular lists of holdings to investors that may or may not be meaningful to the average investor (a long list of derivative positions would likely be difficult for an average investor to decipher.) Mutual funds must report holdings at least quarterly, while ETFs report holdings daily. Hence, transparency means not only an investor’s ability to see and understand what is in the fund, but also a clear understanding of what the portfolio manager is doing with investor assets, and why.
In the case of the fund described in the New York Times article, there seemed to be limited transparency and infrequent liquidity. So while investors knew they were suffering losses (and it appears that the losses were in fairly liquid investments,) there was nothing they could do about it until the next annual withdrawal window. By then, it was too late.
Note: This post originally appeared on Alternative Strategy Partner’s blog page on April 18, 2013.