NEW YORK (HedgeWorld.com)--People tend to be painfully aware of the risks of holding illiquid assets but less mindful of the extra return that can be obtained by taking these risks. A review of current research evaluating the costs and benefits of illiquidity shows that some investment behavior in this regard is not strictly rational.
The author, Hilary Till of Premia Risk Consultancy Inc., Chicago, quotes David Swensen, the manager of Yale University's US$11 billion endowment and a pioneer in alternative investing. American investors pay far too much for liquidity, Mr. Swensen reportedly said.
Hedge funds as a whole are less liquid than traditional investments because of lock-ups and infrequently traded assets, such as over-the-counter derivatives and distressed debt. For investors, a key issue is how to compare investments with different degrees of liquidity.
People get worried when they can't take their money out or when there is uncertainty about the value of the portfolio due to thinly traded instruments. Smoothing of returns by some hedge fund managers might be a way of calming nervous investors, but researchers have argued for investor education instead of obfuscation, Ms. Till points out.
She describes methods for estimating the cost of the illiquid nature of hedge fund contracts and for understanding portfolio valuation risk. There are various approaches to adjusting for illiquidity.
Ms. Till concludes that investors "must decide whether the return premium one receives from holding illiquid investments is sufficient compensation for the added default, liquidation and valuation risks one assumes."
The article was published in a collection edited by Barry Schachter, titled Intelligent Hedge Fund Investing: Successfully Avoiding Pitfalls Through Better Risk Evaluation (London, Risk Books, 2004).
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.