Why wealth managers should consider hedge fund liquidity waterfalls 

A hedge fund allocation can enhance a portfolio by providing access to diversified alternative return sources, capital preservation through asymmetry, and an attractive risk/reward profile. These elements contribute to overall diversification and can act as a "zigging" allocation when other portfolio components are "zagging." However, self-imposed constraints on hedge fund allocations can significantly diminish these benefits. One common constraint we see relates to the increasing emphasis on liquidity broadly across portfolios. While liquidity constraints are often seen as essential for risk management and/or operational efficiency, they can hinder the potential advantages of a semi-liquid allocation.  Below we review some examples of the drawbacks of self-imposed liquidity constraints to a hedge fund (semi-liquid) allocation as it relates to potential benefits.

Diversification is a fundamental principle of asset allocation. By relaxing constraints, hedge funds can take a holistic approach to risk and return, potentially allowing for active management to deliver true portfolio diversification. An important part of that potential diversification benefit is achieved by capturing the more transient liquidity dislocations (ranging from months to maybe 3 years depending on the strategy). Imposing liquidity constraints naturally can shift risk exposures from independent sources to more traditional, beta-dependent ones, which could erode the benefits of diversification and impact return potential. Said plainly, it is hard to deliver something unique by pursuing the same thing in the same manner.

A proper hedge fund allocation can offer capital preservation in part through enhanced risk management and through a hyper focus on price discipline (read downside scenario analysis).  This valuation focus often leads to opportunities that are process driven including special situations, future events, stressed/distressed balance sheets and activist/engaged campaigns among others. In these situations, re-ratings and valuation recovery can take time and this mayvary, potentially leading to episodic returns and alpha.  With downside presumably priced in, success in these opportunities, when combined with enhanced risk management tools, can lead to an asymmetric return profile and likewise, excluding these opportunities due to liquidity constraints can alter that skew. Properly aligned investment terms can not only allow for an effective capture of certain semi-liquid opportunities, but can serve to protect the collective investor base in that pursuit.

Hedge funds in part, seek to capitalize on time horizon arbitrage often created by regulations or short-minded investors by serving as a liquidity provider in markets and facilitating asset transfer while also capturing price recovery in the interim.  Imposing liquidity constraints can limit access to these opportunities and key return sources.  As illustrated below the higher constrained industry indices (HFRX) have significantly underperformed the less constrained (HFRI) indices over time and this is persistent across broad strategy types.  On average across this sample, the underperformance over trailing 5 & 10 years is 380 and 300 basis points annualized, respectively.  We believe this is in large part due to liquidity constraints. 

We encourage wealth managers to diversify portfolios across multiple dimensions including liquidity, particularly where liquidity allocations aim to capture different opportunities. For example, a typical allocation might be 60% liquid, 30% semi-liquid, 10% illiquid with hedge funds serving to capture the more dynamic liquidity dislocations. Importantly, the semi-liquid portion and benefits can be achieved within its own balanced liquidity profile and natural liquidity waterfall. Most investors will rarely (if ever) have a need for 100% of their hedge fund allocation at once, but may require quick access to a portion for rebalancing or upcoming spending needs.  A hedge fund portfolio that includes protective strategies, which tend to be (up to) monthly liquid with no lock-up, can serve as an ideal tool for rebalancing.  A well-diversified hedge fund portfolio by strategy will naturally possess a liquidity waterfall. In ascending order of illiquidity this would typically be hedging strategies, trading strategies, equity, event / relative value, credit and distressed for example.  A hedge fund liquidity waterfall is provided below for illustration assuming all initial lock-up periods have expired.

Wealth managers invest on behalf of their clients for multiple reasons including to compound capital, to preserve capital, to offset inflation impacts, to meet spending needs or liability obligations or some combination of these. However in all cases, the pursuit is for some benefit and to maximize that benefit net of the efforts, risks and costs to do so.  When it comes to execution though, investors can lose sight of optimizing for those benefits. Over the past two decades, a rise in highly liquid instruments has arguably led to a bifurcation in liquidity budgets, with instant/daily liquidity on one end and 7-10+ years on the other. In the middle though, there are unique return sources that are arguably best captured through a hedge fund allocation.  Rather than imposing hard limits (e.g., within 1 day, 1 week, 1 month, etc.), we recommend a more flexible liquidity profile for semi-liquid allocations, allowing for nuanced exposures while maintaining oversight and maximizing the benefits within a balanced liquidity framework.