Returns of liquid versions of hedge fund strategies in aggregate lagged those of private partnership versions of the same approach by an average of one percentage point annualized over the 10-year period ended March 31, according to a new report by alternative investment consultant Cliffwater.
With the proliferation of liquid alternative vehicles — mutual funds, UCITS funds, separately managed accounts, managed account platforms and securities of listed hedge funds — Cliffwater decided to examine “whether or to what extent investors in liquid vehicles forego return in exchange for better liquidity, compared to equivalent investment in institutional private partnership vehicles,” according to the report, “Performance of Private Versus Liquid Alternatives: How Big a Difference?”
Analysis of monthly net-of-fee returns for 109 investment managers that run 148 private partnership and liquid approaches in the same general strategy found on average that the liquid version underperformed the private vehicle by 0.98 percentage points annualized over the decade.
The “liquidity discount” in returns was greatest for liquid event-driven hedge funds, which trailed the illiquid version by 2.26 percentage points over the 10-year time frame; market neutral, 2.24 percentage points; long/short equity, 1.07 percentage points.
Liquid managed futures vehicles had the smallest performance drag over the period, trailing private funds by 0.4 percentage points.
In terms of total risk and market beta risk, Cliffwater's analysis found that risk and alpha generation — risk-adjusted excess return — was roughly similar between private and liquid alternatives. The report's authors concluded from these findings that “the liquid alternatives investor is paying for better liquidity out of alpha rather than other sources of return.”
The difference in return by type of liquid investment vehicle was highest for managed account platforms at 1.68 percentage points, a “statistically significant” variation, according to the report. The liquidity discount was lower, at 0.43 percentage points, for 1940 Investment Company Act mutual funds, and 0.55 percentage points for UCITS.
Despite the average annual 98-basis-point difference in returns of liquid and private hedge fund strategies, Cliffwater's report concluded that “will be viewed by both private partnership investors and retail investors as a reasonable price to pay for enhanced liquidity.”