Efficient Flows


Efficient Flows is the fourth installment in a series of papers written by the AIMA and the CAIA.

This paper deals with another crucial concept in the hedge fund industry: liquidity. Liquidity is crucial for every investor to understand. In a time of ever-increasing disruption, investors need to know when they can access their capital, and under what conditions. There is no one-size fits all approach to liquidity. Some investors prefer rapid access to their capital to meet their various obligations. Others (due to their liability structures) can lock up their capital for the longer term, which can represent an important source of competitive advantage for them, as they are able to harvest the potentially higher returns on offer from taking this approach.

Executive Summary:

  • Liquidity is an important, complex concept vital for every investor to understand. It plays an important role in asset allocation and the return characteristics of a portfolio.
  • Hedge fund strategies span the entirety of the liquidity spectrum in all its dimensions. That is why investors need to understand (a) the liquidity of assets in which managers invest on their behalf, (b) the liquidity requirements for strategies pursued by managers, (c) the funding liquidity of such strategies as well as (d) the liquidity provided to investors by the fund vehicles themselves.
  • The liquidity characteristics of the underlying assets and strategy within an investment portfolio (i.e. understanding the position size at least on an aggregated position level) should always be considered by investors before investing in any fund.
  • Amidst an increasing set of demands from allocators and industry rule-makers, hedge funds have, on average, shortened the length of time it takes for investors to redeem from their investments.
  • It is critical for investors to clarify and understand any arrangements relating to fund liquidity. The AIMA Due Diligence Questionnaire (DDQ) for Investment Managers contains questions relating to the liquidity of the underlying assets in the fund portfolio and how quickly the fund could be liquidated.
  • Investors increasingly acknowledge that hedge fund managers should be compensated for offering greater levels of liquidity.
  • The potential impact of fund liquidity risk should be regularly evaluated when estimating the market impact (or cost) of divesting the investor portfolio within a specific time and within specific market conditions.
  • Depending on the investment plan’s liability structure and appetite for risk, long-term investors are best positioned to take advantage of the liquidity premium, if they manage their portfolio liquidity correctly. Typically, the more illiquid the asset, the greater the expected return on the investment.
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