Is There a Liquidity Risk in Liquid Alts?

Is There a Liquidity Risk in Liquid Alts?

The SEC is scrutinizing liquid alt funds and suggesting mechanisms to mitigate structural risks.

Alternative mutual funds are a fast-growing part of the investment space, pushed by asset management companies that are suffering from the larger secular shift away from active and higher-priced management toward index funds. Packaging hedge fund strategies in mutual fund wrappers carry higher management fees and possibly bring appropriate risk mitigation investments to retail investors. But as more assets flow into the space, they are coming under scrutiny by the Securities and Exchange Commission (SEC) regarding how well they can handle liquidity risk.

In the past several years, these liquid alt funds saw significant inflows, says Keith Black, managing director of curriculum and exams for the Chartered Alternative Investment Analyst Association. In 2007 there was less than $100 billion in the space, but that’s now about $800 billion, he says, including U.S. mutual funds, U.S. exchange traded funds (ETFs) and the Undertakings for Collective Investment in Transferable Securities (UCITS). 

And they are taking a bigger slice of the investor’s dollar. By 2017, assets under management overall are expected to rise to $1.3 trillion, a compounded annualized growth rate of 19 percent. Over this same time period, the proportion of liquid alt funds will rise from 2.2 percent to an estimated 9 percent, Black says.

Portfolio diversification, risk mitigation and the quest for income are responsible for much of the rise. In their strategies, these funds largely mimic hedge funds, which limit entry to private placement partners and have long lock-up periods. In the mutual fund wrapper, net asset values (NAVs) are calculated daily and investor redemptions must be met in seven days. 

That raises concerns that these funds may trip up if asset values fall and the securities in these funds need to be sold quickly, in less liquid markets. 

Further, the volatility of inflows and outflows in liquid alts is significantly larger than even traditional stock and bond funds, says Black.

The SEC addressed these issues and others in a September proposal for liquidity risk management requirements for registered mutual funds and ETFs as part of an overall broader move by the regulator to update the Investment Company Act of 1940.

Among the key points in the proposal are allowing funds to implement “swing pricing” as a way to pass on redemption costs to the shareholders exiting their positions; the hope is that would help protect remaining shareholders from NAV dilution and keep a greater amount of assets on hand that can be turned into cash in three days to satisfy any immediate liquidity needs.

Three Main Types of Liquidity Risk

Norm Champ, lecturer at Harvard Law School and a former director of the SEC’s investment management division who is writing a book about his experience there, says swing pricing is an innovative idea and worth looking into, and that a review of the issue is past due. 

“The issue of what was liquid or what was illiquid in a mutual fund portfolio has been lingering for quite a while. The limit (for illiquid holdings) is 15 percent for mutual funds. That is based on staff guidance,” he says.

The regulatory changes under the Dodd-Frank Act, the growth in these strategies and the current volatility of both the bond and stock markets all make the SEC proposal timely, he adds.

There are three main types of liquidity risk to consider with these funds, Black says. One is how easy is it for the fund manager to sell the assets within seven days at a price close to where they are held. The second is counterparty risk, and the third comes when investors withdraw money and the fund must raise cash on short notice. 

That makes liquid alts more susceptible to liquidity risk, says Aaron Gilman, president and chief investment officer of Independent Financial Partners Wealth Management. 

“When you add layer and layer of leverage, illiquidity and the opaque nature of these (strategies), all it would take is one really bad event…and your NAV drops dramatically,” he says.

Gilman and Black say these funds aren’t that well understood, compounding the issue. 

“Every strategy is different and you need to understand the mechanics. Exactly what happens in a managed futures fund? What happens in a commodity futures fund? What happens in a long-short equity and nontraditional bond?” Black says.

Just like traditional funds, benchmarks are critical. “It’s going to be difficult to hold an investment or explain performance if you’re not sure exactly what performance is supposed to be at a specific point in the market,” he says.

Some investors see liquid alts as a way to ward against market volatility, but Black and Gilman point out that most of these funds weren’t around to experience the 2008 market crash.

Whether or not these SEC proposals will actually minimize the liquidity risk of alternative mutual funds remains to be seen.  

When asked how the proposals might affect the mutual fund industry, Matthew Beck, senior director, media relations at the Investment Company Institute declined to comment on the SEC’s proposed liquidity risk management programs, as they are currently reviewing it and consulting with their members. 

Gilman wondered if the proposal may change how active fund managers behave.

“This will force managers of active funds to be more scared and stay close to what the benchmark is doing to avoid any negative impacts that can arise from people punishing them or looking negatively at the funds,”
he says.

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