Jeff Benjamin

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The unspoken cost of liquid alternatives

Retail products introduce a liquidity premium

Oct 17, 2012 @ 1:30 pm

By Jeff Benjamin

With only about $130 billion in total assets invested in alternative strategy mutual funds and exchange-traded funds, the so-called liquid alternatives space is still relatively small.

But, as more attention is paid to non-correlated strategies, that same liquid alternatives space is seen by a lot of firms across the financial services landscape as the next frontier of hot investment products and strategies.

In many respects the liquid alternative products represent an excellent first step toward greater portfolio diversification for both growth and income. But let us not overlook the significance of the cost associated with liquidity.

“It's kind of along the lines of the emperor has no clothes, because it's not something everyone wants to hear,” said Mark Goldberg, managing director at W.P. Carey Inc.

Take private equity, for example.

In its purest form, a direct investment in a private equity fund would require a multi-year lock-up period, but also introduce a risk premium of about 18% over risk-free assets.

However, according to Mr. Goldberg's analysis, when a private equity strategy is offered in the form of a mutual fund or ETF the added liquidity benefit trims about three percentage points from the risk premium.

“A private equity ETF is not investing in private equity, it's made up of securities that are modeled after private equity returns,” he said.

Mr. Goldberg, who will present his research on liquidity premiums next week in Chicago at the InvestmentNews Alternative Investments Conference, is not opposed to the use of liquid alternatives. He just thinks it's important that advisers and investors fully understand the cost of accessing alternatives through registered, retail-oriented products.

“There are a lot of benefits to buying liquid alternatives, but you do give up something,” he said. “These products are designed to create some liquidity in the alternatives space, but people need to understand that liquidity comes at a cost, and anyone telling you that it's not so is denying all the research that has been done in this area.”

Describing liquidity as a continuum, where nothing is completely liquid and nothing is completely illiquid, Mr. Goldberg has studied the liquidity premium from multiple angles.

For example, comparing the minimum two-year lockups that come with restricted stock to that of the much more liquid common stock, Mr. Goldberg identified a “30% differential,” when combining the illiquidity discount and the liquidity premium.

The analysis even applies to fixed income, where Mr. Goldberg calculated the liquidity premium of newly-issued U.S. Treasury bonds to that of comparable Resolution Trust Corp. bonds issued in the late 1980s to rescue the savings and loan industry.

Even though both categories of bonds have the same government guaranty, Mr. Goldberg calculated a liquidity premium of more than 5% for the newer issues.

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