Focus on hedge funds: Investors should look beyond daily liquidity, counsels FRM’s Luke Ellis

Illiquid positions are still common in the hedge funds space and can be useful for investors, according to Luke Ellis, chief executive and CIO of Financial Risk Management, a newly acquired part of Man Group.

Ellis (pictured), who runs fund of hedge funds investments for the group, said it was more efficient for investors not to be tied into the idea of needing daily liquidity.

Frequent liquidity was like having a deposit account, and implies similarly low returns, he said.

But he added it is important to be able to liquidate investments within 90 days. Ultimately, it is not possible to get decent investment returns and perfect liquidity, he said.

Looking at the broader investment landscape, Ellis said it was in many ways premature for market participants to declare they could see a path forward out of the global financial crisis.

The markets are still in a state that they have not been in for “hundreds of years”, especially as regards North America and Europe, he said.

From the perspective of someone who analyses the performance of hedge fund managers – FRM has $7.5bn in multi-manager managed accounts – Ellis said the prevailing zero- or even negative real interest rate environment had a profound impact on the ability of managers to produce alpha.

Moving from a position that was common for a long time, of real yields hovering around 3.5%, has resulted in a significant reduction in total returns, once real yield, inflation and risk premia are added to the equation, he said.

And when total return is measured against volatility it is resulting in significantly lower information ratios compared to the situation before the financial crisis struck.

Additionally, the volatility of real yield has itself increased, also a difference compared to the pre-crisis status quo.

Ellis said the situation facing investors was similar to the one he experienced when working in Japan in the 1990s. This manifested itself in bouts of stock market index recovery that proved unsustainable.

Prices would start rising only to fall once fundamentals were again reviewed, he said.

This will affect typical equity long/short strategies, he said.

Whereas the typical 80 long/20 short approach with some downside protection through out-of-the-money puts used to work, this was no longer necessarily the case.

People are tending to go a bit more long but, significantly, out-of-the-money puts have become “incredibly expensive”.


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