It’s the End of the World as We Know It…

It’s official. Everyone hates, or at least is falling out of love with, hedge funds. An apocalypse is coming and hedge funds are soon to be no more. Why pay 2 & 20 (by the way, very few actually pay that anymore) for an investment that doesn’t provide “returns better than the market, no matter what the market is doing.” Of course, I’m using a bit of hyperbole, but based on the headlines one might believe it’s the end of the world for hedge funds. And truthfully, in their current form, it might be. As I write this, the headlines on Bloomberg TV states that “Hedge Funds May Lose Quarter of Assets” and “Day of Reckoning Coming.”

As an alternative mutual fund provider, we would like to think a portion of the assets from this potential mass hedge fund exit will be coming our way. And we do believe that there are good reasons for institutions to have at least a portion of their alternatives allocations in more transparent, cheaper and more liquid vehicles. But thus far, alternative mutual funds as a whole haven’t exactly won over large institutions or their consultants. Instead, they seem to be moving toward even less liquid alternatives, such as private equity.

I was pondering this move to less liquid assets, trying to decide if it made sense. One major benefit of private equity is that investors don’t get to see day to day valuation changes of the underlying portfolio, so there is no pressure to react to short-term performance. On the other hand, daily valued mutual fund investors seem to be reacting to ever decreasing windows of performance. It’s been proven that, due to this short term-performance reactionary behavior (that was a mouthful), investors in mutual funds substantially underperform those same funds’ actual returns (“the investor behavior return gap”). Depending on your source, this number falls somewhere between 2-6% annually; at the same time private equity has earned an “illiquidity premium” of about the same amount. Could the “illiquidity premium” and the “investor behavior return gap” be two sides of the same coin? Maybe if we, as investors, ignore the headlines and the day-to-day movements of our portfolio and instead act more like private equity investors, we too can earn the elusive “illiquidity premium” while investing in more liquid alternatives. And then maybe, even as the world ends, we’ll feel fine.