Liquidity is a coward. – Mark Yusko

A key issue with any hedge fund investment is liquidity. How much should you be paid for illiquidity with assets? How much should you be paid for illiquidity with a fund structure? How much liquidity do you need? What are the liquidity terms that are acceptable for a fund?

We have noticed a desire by a growing number of hedge funds to change their liquidity terms or to at least hold the line on making funds more liquid. This may not be a trend, but investor should watch liquidity terms closely and not give away this valuable piece of fund structure. A structure that reduces liquidity or has gate provisions increases the friction and cost of investment decisions. Investors should be compensated for this structural illiquidity.

Alternatively, a fund that has easy liquidity terms may still be harmful to investors if the underlying assets do not match the liquidity terms of the fund. A fund that has daily liquidity but holds assets that cannot be easily sold may be subject to runs. The investor who buys the daily fund but does not use the liquidity when others are exiting will be subject to significant risk from the behavior of the more active fund participants. Liquid assets will be sold first and investors left in the fund will have lower future liquidity.

At a high level, the liquidity of a fund should match the liquidity of the underlying assets that it holds. A fund that trades futures should have better liquidity terms than a fund that invests in private debt. However, terms that allow for gates as firms get larger sends a signal that the firm is not able to generate enough liquidity despite the expected liquidity of the underling assets.

A simple question is whether investors are getting paid enough for funds that are less liquid and are they getting paid enough for the threat of a run. Put differently, investors should be paid a premium for illiquid assets and they should be paid a premia for the illiquidity of the fund vehicle.

This liquidity premium is not alpha and is not based on the skill of the manager. A fund with illiquid assets, all else equal, should generate higher returns and those returns should be passed to the investors and not just be added to incentive fees. There is a price for both structural and asset illiquidity.