Don’t mistake illiquidity for alpha

While many may have doubted the significant risk associated with liquidity in global (and domestic) financial markets — in relation to other types of risks, such as value, market or credit risk — the fallout from last year’s sub-prime crisis has prompted a thought conversion.

One of the leaders in this change of thought is Dr. Ranjan Bhaduri, managing director and head of research at AlphaMetrix, a financial services company based in Chicago, Illinois.

“It is very easy to underestimate the value of liquidity,” explained Bhaduri to members of the Toronto CFA Society during a luncheon at the National Club last week. “That’s because our brains are hardwired to underestimate liquidity.”

This is important, said Bhaduri, because portfolio managers and other financial experts often mistake intuition for logic — and the decisions that are affected by this have a far-reaching impact in the market.

Using a simple “balls in the hat” one-person game, Bhaduri shows how logical fallacy occurs.

In Bhaduri’s game, there is a hat that contains six black balls and four white balls. The player picks balls from the hat and gains $1 for each white ball and loses $1 for each black ball. Each selection is done without replacement until the hat is depleted or until the player chooses to stop; Bhaduri emphasizes that at the end of each pick, the player may choose to stop or continue and that the player has the right to refuse to play (i.e., not pick any balls at all). Given these rules, Bhaduri asks, would a person play?

Bhaduri’s experience is that most would-be players opt out. When pushed, these potential players state that, due to there being more black balls than white balls, the chance of an overall negative outcome is greater, which prompts them not to play.

And it is this answer that confounds Bhaduri, since mathematically it can be proven that there is a positive expected value (of 1/15) in playing this game — “so one should play!” he enthuses.

Bhaduri explains that since a potential player has the ability to stop at any time, this is analogous to perfect liquidity. Bhaduri defines perfect liquidity as “being able to pull out of an investment at any time without the action having an impact on the value of the investment.”

He explains that “this value of liquidity helps overcome the imbalance between the black and white balls, and thus makes this game profitable.” While this proven mathematical statistic may bewilder some financial planners, Bhaduri suggests that the important lesson is not how the formula works but how we, as humans, are “hard-wired to underestimate the value of liquidity.”

Bhaduri believes this underestimation is what prompts investors to ignore the market assumption that those who choose to invest in less liquid instruments should be better compensated than those who don’t.

In practical terms, then, an investor who opts to invest in hedge fund A, with a two-year lock-up and semi-annual returns should be better compensated than an investor who chooses to invest in hedge fund B (with a comparable five-year record) that has no lock-up and monthly returns. “What most analysts would do with these two hedge funds is collect all the data points for the last five years and plot it,” says Bhaduri. “They would use the standard statistics, such as Sharpe, omega, kurtosis, volatility, return and even standard deviation. Yet, no matter what they are charting or plotting, they will not get accurate data as they are comparing apples to oranges.”

This is because liquidity also has value, says Bhaduri, who believes that disregard for liquidity risk is at the heart of the credit crunch.

He suggests that all portfolio managers adopt liquidity buckets — a simple concept that enables them to compare different investments based on liquidity, rather than asset class, geography or other factors. “It’s a partition-based strategy,” explains Bhaduri, “but with an eye on liquidity.”

If managers and analysts were to separate investment vehicles based on their liquidity, they could begin to see which investments are underperforming, based on the market assumption that those who choose to invest in less liquid instruments should be better compensated than those who don’t.

“It is incorrect to merely compare the statistics of these two hedge funds,” says Bhaduri. “Hedge fund B allows the investor to get out of the investment sooner, and this has a value that does not appear when one calculates the statistics. Due to the illiquidity and lock-up, hedge fund A should be furnishing a better statistical return. One needs to quantify the value of liquidity in order to make a fair statistical comparison. Otherwise, it really is comparing apples to oranges.”

What is more disturbing is that Bhaduri suggests that too many portfolio managers mistake the illiquidity of an investment vehicle for alpha. It’s a mistake investors also make.

“Qualitative due diligence is more important than quantitative statistics,” says Bhaduri. “And ‘intuition’ is another word for laziness concerning matters of liquidity.”

Originally published on Advisor.ca on  June 20, 2008