Novus Methodology: Guide to Measuring Liquidity

Since the credit crisis of 2008, fund liquidity has increased in importance with alternative investors and is now one of the primary concerns along with transparency, fees, and performance. Data shows that the concern is fair. In a recent study, we found a relationship between a fund’s liquidity profile and performance during periods of stress, with less liquid funds often exhibiting larger drawdowns than their more liquid peers. While studying a fund’s liquidity in isolation often misses a more critical factor, namely, crowding, it is still important for investors to understand the extent to which their money is locked up in a particular manager. In particular, it is useful to compare the manager’s liquidity in the market to that which they offer their investors. For instance, there could be a situation where a manager has very favorable (highly liquid) terms for investors, yet their portfolio is not liquid. This can spell trouble for investors and lead to gating during a period of stress.

Measuring Liquidity

One of the simplest ways to get a quick pulse on manager liquidity is to calculate the percentage of portfolio they can liquidate in 30 days. Novus calls this metric 30-day liquidity and we calculate it for every manager in our system. The caveat is that the numbers discussed in this post are calculated for the public long portion of each manager’s portfolio, but investors use a similar approach to calculate the actual liquidity of their funds.

The assumption that Novus makes to estimate 30-day liquidity is that the manager never represents more than 20% of the 90-day daily trading volume for any security they are holding. Thus, the metric is wholly dependent on the number of shares of each security the manager holds and the recent three month trading volume of that security. Using that methodology, we calculated 30-day liquidity for all the hedge funds in our data base and found the average fund can liquidate 75% of their portfolio in 30 trading days. This hasn’t changed much in the last decade: that’s a good thing given that the average hedge fund has a 35 day redemption notice for their investors. (Source)

Examples of Managers with Good Liquidity

Lone Pine Capital is an example of a manager that has significantly grown their AUM yet kept liquidity under control. Recently their 30-day liquidity increased to 85% from a trough of 60% in 2013.

Lone Pine Liquidity:

This is striking given the asset growth of the fund and the stable security count the manager maintains. As we have seen before, the preferred way for managers to preserve liquidity is by moving up the market cap spectrum, and Lone Pine is no exception. Their median market capitalization (for all portfolio securities) has been on the rise.

Not all managers can make a claim of stable liquidity. Pershing Square, who, being an activist manager certainly does not manage for liquidity, has seen a significant decline in the metric in the recent months as their assets grew. You can easily make the argument that Pershing does not really need to worry about selling their securities in the market, still it’s fascinating to see this much of a liquidity drop in such a short amount of time. In terms of portfolio liquidity, they are in uncharted territory.

Pershing Square 30-day liquidity:

Digging Deeper into Liquidity Profiles

Coming back to the Lone Pine example, let’s examine their liquidity a bit further. Novus clients can track any fund’s liquidity by clicking on one of the liquidity metrics in the “Categories” drop down on the Novus platform.

Over 65% of the long portfolio of Lone Pine is in the 10-30 day liquidity bucket.

Here is how their liquidity has evolved over time:

We can see that as the 10-30 days bucket expanded the less liquid buckets actually shrank. What’s interesting is that the 10-30 day bucket seems to be the sweet spot for the manager. This is the bucket where Lone Pine has the highest contribution, annualized ROIC, and win/loss ratio. These three metrics are shown in order in the following three charts segmented by liquidity buckets.

Many managers do not get paid to be in illiquid securities. Lone Pine on the other hand has been collecting a healthy illiquidity premium, as the securities in their most illiquid bucket (grey bar in the charts above) have been some of the highest contributors.

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Novus clients keep a keen eye on their managers’ liquidity and treat this as one of the more important metrics they monitor. A significant drop in the liquidity profile could mean drastic changes in a manager’s portfolio and often warrants a phone call. At the end of the day, liquidity is just another arrow in the quiver of manager due diligence. In some cases, it could be a critical tool and benefit the investors that track it at the expense of those who do not.