Illiquid Assets: Dimensions of Risk

Exploding spreads in structured mortgage products, which have driven sharp drops in asset values and collateral calls have shined a bright light on the risks posed by illiquid assets. Bear Stearns is now being held up as the latest victim of flying too close to the Sun, loading leverage on top of complex, illiquid assets that, in fact, had values far lower than those reflected on its books in the wake of a liquidation. Today's article in the Wall Street Journal made some good points that plainly chronicle some of the issues facing those investing in illiquid assets:

Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead use a mathematical model to value an asset, a practice called marking to model.

Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an asset-management company that runs a hedge fund.

Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely from one dealer to the next.

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Mr. Lo has found that returns for illiquid assets and funds that invest in them tend to have little variation from one month to the next. Paradoxically, it is this smoothness of returns that show how illiquid, and risky, a position might be.

Andrew Lo is a smart guy. He has done seminal work in the area of analyzing the properties of hedge fund returns. His statements are both accurate and logical and, not surprisingly, mirror those of someone who has written about the risks of running an illiquid asset book - me. From Broadening the Multi-Strategy Mandate 07/21/2006:

For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

Bottom line: if you are running an illiquid asset book, especially one that is leveraged, you'd better have some of the following working for you:

1. Immense liquidity to support margin calls in an eroding market;
2. A diversified portfolio so this one book doesn't drag down your entire firm (a la Amaranth);
3. Valid, conservative market data points on the bid side to back up "mark to model" valuations; and
4. A long time horizon.

And you don't need to be running a complex, leveraged mortgage derivatives book for this to be the case, which is why I kind of chuckle when all this emphasis is being placed on Bear Stearns. Risks of this sort abound across a wide array of portfolios, many of which are anything but exotic. How about the following:

1. A large short position where the borrow is tight and the market is rallying;
2. A large long position in an thinly-traded stock;
3. A highly concentrated portfolio of small- and mid-cap stocks;
4. A leveraged book of correlated large-cap longs in a declining market.

Are these "exotic" risks? No. Can they be marked-to-market and not just marked-to-model? Yes. Can you get competitive dealer bids? Yes. Is leverage the killer in each situation? No. Is illiquidity the killer in each situation? No. The nature of the risk differs based upon the situation. Sometimes it is liquidity-based. Other times it is leverage-based. Sometimes it is both. So let's not throw stones at Bear Stearns and make like they are another LTCM. Because they're not. Funds take risks. Stuff happens. Disclosure of these risks needs to be extremely clear, accurate and detailed. Investors need to know what they're getting, and valuations need to be done in a rigorous, transparent manner. If this is done and the s**t hits the fan, so be it. It is the by-product of playing the game. Hedge fund returns, as Mr. Lo and others have discovered, are generally negatively skewed, e.g., akin to selling options, collecting premium, generating superior returns for a period and then BANG - getting hit hard, and sometimes getting carried out. Hedge fund investment is not a business for the meek and certainly not one for the stupid. If investors thought they were getting a free lunch by investing in leveraged "high quality" paper and collecting juicy returns, shame on them. Because in the markets, you seldom get something for nothing.