Friday, May 10, 2013

Illiquidity trap

Another difficult year for some investment funds

Some Polish absolute return investment funds are facing a though year - again.

Investor FIZ is down -12.96% and Opera FIZ felt -12.43% YTD.

This may not sound too bad for the recent investors in some of the John Paulson's funds.

However, if you take a longer perspective, the numbers start to look much more ugly.

Investor FIZ is down -68.71% from its peak in October 2007, while Opera FIZ decreased by -80.45% from June 2007.

I understand that substantial drawdowns may occasionally happen to even the best managers.

They are often connected either with elevated market volatility or slow market convergence process.

To demonstrate the later case let's take a look on a potential a pair trading involving BRENT and WTI crudes:

Source: Stooq

The fundamental price difference between them is mostly connected with transportation costs. Hence, the spread should be pretty stable and one should be able to quite easily arbitrage the temporary premium or discount in the price of one of these commodities.

However, as you can see above, some other factors can "temporarily" push the spread to the extremes.

If one used historical price data to model the possible spread distribution and opened opposite positions (long WTI, short BRENT) based on such a model in mid 2011, the widening spread could have either caused significant drawdown or forced the over-leveraged investor to close the trade.

But it was always possible to close such a trade! And it narrowed eventually, enough to produce a profit for the patient investor.

Unfortunately, there is very little hope for Opera FIZ and Investor FIZ investors...

The value of Opera FIZ certificates has been flat for a couple of years. And we should expect the same from Investors FIZ... :(

The reason is quite simple.

A significant part of these funds' assets is trapped in illiquid investments.

In the Investor FIZ portfolio one may find such "gems" as Tamex:

Source: Stooq

Tamex is listed on the NewConnect alternative market, and sometimes its shares are not traded at all for dozens of days.

Another "interesting" case is Indian Spice Mobile:

According to the latest Investor FIZ financial statement, the fund has Spice Mobile shares worth over PLN 6.3 million. Meanwhile the company's 30 day average volume is... PLN 6,205. The maximum daily turnover over the recent year was PLN 456k.

It is hardly possible to liquidate the position Investor FIZ has!

Similarly, Opera FIZ is stuck with illiquid and unprofitable/indebted private equity holdings like Termisil and SkyCash. It is hard to predict, whether these companies will become successful or be sold at a profit. What's clear however, they lock significant part of or even siphon off the fund's capital and make its return to growth extremely challenging.

Unfortunately there seems to be more skeletons in the closets at both these funds.

Marking to - totally illiquid - markets

Valuation of funds' assets is usually based on their market price. For example if a fund owns 1,000 shares of some listed company and the recent price of one share is 100, the accounting value of this holding is 1,000 times 100 or 100,000.

The problem here is, this valuation depends on the marginal price of the asset.

It is OK, as long as your position is small relative to the market turnover of this particular company.

However, such approach is very misleading when liquidity is low.

In such a situation, one should estimate the value of the asset based on the current, short term historical or eventually short term predicted liquidity.

In the case of the above mentioned Investor FIZ holdings - Tamex and Spice Mobile - the realistic value is close to zero. 

If Investor FIZ had decided to dump its shares on the market, they either would have tanked or it would not been possible at all.

Meanwhile, Tamex and Spice Mobility constitute some 11% of Investor FIZ assets.

Marking to magic

The situation is more complex with unlisted private equity holdings, such as Termsil and SkyCash.

Most often such assets are valued using discounted cash flow method (DCF), comparison method or adjusted purchasing price.

Each of these models is very sensitive to its assumptions and parameters. One can practically set any desired value in quite a broad range.

According to the most recent Opera FIZ financial statement, Termisil and SkyCash accounted for more than 20% of the funds' assets.

The real power of diversification

I have a problem with so called Modern Portfolio Theory.

To make it work, one "just need" to know returns of the particular shares to be put into the portfolio.

Having returns, you can easily calculate variances and covariances needed to optimize the structure of the portfolio - i.e. select the weights of the assets.

However, you need to know (estimate) the future returns!

And as Niels Bohr said, prediction is very difficult, especially about the future.

So, is there any other potential value of the portfolio diversification?

Actually, yes - it can reduce the liquidity risk.

A good example here may be the Renaissance Institutional Equity Fund (RIEF).

It is a younger (but bigger) sibling of the Renaissance Medallion Fund mentioned in my previous post.

At the end of 2012, RIEF manged USD 34.36 billion.

These assets were dispersed over 2,815 holdings. Hence the average single position represented just 0.0355%, and the largest 1.25% of the fund's portfolio.

The important benefit of such a wide diversification is that any single asset cannot significantly affect the whole portfolio.

The market and correlation risk are still present though. However, when you combine asset diversification with strategy diversification, it may be possible to significantly reduce the overall risk and generate positive returns.