The current size of global hedge fund assets is estimated at US$1.5 trillion, representing a compound annual growth rate in assets of about 40% over the past five years. As the hedge fund industry takes on a more mainstream aspect and caters to a broader investor base, the question of redemption frequency (the length of time that needs to elapse before an investor into a fund can redeem their assets) and its relationship to fund performance is becoming increasingly relevant. To this end, this write-up sets out to answer such questions as a) the prevalent redemption preferences among hedge fund managers and recent changes therein, b) the effect of funds’ regions of investment and/or strategies employed on the choice of lock-up period, and c) whether longer lock-up periods do indeed have a positive effect on fund performance1.
Current Structure and Growth Trends
While a good majority of the funds surveyed allow their investors to redeem on a monthly (60%) or a quarterly (24%) basis, nearly one-eighth of the funds enforce lock-ups of only a week or less. The rationale behind this preference has largely to do with the nature of the asset classes and markets that these funds invest in.
In terms of strategic allocations, a lock-up period of a week or less is mainly employed by funds that invest in highly liquid instruments such as equities, bonds, commodities or derivatives thereof. Indeed, commodity trading advisors (CTAs), long/short equity and fixed income managers account for about 30%, 25% and 20% respectively, of the funds that allow weekly redemptions. Contrast this with managers that allocate to relatively long-term special situations (such as event driven and distressed debt managers), who account for 2% of the funds with weekly redemption clauses and about 7.5% of those with longer lock-ups. It is for similar reasons that funds with diversified portfolios – ie multi-strategy funds or those with a global investment mandate – tend to have shorter lock-up periods than the industry average.
That said, a comparison of the year-on-year growth in the total number of funds over the last three years, grouped by redemption preferences (see Figure 1 below), suggests that the number of managers insisting on longer lock-up periods is on the rise, albeit gradually.
Figure 1: Year-on-year Growth in Number of Hedge Funds
For instance, in 2004, when the industry grew at an average of 30% over the previous year, funds with lock-ups of two months or less saw the most launch activity registering growth well above the industry average. In 2006, on the other hand, hedge funds with quarterly or bi-annual redemptions grew year-on-year at a pace on par with or exceeding the industry average (of 12%).
Given that over 95% of the funds surveyed have weekly, monthly or quarterly lock-ups, this section examines the bearing that either of these redemption preferences on hedge fund performance over time. To this end, we compare the average annualised rolling-period returns of each of these groups of funds over the past 12, 36 and 60 months (depicted in Figure 2 below). Two interesting trends emerge from Figure 2: a) that funds with longer lock-ups enjoy better returns (owing to greater flexibility and control in terms of asset allocations and holding periods); and b) that the relation between lock-up period and fund performance has become a clearer and more obvious trend in recent years, as suggested by the steepening slope of the curves tracing more recent performance.
Figure 2: Comparison of Past 5-years’ Performance by Lock-up Period
To summarise, longer lock-up periods have led to significantly higher returns for hedge funds, especially in more recent years. Also, a rapidly expanding alternative investment landscape is driving hedge funds to seek absolute returns in more illiquid investments, which is further driving lock-up periods longer. These trends, as well as the growing number of funds with longer lock-up clauses, underpin broader changes in the structure, growth and performance of the alternative investment universe in general, and hedge funds in particular.
In a rapidly expanding alternative investment landscape that has come to include investment vehicles targeting absolute returns in the short term (such as long-only absolute return funds, 68%2 of which allow weekly redemptions) as well as the very long term (such as private equity and private real estate funds; for instance, a typical private equity fund has an investment horizon of about six years3), hedge funds are increasingly being forced to chase absolute returns in more illiquid markets and asset classes than the staple of long/short and relative value strategies.
2Based on a sample of 305 long-only absolute return funds in the Eurekahedge databases.
3Based on a sample of 2,700 funds in the Eurekahedge private equity databases.