Friday, July 21, 2017

Cost of liquidity - The hidden management fee that needs to be calculated

Investors are looking closely at the fees being charged, but the hidden fee of liquidity may be the most significant cost that is often not talked about. Large firms that are charging less may have higher costs associated with liquidity than small firms. As the size of the firm grows,  the cost of entering and exiting may be higher. Additionally, some markets that may offer opportunities are avoided because the cost of trading when liquidity is lower is higher.

There are economies of scale for managing a hedge fund business as a firm grows, but there are potential diseconomies of scale associated with the investment management of the business. You may get firms to be much more competitive on price as the assets under management grow or as it prices a large new inflow, but there may also be higher investment costs with running the money. One way to combat this higher liquidity cost is to increase expenditure and resources on trading and execution algorithms.

As firms get larger or price based solely as a management fee there may be the potential for misalignment of incentives and hidden performance costs. Larger firms that have covered fixed costs could easily focus more on incentive fees but it seems merely likely they will cut incentives and actually skew toward locking in management fees. 

There is a trade-off between the benefits from scale through risk management, research, execution, and business cost savings against the costs of liquidity management. There will be a point where the added net return from scale is outweighed by the performance drag from liquidity shortages.

Nevertheless, the cost of liquidity is extremely hard to measure because when you need it, it will not be available. The inflection point between economies and diseconomies of scale is hard to determine. So a natural question is, "What is the capacity of any given firm?" and "What is the capacity for a given strategy or across all firms pursuing the same strategy?" 

It is surprising that more firms have not closed to new investments as they have grown. It is likely most firms are optimistic and gauge capacity on the high side. Additionally, back of the envelope calculations on trading across firms suggest that many trades can easily be considered crowded. Discounting the uncertainty of liquidity is more important than calculating the discount or savings from lower management fees. 

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