OPINION: LIQUIDITY MAY BE DOWN BUT DON’T COUNT IT OUT

As bull markets progress, there is a nataural tendency for investors to become more illiquid, sometimes without even realizing it. In this phenomenal 15-year run, a number of events are causing this to occur once again. For one, most institutional managers have been mandated to stay fully invested, removing any cash that might mitigate a market decline. Secondly, mergers among investment management firms are resulting in such concentrated pools of capital that one wonders how much flexibility they are losing. The combination of the two large Swiss banks, Union Bank of Switzerland and Swiss Bank Corp., will put nearly $850 billion under the aegis of Gary Brinson, swamping Fidelity as the world’s largest asset manager. As those folks in Boston found out, however, size is the mortal enemy of performance.

The most disturbing trend that compromises liquidity, though, in my view, is the rush to alternative investments by most institutional investors and high-net-worth individuals over the past few years. These investments, which include venture capital, leveraged buyouts, commodity pools, real estate and hedge funds, all have a similar characteristic: They involve tying money up, in most cases as limited partnerships, for long periods. In other words, they are illiquid.

How much money is going into alternative investments? It is hard to get an accurate total, but best guesses put the amount at over $100 billion in 1997, up more than 50% in the last few years. Many pension plan sponsors, particularly endowments and foundations, have raised alternative exposure to greater than 20% of assets. In a number of cases, these investments have been funded, not from equity money, but from fixed income. In some funds, then, the total of equity and alternative investments tops 80%.

What’s the attraction? For one, eye-popping performance for many of these investments (annualized gains of 50% to 100%) over the last several years. But secondly, and as importantly, many consultants have signed off on the concept with stu
dies showing low correlations over long periods for these investments compared to U.S. equities. In other words, if one feels the latter category is overvalued, there is less risk, theoretically, in investments that do not track the equity markets too closely.

What’s the problem? In our view, there are many. In the case of private equity, which includes leveraged buyouts, venture capital and mezzanine financing, while the amount of new money going into such pools is increasing exponentially, the quality of the deals is not. Already, rates of return are coming down sharply. Investors’ expectations of 20%-plus gains ad infinitum forget the reality that these funds earned only 2% annualized for the period 1982 (the high-water mark then for funds invested) through 1994.

In the case of real estate and commodity pools, which include oil and gas and timber investments, the bet is basically a hedge against inflation. In an increasingly deflationary world, however, these investments could be illiquid sinking stones. Remember the mid-1980s, when investors were trapped in them?

The biggest problem with nearly all of these investments, though, is the high correlation they have with U.S. stocks in a bear market. Nearly all of the private equity commitments depend upon the public equity market for their exit strategies and when these close, there is no door.

The one alternative investment that theoretically gives the opportunity to profit from tough economic and stock market conditions is the hedge funds, which can sell short as well as go long. Their experiences may be better during the next secular bear market, but between 1969 and 1974 – when the major market averages were down nearly 50% and the average stock 75% – approximately 90% of the hedge funds went out of business.

What is the best alternative investment in times of stress? Cash. It is also the most liquid. It’s a pity it is almost reviled today.

Mr. Babbitt is president and CEO of Avatar Investors Associates Corp., a New York money manager.