The number and size of open-end funds investing in illiquid assets have grown dramatically in recent years. For example, in 2016, the open-end Blackstone Real Estate BREIX was founded. By Sept. 30, 2024, the fund had $110 billion in total assets under management. Interval funds (open-end funds with predetermined repurchase periods) and tender-offer funds (closed-end funds with repurchase timing at the fund’s discretion) provide investors with a way to invest in illiquid alternative asset classes such as real estate, private credit, private equity, and insurance-related derivatives while offering a degree of liquidity. According to Morningstar, assets under management in interval funds surged by nearly 40% annually over the past decade, and by September 2024, there were more than 100 active interval funds with AUM surpassing $80 billion. Similarly, tender-offer funds recently eclipsed $60 billion in AUM.
These funds provide a liquidity transformation service for investors by issuing and redeeming shares that are more liquid than their assets. However, because of the illiquidity of the assets, managers need time to transfer capital to the underlying market, creating risks—funds may be forced to sell illiquid assets at a discount if too many investors redeem shares quickly, and they can be susceptible to NAV-timing strategies if prices are stale.
Stale Pricing Risk
Highly illiquid assets trade infrequently, making it difficult to know their true market value. To address this issue, funds that invest in illiquid assets create fair valuation estimates at periodic intervals. These valuation estimates determine the share values at which interval and tender offer funds issue and redeem their shares. Because the true value is uncertain, wealth transfers can be created between buy-and-hold investors and those entering and leaving the fund to the extent that the fair valuation estimate is different from the true value. While any wealth transfers are likely to wash out over time for buy-and-hold investors (if these differences are minimal and occur randomly), to the extent there are systematic differences between the fair valuation estimates and their true value, NAV-timing investors could create trading strategies that would systematically transfer wealth from buy-and-hold investors to themselves. Thus, it is important to understand the mechanisms that can destabilize and restabilize these intermediaries.
Research Findings
Spencer Couts, Andrei Gonçalves, and Andrea Rossi, authors of the February 2024 study “Unsmoothing Returns of Illiquid Funds,” found that fund-level autocorrelations are high in private credit and hedge funds—funds with similar illiquid investments have a common source of spurious autocorrelation. The spurious nature of the autocorrelation leads investors to both underestimate risks and overestimate alphas. They also found that issues of autocorrelation were not fully resolved by traditional unsmoothing methods, leading to the underestimation of systematic risk and alphas. Thus, they created a more complex three-step method, which did successfully address the problem. Their findings led Couts, Gonçalves, and Rossi to conclude that applying their new return unsmoothing method to hedge funds leads to substantially improved measurement of risk exposures and risk-adjusted performance relative to what is obtained from returns using traditional unsmoothing methods. The improvement was even more pronounced for private credit funds owing to the high degree of illiquidity in their underlying assets.
In his November 2022 study “Liquidity Transformation Risks and Stabilization Tools: Evidence from Open-end Private Equity Real Estate Funds,” Couts analyzed the effects of stale pricing, liquidity restrictions (limitations placed on the amount of capital that can either enter or leave an intermediary over a given period), and liquidity buffers on NAV-timing profits in US open-end private equity real estate funds. Liquidity buffers refer to the use of liquid assets, such as cash and liquid publicly traded securities, and credit lines to absorb the capital flow shocks from investors. They are used by managers to prevent them from having to acquire or sell illiquid assets too quickly when they have large fund flows. His sample consisted of US open-end private equity real estate fund data from 2004 through 2015. (These funds have existed since the 1970s.) The sample is survivorship-bias-free and consists of 1,361 fund-quarter observations over 48 quarters for 34 total funds, with a minimum of 21 funds in each quarter. As of the fourth quarter 2015, the sample represented 34 funds with approximately 3,500 investment properties and $250 billion in AUM.
Couts began by noting that he chose to analyze open-end private equity real estate because:
“Stale valuations are believed to be the primary source of autocorrelation for illiquid funds and assets. Consistent with this, commercial real estate assets are some of the most illiquid assets and are valued through an appraisal, or valuation estimation, process. Therefore, the fragility risks coming from stale valuation estimates should be easier to isolate and observe. Additionally, OPERE [US open-end private equity real estate] funds report their uncalled capital commitments and unfulfilled redemption requests (queues).”
He added, “Because commercial real estate has both strong public and private markets, returns from the publicly traded real estate investment trust market provide a good proxy for the economic returns of the OPERE fund market.”
Turning now to the results of Couts’ analysis, the following is a summary of his key findings:
- The NCREIF Fund Index of open-end private real estate funds showed much smoother and lagged returns (of about four quarters) relative to public markets such as the free-float, market-cap-weighted FTSE NAREIT Index of US equity REITs; stale pricing resulted in returns that were predictable (which could allow investors to create NAV-timing strategies in the absence of restrictions).
- Without trading constraints, NAV-timing strategies were statistically and economically significant.
- A long-short strategy based on investing in either the index of OPERE funds or the three-month T-bill would have achieved annualized private real estate factor and five-factor (beta, size, value, profitability, and investment) alphas of 18.2% and 15.5%, respectively. Similar results were found using the real estate Q-factor model (the market factor, investment, and profitability).
- A long-short strategy based on investing in either the top- or bottom-quintile funds would have achieved annualized private real estate factor and five-factor alphas of 5.9% and 3.5%, respectively. In the cross-section of returns among private real estate funds, the lag effect allowed for unrestricted NAV-timing strategies up to three quarters.
- The findings of significant alphas being greater than a simple buy-and-hold strategy suggests that significant shareholder-run incentives and wealth transfer risks existed.
- An important source of return variation in the sample came from the global financial crisis, highlighting the transfer risks created from stale pricing. These risks appear to be the greatest when the overall economy experiences significantly negative macroeconomic shocks (left tail events)—when investors are most concerned about fragility risks.
- Investor behavior is consistent with these strategies. A 1 standard deviation increase in lagged public market index returns, private market index returns, and fund-level returns led to 18%, 21%, and 43% standard deviation increases in fund subscription requests, respectively. Significant wealth could be transferred without an appropriate protective mechanism. However, funds choose to limit capital flows in a manner consistent with these strategies. A 1 standard deviation increase in public market index returns, private market index returns, and fund-level returns led to 18%, 19%, and 47% standard deviation increases in fund queues; strategies that are most profitable on paper also became the most overallocated and diluted as managers limited the vast majority of the fund flow requests in order to redeem and place capital prudently (For example, Blackstone Real Estate’s gated redemptions—at the 2% per month/5% per quarter limit—from November 2022 through January 2024).
- After accounting for investor queues, the returns to NAV-timing strategies were statistically and economically equivalent to those of buy-and-hold strategies: Managers protected against the wealth transfer and NAV-timing risks created by stale prices when they discretionarily chose to limit fund flows to prevent selling assets at a discount or buying them at a premium. In other words, fund managers were able to limit most of the capital trying to enter and leave their fund through the queuing mechanism. It also suggests that investors are unlikely to be able to exploit the return predictability found in OPERE funds.
- Lockup periods do a poor job of protecting against the NAV-timing risks associated with stale pricing.
Summarizing his findings, Couts explained, “Investors behave as if they recognize returns are predictable, crowd each other out, and eliminate the trading opportunities in a way similar to the ‘winner’s curse’ discussed in the IPO literature. A novel finding is that it is the illiquidity in the underlying assets which creates both the risk and the mitigant.”
Finally, capital outflows correlated positively with lagged cash balances when investors wanted to leave the fund. For funds that had either a negative fund flow or a redemption queue, larger capital outflows occurred both at those times and in those funds with larger lagged cash holdings.
These findings led Couts to conclude, “Liquidity buffers can increase fund fragility risks when added to discretionary liquidity restrictions”—they can be counterproductive. He added that because not marking-to-market assets leads to stale pricing, it increases the risk to OPEREs of “runs on the bank,” creating negative externalities (increasing wealth transference risk): “liquidity buffers do not deter the risks associated with return predictability. In fact, it provides evidence that liquidity buffers amplify fragility risks when added to discretionary liquidity restrictions.”
Investment Takeaways
Illiquid assets are associated with having stale prices and, thus, predictable returns. Managers protect against these risks by using liquidity restrictions, which are primarily used to prevent managers from having to buy or sell illiquid assets too quickly. Liquidity restrictions also provide a secondary protection against the fragility risks created by stale pricing. The takeaway is that it is the illiquidity in the underlying market that creates both the risk and the risk mitigant.
Couts’ findings suggest that investors who allocate to real estate are better off investing in interval and tender-offer funds, which limit issuances and redemptions to predetermined schedules, instead of investing directly in the assets. In addition to improving diversification, the benefit of investing in an intermediary that invests in illiquid assets is the risk sharing that occurs among the investors. His findings led him to conclude, “Investors achieve higher expected returns by pooling their capital together and investing in illiquid assets collectively when they are independently exposed to the risk of a liquidity shock. Consistent with this intuition, open-end funds that limit fund flows at times, provide liquidity to those investors whose fund flow requests are not positively correlated with those of other investors.”
Postscript
In December 2023, Couts examined the performance of Cliffwater Corporate Lending CCLFX, which invests in floating-rate, private credit that is senior, secured, and backed by private equity sponsors, to determine the degree of autocorrelation of returns. He found that while the fund’s returns are positively correlated with its own lagged returns, as well as the lagged returns of other debt-based and market-based return series, the cross-correlations became insignificant (or even turned negative) beyond one month and were nonexistent in quarterly returns (when redemptions can occur). He also found that even without the quarterly redemption restrictions, the cost of not being invested in Cliffwater Corporate Lending was greater than any wealth transfer benefit associated with trying to implement a NAV-timing strategy: While the timing (switching) strategies generated alphas in the regressions, the returns were less than those of a buy-and-hold investor in the fund. As to risk-adjusted returns, while the fund’s monthly and quarterly alphas decreased slightly when one-month lagged and two-month lagged variables were added, the alpha values were still economically and statistically significant.
The findings of a lack of any significant autocorrelation beyond one month should not be surprising because Cliffwater does provide daily pricing (to allow for daily purchases), there is virtually no duration risk since all loans are floating rates with either 30- or 90-day resets, and the loan quality is higher (the higher the loan quality, and the lower the duration risk, the lower will be the fund’s volatility, reducing the risk of autocorrelation in returns owing to stale pricing).
Larry Swedroe is the author or co-author of 18 books on investing. His latest is Enrich Your Future.
Larry Swedroe is a freelance writer. The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.
