Managing Exits from Illiquid Hedge Funds and Private Equity

# When to Exit Illiquid Investments (Private Equity, Hedge Funds etc.)


# When to Exit Illiquid Investments (Private Equity, Hedge Funds etc.)












I have a question that is only tangentially related to quant trading but was wondering if some of the members of this forum could impart some of their typical wisdom.

For context, in addition to trading some of my own systematic strategies, I invest a proportion of my account in systematic Hedge Funds and Private Equity. I work a full-time job so it’s too much work to invest completely without external help. In addition, I select for funds that have uncorrelated return streams and this provides my overall portfolio with some level of diversification. The funds I invest in have a live track record exceeding 20 years because I value (rightly or wrongly) the ability of a fund to adapt to various regimes/market cycles.

My question is: is there a reasonable way to assess whether I should pull the plug of an underperforming fund? How can I assess when a fund has lost its edge and is no longer a reasonable investment? This question is similar to “when should I stop trading a systematic strategy?” but it’s a bit trickier due to the nature of hedge funds. Exiting a hedge fund incurs significant fees and exiting can sometimes take 3-6 months. In addition, once I’ve exited a fund, there are significant costs to re-entry should performance revive in the future. I don’t think a reasonable approach would, for example, be “generate a 200dma of the fund performance and enter/exit depending on whether the fund returns are above this ma.” This approach would incur too many fees.

The other consideration that complicates the decision is the “fact” that the forward returns of private equity and systematic hedge funds tends to higher when the fund has incurred a drawdown. In fact, from my research (after trying to account for survivorship bias), I found that the steeper the drawdown, the better the forward performance, on average. Take trend following, as an example, I think forward returns for trend following strategies tend to be better after a period of underperformance. This has led some fund-of-funds to favoring a buy-the-dip approach.

After thinking about this issue, my thoughts on possible solutions are:

Don’t be concentrated in any individual fund. Then hold all funds “forever.” This will eliminate onerous entry/exit fees and prevent “selling at the low.” Of course, some funds will go to 0 and the money invested there will be a 100% loss. However, since concentration in any particular fund is low, this should be a survivable situation. Find the maximum Peak-to-Trough drawdown over the entire fund history and exit when current returns dip below some multiple of this drawdown. For example, if maximum historical drawdown is 30%, exit if current drawdown is 45% (1.5x). Never re-enter. This would open up the possibility of selling on the lows. In addition, there are not that many good funds in the world :wink: so this strategy would reduce your selection to “inferior” candidates over time. The benefits of this approach would be to allow greater concentration on funds that you have high conviction on (since max risk would, in theory, be capped) Please let me know your suggestions/comments. Very keen to hear what others think.

## Answer by Jonah Pandarinath (score 0)

https://quant.stackexchange.com/a/78210

TLDR: No, there is not a simple systematic way to figure out when to pull the plug on an underperforming fund. This is for a few reasons:

- PE/Hedge Funds make it difficult to exit since they hold illiquid assets and do not have additional capital to pay you out lying around. This attracts a specific type of investor.

- Unless you have an outsized amount of capital, you will likely still be concentrated in a few funds due to minimum buy-in requirements.

- Investors should be careful in rebalancing positions into a losing position as they often sell a winning position to double down on a losing position, thus leaving them holding a portfolio of losing positions.

- AQR's Quant Winter and capital flight despite turned around performance.

- Most investors are under diversified in an individual country and should look to diversify internationally, and (as you are practicing) across many different asset classes.

1. Illiquid assets. One thing you should consider is time horizon. Over the life of your portfolio eventually you will want to liquidate your positions. This could be anywhere from 1 to 55 years from now, however during that time eventually you will incur the costs to exit a position. On this note, hedge funds make it difficult to exit a position to attract a certain type of investor. With long term assets, like infrastructure or (arguably medium term) private equity assets, a hedge fund does not have the capital to let investors actively buy in or exit a position since it takes them several years to see a return on PE investments, and even longer on infrastructure.

2. Can you diversify to the magnitude you would like without concentrating? To your point on diversification on many different funds, it is likely not sustainable to invest in the amount of funds you are considering (unless you significant capital to justify the minimum buy-ins for many hedge funds/PE funds). This is for the same reason that individual portfolios usually hold an ETF like SPY, instead of holding all 500 companies in the S&P500. It incurs too many trading costs for the marginal benefit of diversification past a certain point. Yes, you are absolutely paying a management fee for someone else to rebalance the ETF, however this fee is significantly lower than buying/selling 500 names yourself and rebalancing as new names get added (unless you have a sufficiently large amount of capital, and access to rebalance/weighting data, and a trader...)

3. Portfolio of losing assets. Another thing to consider if you are going to make a systematic strategy is a common behavioral finance bias, which is to sell winners in a portfolio since they increased in value, while holding onto losers to not incur the loss. If you do this too often, and trade too often, eventually you end up holding a portfolio full of losing assets.

4. Where a systematic strategy fails There is no systematic strategy to figure out exactly when you should exit a fund or enter a fund. Recently AQR went through a "Quant Winter" (https://www.ft.com/content/e0f98278-432e-4ece-b170-2c40e40d2835) which saw many investors pull capital from the firm, however investors who pulled capital from AQR left while the fund turned around performance since AQR is continuously improving its strategies. If you took a historical calculation of max drawdowns you would have likely sold at one of the worst times, since most of their funds have turned around reporting record setting returns.

5. Under diversified by country My last major point is that most investors are under diversified. Consider person A who lives in lets say Canada, gets paid in Canadian dollars, owns a home in Canada, has a bank account in Canada, and invests in the Canadian stock market. If for any reason the Canadian dollar losses all of its value, this investor is not in the best position. A better position would be for this investor to avoid investment in the Canadian stock market to diversify their holdings. (This is what Norway's sovereign wealth fund did where it invested additional capital from oil revenues abroad to diversify its assets).