Tuesday, June 26, 2007

Bear Stearns lessons for us traders

Good stuff from the WSJ on low liquidity assets:

Figuring out the risk profile of illiquid assets -- and funds that invest in them -- can be tricky. Typical methods for assessing risk rely on measuring volatility -- the choppier returns are, the riskier the investment. But because illiquid assets don't trade regularly, marking to market -- or using recent sales prices to determine an asset's value -- may not be possible. In these cases, a fund manager may instead use a mathematical model to value an asset, a practice called marking to model.

Such models tend to smooth returns, making an asset look much less risky, says Massachusetts Institute of Technology finance professor Andrew Lo, who is also a principal in AlphaSimplex Group LLC, an asset-management company that runs a hedge fund.

Using broker-dealer quotes for illiquid assets can also damp volatility because they are often based on an average of bid and offer prices rather than actual sales prices. What's more, price quotes can vary widely from one dealer to the next.

Mr. Lo has found that returns for illiquid assets and funds that invest in them tend to have little variation from one month to the next. Paradoxically, it is this smoothness of returns that show how illiquid, and risky, a position might be.

Still, illiquid assets can be lucrative when held by investors with long time horizons, who don't have to worry about creditors suddenly calling in loans and who understand the risk they've taken on. "If you're a pension fund and you don't have any issues with being able to fulfill your obligations, illiquidity risk is a very good way to earn extra returns," says Mr. Lo.

Timber funds illustrate some of the potential, as well as the risks. These funds, in which investors hand over money to a manager who buys and oversees forest lands, can lock up investors for 10 to 15 years, typically returning their money after selling off the properties involved. Cashing out of a timber fund early can mean selling at a discount of 20%. For a direct investor in timber, selling carries the same vagaries of selling a home: You can guess what the price will be based on appraisals, but you won't know for sure until you put it to market.

"This isn't a good investment for short-term investors -- there's too much volatility," says Dick Molpus, of Mississippi-based timber-investment manager Molpus Woodlands Group.

UPDATE: Alex Forshaw has a practical example of how not to trade illiquid assets today.

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