Short – term buying and selling can have an enormous impact on the prices of securities. If an asset trades all the time, the value is widely known. Its easy to know what a share of Microsoft stock is worth because millions of shares are bought and sold every day, for example.
If an asset doesnt trade often, you have little observable, unbiased market indicator of what the true price should be. To get around this situation, hedge funds have many techniques to assign values to illiquid securities :
Net present value: The discounted value of all the expected cash flows Black – Scholes: A complicated mathematical model used to find the value of an option
Relative valuation: Basing the securitys price on a similar security that trades frequently
If a hedge fund youre interested in invests in illiquid securities, find out what its policy for valuation is. And know that you take on some risk if the fund buys a lot of these assets; the price assigned to the fund may not hold when the illiquid securities have to be sold.Managing side pockets
A side pocket in a hedge fund is a group of securities held by only some of the funds investors. Hedge funds set up side pockets —also called designated investments or special investments —for two main reasons:
To hold illiquid securities away from money that investors can redeem. For example, the fund may allow investors to pull money out of the main part of the fund once per quarter, but it may decide that investors can redeem funds in the side pocket only once every two years. Likewise, new fund investors cant enter into the side pocket so that the valuation of those investments doesnt become an issue for them. If you invest in a fund thats just starting out, part of your investment may be held in a side pocket.
To allow certain fund investors access to securities that other investors many not have. The fund may provide performance enticements or other special benefits that attract specific investors. A fund may also set up a side pocket to meet the needs of a large institutional investor that can put a great deal of money into the fund.
Side pockets are priced separately from the rest of the fund. Because theyre often set up just to hold illiquid investments, their price may be more uncertain.
