In the quest for alpha, many hedge fund managers have started looking to less liquid assets to juice returns. Investrs tend to require a degree of liquidity, in case they choose to redeem their shares, so managers have taken to using side pockets, segregated accounts created specifically for holding illiquid hedge fund assets.

Q. OK. We’re not talking billiards, I’m pretty sure. So, what is a “side pocket”?

A. It’s a hedge fund term. You know that mostly, hedge funds have relatively liquid assets… not as liquid as mutual funds or ETFs, of course, but investors can typically get out over a period many months. That means, naturally, they have to be invested in pretty liquid assets, because when the investor wants out, you have to dispose of the underlying assets to raise cash. But sometimes, funds have illiquid assets… and those are often held in a segregated account called a side pocket.

Q. So, do you mean they intentionally invest in these sorts of assets? Or, is this something that happens by accident?

A. Both. First off: as we’ve discussed, total liquidity and alpha don’t always go together. As they reach for return, institutional investors in particular are willing to put up with a little more illiquidity… maybe a little real estate, or a PIPE. So some hedge funds are adding these sorts of strategies, but they put them in a “side pocket”.

Q. OK, but really, what’s the point? Why segregate these assets, exactly?

A. Several reasons, but one big one regards computation of the manager’s incentive fees. Illiquid assets are inherently hard to mark, so it’s easy to over- our under- pay incentive fees… that’s a solid reason to keep them. In addition, side pockets mean managers don’t have to sell illiquid assets at bargain prices when investors redeem.

Q. But you said that sometimes, side pockets are accidental?

A. Right. This isn’t good news when it happens. For example, when the last crash came, lots of people tried to redeem out of supposedly liquid hedge funds all at once. But, surprise! A bunch of markets simply froze up, and even financial assets that folks expected to be liquid just couldn’t be sold. So lots of those went into a side pocket, to be held until liquidity returned.

Q. This distinction between liquid and illiquid assets raises an interesting point. If I really want a mixed strategy, some liquid and some illiquid, what’s the most common vehicle?

A. Frankly, these aren’t so common. As we said, some hedge funds are investing more in PE type assets. But, on the other hand, most Funds of Funds, for example, focus either on all hedge funds, or all on private equity funds. There aren’t many that mix and match, largely because of the complications that arise from having a ton of crazy side pockets set up when investors want to redeem out.