The Liquidity Risk of Liquid Hedge Funds

• Main Author: TEO, Melvyn
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Hedge funds; Liquidity risk; Funding liquidity; Market liquidity; Redemption gates; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/bnp_research/12; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=1009&context=bnp_research
• Institution: Singapore Management University

This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79 percent per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the TED spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).