Can Hedge Funds Time Market Liquidity?
Pennsylvania State University
Texas A&M University - Department of Finance
University of Massachusetts at Amherst - Department of Finance & Operations Management; China Academy of Financial Research (CAFR)
Andrew W. Lo
Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)
November 20, 2012
Journal of Financial Economics (JFE), Forthcoming
AFA 2013 San Diego Meetings Paper
We explore a new dimension of fund managers’ timing ability by examining whether they can time market liquidity through adjusting their portfolios’ market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, we find strong evidence of liquidity timing. A bootstrap analysis suggests that top-ranked liquidity timers cannot be attributed to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0%–5.5% annually on a risk-adjusted basis. We also find that it is important to distinguish liquidity timing from liquidity reaction which primarily relies on public information. Our results are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision-making.
Number of Pages in PDF File: 55
Keywords: Hedge funds, liquidity timing, investment value, liquidity reaction, performance persistence
JEL Classification: G23, G11Accepted Paper Series
Date posted: January 22, 2010 ; Last revised: December 6, 2012
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