The Evolving Beta-Liquidity Relationship of Hedge Funds
Universite du Luxembourg - School of Finance
VU University Amsterdam - Faculty of Economics and Business Administration
September 1, 2013
We model the time-varying stock market exposure of an investor, who takes into account the possible effect of liquidity on subsequent returns and volatility. The optimal timing rule is such that the relation between liquidity and beta can be either positive or negative, depending on the investment opportunity set. We empirically test the timing relation for hedge funds using an optimal changepoint approach. We find a structural change in the relation between hedge funds’ stock market exposure and aggregate stock market liquidity that takes place in the period 2000-2002. Before the changepoint, market betas are negatively related to liquidity, which is suggestive of the role of hedge funds as providers of liquidity. After the break, the relationship is inverted, pointing towards an increased liquidity timing ability of hedge funds, as users of liquidity. The results show that timing ability of hedge funds related to liquidity is not necessarily a stable trait, and the period 2000-2002 is suggestive of the impact that changes in market structure, such as best execution rules and decimalization, can have on the behavior of sophisticated investors. Several dynamic trading strategies are analyzed for similarities and we find a strikingly similar pattern in the beta-liquidity relationship of the returns to momentum.
Number of Pages in PDF File: 42
Keywords: market timing, hedge funds, market liquidity, hedge funds, momentum
JEL Classification: G12, G23working papers series
Date posted: March 19, 2012 ; Last revised: September 27, 2013
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