Market Liquidity and Exposure of Hedge Funds

Abstract:     
We analyze the sensitivity of the stock market exposure of hedge funds to liquidity and find that impact of liquidity on market exposure is not stable over time but reverses around a breakpoint. The results are robust to different fund selection criteria, volatility timing, the presence of illiquid holdings and the exact position of the break point. To find out if dynamic trading strategies can explain this result, we model the return to a pairs-trading strategy that takes finite liquidity into account and find that the breakpoint is strongest for funds that load on the pairs trading return. The reversal of the relationship points towards liquidity supply before, and liquidity timing after the breakpoint. The breakpoint coincides with the drastic improvement in stock market liquidity around 2003.

Number of Pages in PDF File: 37

Keywords: hedge funds, market liquidity, liquidity timing, pairs trading

JEL Classification: G12, G23

working papers series