The Impact of Hedge Funds on Asset Markets

Abstract

This paper provides evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average …first order autocorrelation coefficient of hedge fund returns, and show that it has strong and robust in- and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We rationalize these …findings using a simple equilibrium model in which hedge funds provide liquidity in asset markets.

Keywords: hedge funds, liquidity, return predictability, equities, bonds, currencies.

JEL Classification: G11, G12, G14, G23