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Can Hedge Funds Time Market Liquidity?

55 Pages Posted: 22 Jan 2010 Last revised: 18 Feb 2015

Charles Cao

Pennsylvania State University

Yong Chen

Texas A&M University - Department of Finance

Bing Liang

University of Massachusetts Amherst - Department of Finance

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Date Written: November 20, 2012

Abstract

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.

Keywords: Hedge funds, liquidity timing, investment value, liquidity reaction, performance persistence

JEL Classification: G23, G11

Suggested Citation

Cao, Charles and Chen, Yong and Liang, Bing and Lo, Andrew W., Can Hedge Funds Time Market Liquidity? (November 20, 2012). Journal of Financial Economics (JFE), Forthcoming; AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1537925 or http://dx.doi.org/10.2139/ssrn.1537925

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Yong Chen (Contact Author)

Texas A&M University - Department of Finance ( email )

360 Wehner Building
College Station, TX 77843-4218
United States

Bing Liang

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)

HOME PAGE: http://web.mit.edu/alo/www

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
Cambridge, MA 02142
United States

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