53 Pages Posted: 8 Mar 2011
Date Written: March 7, 2011
This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79% per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the Treasury-Eurodollar spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).
Keywords: Hedge Funds, Liquidity risk, Funding liquidity, Market liquidity, Redemption gates
JEL Classification: G11, G12, G14, G23
Suggested Citation: Suggested Citation
Teo, Melvyn, The Liquidity Risk of Liquid Hedge Funds (March 7, 2011). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1779984