Liquidity Provision and the Cross-Section of Hedge Fund Returns

Management Science, Forthcoming

88 Pages Posted: 25 Jun 2013 Last revised: 16 Nov 2017

See all articles by Russell Jame

Russell Jame

University of Kentucky - Gatton College of Business and Economics

Date Written: June 24, 2016

Abstract

I investigate whether hedge funds that supply liquidity earn superior returns. Using transaction data, I find that hedge funds following short-term contrarian strategies (i.e., liquidity-suppliers) earn significantly higher returns on their equity trades and holdings. Similarly, using commercial databases, I find that hedge funds with greater exposure to a liquidity-provision factor earn significantly higher excess returns and Sharpe ratios. The superior performance of liquidity-supplying hedge funds arises from strategies that are more complex than mechanical short-term reversal strategies. For example, among stocks with similar past returns, liquidity-supplying funds are more likely to trade against stocks heavily traded by constrained mutual funds and less likely to trade against stocks heavily traded from unconstrained mutual funds. The outperformance of liquidity-supplying funds is also concentrated in periods of low funding liquidity, suggesting that less-binding financial constraints contribute to their superior returns.

Keywords: Hedge Funds, Liquidity Provision, Financial Constraints

JEL Classification: G10, G20

Suggested Citation

Jame, Russell, Liquidity Provision and the Cross-Section of Hedge Fund Returns (June 24, 2016). Management Science, Forthcoming . Available at SSRN: https://ssrn.com/abstract=2284696 or http://dx.doi.org/10.2139/ssrn.2284696

Russell Jame (Contact Author)

University of Kentucky - Gatton College of Business and Economics ( email )

550 South Limestone
Lexington, KY 40506
United States

HOME PAGE: http://russelljame.com

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