41 Pages Posted: 11 Mar 2015 Last revised: 28 Jul 2017
Date Written: July 25, 2017
We examine the determinants and consequences of liquidity transformation by funds of hedge funds (FoFs) by proposing a new measure, illiquidity gap, which captures the mismatch between the liquidity of their portfolio and the liquidity that they offer to their investors. We find that higher liquidity transformation is driven by FoFs’ incentives to attract more capital and earn higher compensation. Greater liquidity transformation is associated with higher exposure to investor runs, and worse performance during crisis but better performance otherwise. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers, and more so after poor performance.
Keywords: funds of hedge funds, liquidity transformation, asset liability management, investor fragility, cash holdings
JEL Classification: G11, G20, G23
Suggested Citation: Suggested Citation
Agarwal, Vikas and Aragon, George O. and Shi, Zhen, Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds (July 25, 2017). Available at SSRN: https://ssrn.com/abstract=2574963 or http://dx.doi.org/10.2139/ssrn.2574963