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Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds

41 Pages Posted: 11 Mar 2015 Last revised: 28 Jul 2017

Vikas Agarwal

Georgia State University; University of Cologne - Centre for Financial Research (CFR)

George O. Aragon

Arizona State University (ASU) - Finance Department

Zhen Shi

Georgia State University

Date Written: July 25, 2017

Abstract

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

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

Vikas Agarwal

Georgia State University ( email )

35 Broad Street,
Suite 1221
Atlanta, GA 30303-3083
United States
404-413-7326 (Phone)
404-413-7312 (Fax)

HOME PAGE: http://www.gsu.edu/~fncvaa

University of Cologne - Centre for Financial Research (CFR)

Albertus-Magnus Platz
Cologne, 50923
Germany

George O. Aragon

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Zhen Shi (Contact Author)

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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