Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds
50 Pages Posted: 11 Mar 2015 Last revised: 15 May 2018
Date Written: May 10, 2018
We examine liquidity transformation by funds of hedge funds (FoFs) by developing a new measure, illiquidity gap, which captures the mismatch between the liquidity of their portfolios and the liquidity available 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 periods. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers.
Keywords: funds of hedge funds, liquidity transformation, asset liability management, investor fragility, cash holdings
JEL Classification: G11, G20, G23
Suggested Citation: Suggested Citation