66 Pages Posted: 11 Nov 2016 Last revised: 24 Dec 2016
Date Written: December 23, 2016
I develop a simple model in which hedge fund managers with access to less profitable investment strategies choose a higher exposure to funding risk in an attempt to generate competitive returns. Empirically, I find that hedge funds with a higher loading on a simple funding risk measure generate lower returns than hedge funds with a lower loading on that risk measure. In line with the model predictions, I find that (i) this underperformance is driven by a high loading on adverse funding shocks, (ii) a higher loading on funding risk predicts lower fund flows, and (iii) the results are significantly weaker for funds with less favorable redemption terms or funds with multiple prime brokers.
Keywords: Fund redemptions, funding risk, hedge funds, limits of arbitrage, lockups
JEL Classification: G01, G23, G31
Suggested Citation: Suggested Citation