Illiquidity in Intermediate Portfolios: Evidence from Large Hedge Funds

64 Pages Posted: 27 Feb 2020

See all articles by Daniel Barth

Daniel Barth

Board of Governors of the Federal Reserve System

Phillip Monin

Board of Governors of the Federal Reserve System

Date Written: February 25, 2020

Abstract

Evaporating liquidity is a central feature of many financial crises. Questions remain about the importance of illiquidity and the distribution of illiquidity exposure across financial market participants. We use regulatory data on hedge funds — who unlike public mutual funds often invest in illiquid markets — to address three empirical questions: how large is the illiquidity premium, how important is it for hedge fund returns, and who ultimately captures the premium, fund managers or investors? We estimate an annual illiquidity premium of 56 basis points for an additional log-day needed to sell assets without price impact, of which investors capture 77%. Portfolio illiquidity explains 27% of alpha, but share restrictions explain 55%. Consistent with compensation for undiversifiable illiquidity risk, managers of illiquid funds charge higher incentive fees. Our findings suggest the costs and risks associated with illiquid assets are substantial and require significant compensation. Moreover, the returns of some funds are highly dependent on the illiquidity premium, which may indicate these funds have significant exposures to illiquidity. However, through share restrictions much of this exposure is passed to fund investors, who are likely better able to diversity across many asset classes.

Keywords: hedge funds, illiquidity, share restrictions, intermediaries

JEL Classification: G11, G12, G23

Suggested Citation

Barth, Daniel and Monin, Phillip, Illiquidity in Intermediate Portfolios: Evidence from Large Hedge Funds (February 25, 2020). OFR WP 20-03, Available at SSRN: https://ssrn.com/abstract=3544312 or http://dx.doi.org/10.2139/ssrn.3544312

Daniel Barth (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Phillip Monin

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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