Liquidity Risk of Hedge Funds

During the 2008 financial crisis, the use of redemption gates by hedge fund managers caught many investors by surprise. Gates allow hedge funds to limit the percentage of fund capital that can be redeemed by investors at any time. There were also underlying concerns about an asset-liability mismatch in the hedge fund industry. Could a disparity exist between the liquidity that hedge funds say they can provide and the liquidity of their underlying assets? How liquid are these liquid hedge funds? Do they take on excessive liquidity risk? That is, are they forced to sell assets at fire sale prices in response to investor redemptions? If so, what drives the excessive liquidity risk-taking? 

On the 10th anniversary of the 2008 financial crisis, Professor Melvyn Teo, Deputy Dean (Faculty & Research) and Lee Kong Chian Professor of Finance, shares insights from his research on the liquidity risk of liquid hedge funds.

Faculty Profile: https://business.smu.edu.sg/faculty/profile/9540/Melvyn-TEO

Research Interests:

Asset Pricing and Capital Markets

Hedge Funds and Private Equity

Behavioral Finance

Research Paper:

TEO, Melvyn. (2011). The Liquidity Risk of Liquid Hedge Funds. Research Collection BNP Paribas Hedge Fund Centre. Journal of Financial Economics, 100(1), 24.

 

Abstract:

This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79 percent per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the TED spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).

Keywords

Hedge funds, Liquidity risk, Funding liquidity, Market liquidity, Liquidity, Risk, Redemption gates, Finance, Financial Management, Portfolio and Security Analysis,