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Liquidity Risk, Return Predictability, and Hedge Funds’ Performance: An Empirical Study

Published online by Cambridge University Press:  08 January 2013

Rajna Gibson Brandon
Affiliation:
rajna.gibson@unige.ch, University of Geneva, Unimail, 40 Bd du Pont d’Arve, 1211 Geneva 4, Switzerland, and Swiss Finance Institute;
Songtao Wang
Affiliation:
wungsungtao@yahoo.com, University of Zurich, Plattenstrasse 30, 8032 Zurich, Switzerland, and Swiss Finance Institute.

Abstract

This article analyzes the effect of liquidity risk on the performance of equity hedge fund portfolios. Similarly to Avramov, Kosowski, Naik, and Teo (2007), (2011), we observe that, before accounting for the effect of liquidity risk, hedge fund portfolios that incorporate predictability in managerial skills generate superior performance. This outperformance disappears or weakens substantially for most emerging markets, event-driven, and long/short hedge fund portfolios once we account for liquidity risk. Moreover, we show that the equity market-neutral and long/short hedge fund portfolios’ “alphas” also entail rents for their service as liquidity providers. These results hold under various robustness tests.

Type
Research Articles
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2013 

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