- Returns for eight of 11 hedge fund category indexes (Convertible Arbitrage, Emerging Markets, Equity Market Neutral, Event Driven, Fixed Income Arbitrage, Fund of Funds, Long/Short Equity, and Multi-Strategy) exhibit significantly positive relationships with liquidity.
- Hedge funds with high liquidity risk subsequently outperform those with low risk by an average of about 6.5% annually over the entire sample period, but they underperform during liquidity crises.
- Results are independent of share restrictions, suggesting frequent imbalances between the liquidity funds offers investors and the liquidity of fund positions.
- Among commonly used stock return indicators, price-impact liquidity correlates most strongly with VIX (-0.27).
Results suggest the possibility flow-driven implosion during liquidity crises of hedge funds with high liquidity risk and mismatched liberal investor withdrawal policies.
Cautions regarding findings include:
- Tick-by-tick stock price-impact liquidity calculation is impractical for many investors.
- Obstacles to hedge fund switching, such as withdrawal restrictions and tax implications, may limit exploitability of findings.