Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for May 2024 (Final)

Momentum Investing Strategy (Strategy Overview)

Allocations for May 2024 (Final)
1st ETF 2nd ETF 3rd ETF

Hedge Fund Outperformance: Skill or Liquidity Risk?

| | Posted in: Investing Expertise, Mutual/Hedge Funds

Can outperforming hedge funds readily convert assets into cash for fund investors? In their October 2008 paper entitled “Hedge Fund Alphas: Do They Reflect Managerial Skills or Mere Compensation for Liquidity Risk Bearing?”, Rajna Gibson and Songtao Wang study the effect of market-wide liquidity risk (the time and costs of transforming a given position into cash and vice versa) on the performance of various hedge fund portfolio strategies. The strategies they consider are: Convertible Arbitrage, Dedicated Short Bias, Emerging Markets, Equity Market Neutral, Event-Driven, Fixed Income Arbitrage, Global Macro, Long/Short Equity Hedge, Managed Futures and Multi-Strategy. Using performance data for a broad sample of live (2,743) and defunct (1,955) hedge funds during 1994-2006 and contemporaneous measures of market-wide (U.S. equities) liquidity, they conclude that:

  • Over the sample period, the Event Driven, Long/Short Equity Hedge and Multi-Strategy fund strategies have the highest average annualized returns and (except for Long/Short Equity Hedge) Sharpe ratios. The Dedicated Short Bias strategy underperforms, with a negative average annualized return.
  • After accounting for market-wide liquidity risk, outperformance disappears or weakens dramatically for seven of ten hedge fund strategy portfolios. In other words, alphas largely reflect compensation for liquidity risk for all hedge fund strategies except Equity Market Neutral, Fixed Income Arbitrage and Multi-Strategy. This compensation is distinct from fund manager skill.
  • These results are robust to an alternative fund performance evaluation model, an alternative measurement of liquidity risk, the exclusion of the January effect on liquidity and the exclusion of data during financial crises.

In summary, hedge fund investors should recognize that many funds generate “alpha” by taking liquidity risks that make converting assets to cash difficult.

The proliferation of hedge funds with similar strategies seems to amplify liquidity risk invisibly (i.e., in a way not apparent in data from before fund proliferation).

Daily Email Updates
Filter Research
  • Research Categories (select one or more)