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Hedge fund alphas: do they reflect managerial skills or mere compensation for liquidity risk bearing?

Author

Listed:
  • Rajna GIBSON

    (University of Geneva and Swiss Finance Institute)

  • Songtao WANG

    (University of Zurich (PhD Candidate in Finance) and Swiss Finance Institute)

Abstract

In this article, we study the effect of liquidity risk on the performance of various hedge fund portfolio strategies. The portfolio strategies in each hedge fund style are formed by incorporating predictability in: (i) managerial skills, (ii) fund risk loadings, and (iii) benchmark returns. As in Avramov et al. (2007), we find that, before taking into account the effect of liquidity risk, long-only constrained hedge fund style portfolios that incorporate predictability in managerial skills generate superior performance. However, the outperformance disappears or weakens dramatically for seven out of ten types of hedge fund style portfolios once the effect of liquidity risk is incorporated into the performance evaluation framework. Hence, for most hedge fund style-based portfolio strategies, “alphas” to a large extend reflect mere compensation for liquidity risk bearing. These results are robust to: (i) an alternative performance evaluation model (ii) an alternative liquidity risk proxy, (iii) the exclusion of the January effect on the liquidity premium and (iv) the exclusion of the recent financial crises data.

Suggested Citation

  • Rajna GIBSON & Songtao WANG, 2008. "Hedge fund alphas: do they reflect managerial skills or mere compensation for liquidity risk bearing?," Swiss Finance Institute Research Paper Series 08-37, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp0837
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    More about this item

    Keywords

    Hedge Funds; Liquidity Risk; Managerial Skills; Predictability.;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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