Hedge fund return sensitivity to global liquidity
This article identifies a common latent liquidity factor, which is the driver of observable and commonly used liquidity proxies across asset classes. We use two methodologies to identify the latent liquidity factor: state space modeling (SSM) and principal component analysis (PCA). We find that the returns of hedge funds respond to an increase in illiquidity with statistically significant negative returns. The relative size of the liquidity factor loadings of the different hedge fund indices is generally consistent with the liquidity sensitivities of the underlying strategies. The results hold up in a range of robustness tests. Finally, we find a surprisingly strong link between global risk factors and hedge fund returns, questioning the industry's claim to deliver pure manager alpha.
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