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Hedge fund return sensitivity to global liquidity

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  • Kessler, Stephan
  • Scherer, Bernd

Abstract

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.

Suggested Citation

  • Kessler, Stephan & Scherer, Bernd, 2011. "Hedge fund return sensitivity to global liquidity," Journal of Financial Markets, Elsevier, vol. 14(2), pages 301-322, May.
  • Handle: RePEc:eee:finmar:v:14:y:2011:i:2:p:301-322
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    Cited by:

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    2. Akay, Ozgur (Ozzy) & Senyuz, Zeynep & Yoldas, Emre, 2013. "Hedge fund contagion and risk-adjusted returns: A Markov-switching dynamic factor approach," Journal of Empirical Finance, Elsevier, vol. 22(C), pages 16-29.
    3. Akay, Ozgur (Ozzy) & Senyuz, Zeynep & Yoldas, Emre, 2013. "Hedge fund contagion and risk-adjusted returns: A Markov-switching dynamic factor approach," Journal of Empirical Finance, Elsevier, vol. 22(C), pages 16-29.
    4. Schaub, Nic & Schmid, Markus, 2013. "Hedge fund liquidity and performance: Evidence from the financial crisis," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 671-692.
    5. Baibing Li & Ji Luo & Kai†Hong Tee, 2017. "The Market Liquidity Timing Skills of Debt†oriented Hedge Funds," European Financial Management, European Financial Management Association, vol. 23(1), pages 32-54, January.
    6. Luo, Ji & Tee, Kai-Hong & Li, Baibing, 2017. "Timing liquidity in the foreign exchange market: Did hedge funds do it?," Journal of Multinational Financial Management, Elsevier, vol. 40(C), pages 47-62.

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