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Can hedge funds time market liquidity?

Author

Listed:
  • Cao, Charles
  • Chen, Yong
  • Liang, Bing
  • Lo, Andrew W.

Abstract

We explore a new dimension of fund managers' timing ability by examining whether they can time market liquidity through adjusting their portfolios' market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, we find strong evidence of liquidity timing. A bootstrap analysis suggests that top-ranked liquidity timers cannot be attributed to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0–5.5% annually on a risk-adjusted basis. We also find that it is important to distinguish liquidity timing from liquidity reaction, which primarily relies on public information. Our results are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision making.

Suggested Citation

  • Cao, Charles & Chen, Yong & Liang, Bing & Lo, Andrew W., 2013. "Can hedge funds time market liquidity?," Journal of Financial Economics, Elsevier, vol. 109(2), pages 493-516.
  • Handle: RePEc:eee:jfinec:v:109:y:2013:i:2:p:493-516
    DOI: 10.1016/j.jfineco.2013.03.009
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    References listed on IDEAS

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    More about this item

    Keywords

    Hedge funds; Liquidity timing; Investment value; Liquidity reaction; Performance persistence;

    JEL classification:

    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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