Liquidity Risk and the Cross-Section of Hedge-Fund Returns
Abstract
This paper demonstrates that liquidity risk as measured by the
covariation of fund returns with unexpected changes in aggregate liquidity is
an important determinant in the cross-section of hedge-fund returns. Using the
aggregate liquidity risk factor in Sadka (2006), this paper shows that funds
that significantly load on liquidity risk subsequently outperform low-loading
funds by about 8% annually over the period 1994--2007. This outperformance is
independent of the illiquidity of a fund as measured by lockup and redemption
notice periods. These findings are also robust to risk controls, portfolio
rebalancing frequency, and potential return smoothing. The results highlight
the importance of understanding systematic liquidity variations in the
evaluation of hedge-fund performance.
A copy of the paper is available [here].