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Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds

Published online by Cambridge University Press:  08 October 2018

Vikas Agarwal ,
George O. Aragon  and
Zhen Shi
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Abstract

We examine liquidity transformation by funds of hedge funds (FoFs) by developing a new measure, illiquidity gap, that captures the mismatch between the liquidity of their portfolios and the liquidity available to their investors. We find that higher liquidity transformation is driven by FoFs’ incentives to attract more capital and earn higher compensation. Greater liquidity transformation is associated with higher exposure to investor runs and worse performance during crisis periods. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 6 , December 2019 , pp. 2355 - 2381
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We thank Jennifer Carpenter, Chris Clifford, Jennifer Conrad (the editor), Jesse Ellis, Francesco Franzoni, Gerald Gay, Itay Goldstein, John Griffin, Wei Jiang, Olga Kolokolova, Bing Liang (the referee), Tarun Ramadorai, Sugata Ray, Honglin Ren, Ronnie Sadka, David Smith, Avanidhar Subrahmanyam, Baozhong Yang, and Yao Zeng for their helpful comments and constructive suggestions. We benefited from the comments received at presentations at Arizona State University, Georgia State University, University of Utah, Syracuse University, the 2014 Michigan State University Federal Credit Union Conference on Financial Institutions and Investments, the 2014 University at Albany’s Inaugural Financial Market Symposium: Hedge Funds and Regulation, the 2015 Annual Paris Hedge Fund Conference, the 2015 China International Conference in Finance, the 2015 Liquidity Risk in Asset Management: Financial Stability Perspective Conference at the University of Toronto, the 2016 AIM Management Group Investment Conference, and the University of North Carolina 2016 Hedge Fund Research Conference. We thank Muneem Ahad, Adrien Becam, Yung-Ling Chi, Kevin Mullally, Honglin Ren, Daruo Xie, and Hu Zhang for excellent research assistance. Vikas also thanks the Centre for Financial Research (CFR) in Cologne for its continued support.

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