Can Hedge Funds Time Market Liquidity?
Charles Cao, Texas A&M University
Yong Chen, Penn State University
Bing Liang, University of Massachusetts
Andrew Lo, MIT

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.

Knowing when and why fund managers outperform the market is very important to investment sponsors and to investment managers who want to improve their own performance. The results of this study help us better understand the market timing skills of hedge fund managers when faced with time-varying liquidity conditions.


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