Can Hedge Funds Time Market Liquidity?

This paper examines how hedge funds manage their market risk according to changes in aggregate liquidity conditions. Using a large sample of equity-oriented hedge funds during the period of 1994–2008, we find strong evidence that hedge-fund managers possess the ability to time market liquidity at both the style category level and the individual fund level. They increase (decrease) their portfolios’ market exposure when equity-market liquidity is high (low). This liquidity timing ability is asymmetric, and depends on market liquidity conditions: hedge fund managers reduce their portfolios’ market exposure significantly when market liquidity is extremely low, but do not increase their market exposure when market liquidity is unusually high. Finally, investing in top liquidity timing funds can generate economically significant profits. The top timing funds subsequently outperform the bottom timing funds by 5-6% per year on a risk-adjusted basis. Our results persist after controlling for alternative benchmark models, various data biases, and return-timing and volatility-timing abilities.