Liquidity Spillovers in Hedge Funds: Evidence from the Holdings of Funds of Hedge Funds

We examine whether funds of hedge funds (FoFs) engage in costly fire sales of their hedge fund investments during the 2004–2011 period. We find that FoFs experiencing large outflows tend to liquidate holdings in funds with relatively few redemption restrictions (“liquid funds”), even when these funds perform well. A tracking portfolio that buys liquid funds involved in fire sales over the prior four quarters earns quarterly abnormal returns of 1.5%. We find no similar effects among illiquid funds, suggesting that trading costs from unanticipated redemptions explain the performance effects. We also show that liquidity mismatches between a FoF’s holdings and its investors helps predict liquidity risk in FoF returns, that is, FoFs with “excessive” exposure to illiquid funds outperform during normal periods but underperform during market crises. We find evidence that best performing hedge funds are unlikely to accept investments from FoFs that are subject to greater liquidity mismatches as hedge funds are likely to face significant liquidity spillover risks in case of large outflows from FoFs.  Agarwal ([email protected]) and Shi ([email protected]) are with Finance Department, J. Mack Robinson College of Business Georgia State University Atlanta, GA. Vikas Agarwal is also a Research Fellow at the Centre for Financial Research (CFR), University of Cologne. Aragon ([email protected]) is with Finance Department, W.P. Carey School of Business Arizona State University, Tempe, AZ.