Liquidity Risk and Hedge Fund Performance Evaluation

Abstract

In this article the author uses two models, a lagged-effects model and a serial correlation model, which identify potential liquidity risk in hedge fund portfolios. From the serial correlation model a liquidity risk factor was developed and added to a multi-factor equilibrium model in order to re-estimate Alpha across a universe of hedge funds. It was found that much of what passes for fund Alpha in a multi-factor risk model lacking a liquidity risk factor is actually a compensation for bearing liquidity risk in the context of a model that includes the innovative liquidity risk factor. This result has implications for both a pre-investment due diligence and a manager selection as well as the postinvestment fund performance evaluation and risk management.(original abstract)