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Liquidity Driving Hedge Fund ReturnsSubmitted by: Andy Deutsch, Risk Product Development

Liquidity has been cited as a one of the main reasons for the systemic breakdown of the financial markets. Consequently, more investors are now looking into liquidity risk in addition to more typical risk measures. Liquidity risk, however, is not easily quantified.

Financial instruments that are not liquid have static pricing over long periods. Funds with a large percentage of their assets invested in these instruments can be categorized as illiquid, and tend to demonstrate relatively smooth monthly returns. We decided take a look at all the funds in the HFR universe, and categorized them as either liquid or illiquid by calculating their autocorrelation and thereby outing a value on how smooth their returns are. We calculated this value based upon 6 lags of autocorrelation and scaled so as to fit a chi square distribution. We then categorized a fund as illiquid if the probability that value exceeds the critical value associated with 5%. We considered a fund very illiquid if the probability that value exceeded the critical value associated with 1%.

We performed the analysis at two different times on the funds in the HFR database that reported returns for at least 24 months. The first analysis was performed in May 2007, with data through April 2007. The more recent analysis has data through January 2009. The initial analysis had a breakdown of 60/40 of liquid to illiquid funds. Now we're seeing a 50/50 split. On the highly illiquid front the breakdown was 76/24 liquid to highly illiquid, now it is 62/38 in favor of liquid funds. The analysis shows that funds are trending towards being more illiquid. This could be due to the fact that funds are holding their illiquid instruments and trying to realize the losses associated with them.

On a return analysis level, in the first study the illiquid funds had better 12 month returns than the liquid funds with the illiquid funds retuning 9.5% versus 7.8 for the more liquid funds. In the weaker market of the last year, the returns for funds on the whole have gone down tremendously and even more so for illiquid funds. The comparative returns for 12 month returns for illiquid vs. liquid funds is now roughly -22% to -7%. The conventional wisdom is that a liquidity premium exists and the return on illiquid instruments should be more than that of liquid instruments. In down markets, however, the opposite appears to be true.

To view the distribution of funds chart and returns by liquidity bucket chart, please visit here.

Full post as published by Institutional Shareholder Services -- Corporate Governance Blog on March 24, 2009 (boomark / email).