Hedge Fund Liquidity Management: Insights for Fund Performance and Financial Stability

George O. Aragon, A. Tolga Ergun, and Giulio Girardi

Abstract:

Using Form PF filings over 2013–2022, we find that hedge funds maintain higher levels of cash holdings and available borrowing (“liquidity buffers”) when they hold more illiquid assets, have shorter-term commitments from investors and creditors, and when market volatility is greater. Funds with low abnormal buffers – buffers below the level predicted by fund attributes – outperform their benchmarks and exhibit stock selection skill around earnings announcements. However, such funds suffer from costly asset fire sales during the 2020 crisis period. We find evidence that this fire-sale activity contributed to price volatility during this period – stocks with greater ownership by low abnormal buffer managers realize significantly worse cumulative abnormal returns over the first quarter of 2020. Our results highlight the potential policy trade-offs between systemic risk-oriented policies requiring larger liquidity buffers to improve funds’ resilience and the impairment of regular price discovery in financial markets during normal times.