Hedge Fund Liquidity and Performance : Evidence from the Financial Crisis

In this paper, we investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that more illiquid funds produce both higher returns and alphas in the pre-crisis period. Hence, funds generate a share illiquidity premium for investors as a compensation for limited liquidity. In contrast, in the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage these illiquid assets effectively in the pre-crisis period, they do not seem to be sufficient to ensure effective management of illiquid portfolios in a crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset-liability mismatch, i.e., funds holding illiquid asset portfolios combined with weak share restrictions, perform particularly poorly and experience the strongest outflows in a crisis. However, share restrictions are not only a proxy for asset portfolio liquidity but also for incentives. Funds with stronger share restrictions and greater managerial discretion have fewer incentives to perform better because investors cannot immediately withdraw their money after poor performance. We show that hedge funds with stricter share restrictions and higher incentive fees do not experience a share illiquidity discount in the crisis period