Investible benchmarks & hedge fund liquidity

A lack of commonly accepted benchmarks for hedge fund performance has permitted hedge fund managers to attribute to skill returns that may actually accrue from market risk factors and illiquidity. Recent innovations in hedge fund replication permits us to estimate the extent of this misattribution. Using an option-based model, we find evidence that the value of liquidity options that investors implicitly grant managers when they invest may account for part or even all hedge fund returns. Coupled with the competition from hedge fund replication vehicles, this finding may motivate hedge fund investors to demand less restrictive investment terms in the future.