Market Liquidity and Exposure of Hedge Funds

We examine whether the drastic improvement in liquidity in the US stock market after 2003 has impacted the systematic exposures of hedge funds to the US-stock market. The relation between market exposure and Amihud's illiquidity measure reverses significantly around a breakpoint situated somewhere around 2003. The results are robust to different fund selection criteria, volatility timing, the presence of illiquid holdings and the exact position of the break point. Using the returns to a pairs trading strategy as a sorting criterion for creating portfolios, we find that the effect is strongest for funds that have a significantly positive loading on the pairs trading return. The results suggest that before 2003, time-varying illiquidity led to a time-varying long bias in US-stock market exposure. The reversal of the relationship points towards liquidity timing by hedge funds in the most recent period