Liquidity Management Of Hedge Funds Around The 2008 Financial Crisis
Tilburg University – Department of Finance
November 10, 2015
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This paper studies how hedge funds adjusted their holdings of liquid and illiquid stocks before, during and after the 2008 financial crisis. I find that hedge funds sold more liquid than illiquid stocks at the peak of the crisis, and they repurchased a large amount of liquid stocks during the upturn but continued to sell illiquid stocks. Consistently, hedge funds’ portfolio composition shows a delayed “flight to liquidity”: the proportion of hedge funds’ liquid stock holdings decreased slightly at the peak of the crisis and then increased substantially to a highest level ever since 2007. This result confirms the prediction in Scholes (2000) that institutional investors should sell liquid stocks first during a crisis and build a “liquidity cushion” for future liquidity needs later. For comparison, I show that pension funds have a nearly constant portfolio composition of liquid versus illiquid stocks through the entire crisis.
Liquidity Management Of Hedge Funds Around The 2008 Financial Crisis – Introduction
In the previous decade, the theoretical literature of dynamic portfolio choice with trading costs has developed rapidly. After experiencing the financial crises in 1998 and 2008, more and more scholars started to notice the important role of liquidity management in portfolio choice, especially during times of liquidity crisis. For example, Scholes (2000) suggests that financial institutions should sell liquid assets first for urgent liquidity needs to reduce the transaction costs, and he emphasizes the need to build “a dynamic liquidity cushion” for future liquidity needs. Duffie and Ziegler (2003) investigate numerically the trade-off between selling off an illiquid asset to keep a “cushion of liquid assets”, and selling a liquid asset to maximize short-term portfolio value. Brown, Carlin, and Lobo (2010) solve the optimal liquidation problem in a dynamic framework and show that it is optimal for myopic investors to first trade liquid assets, but long-run investors may decide to postpone selling their most liquid securities if they expect their liquidity needs are going to be larger in later periods.
Among all types of investors, hedge funds might be the group of investors that care most about their liquidity management. It is because clients of hedge funds are mainly sophisticated institutional investors which react quickly to market changes. Moreover, the use of leverage and short positions makes hedge funds more sensitive to fund outflows than other investors. Yet there is no empirical work on how hedge funds manage the liquidity of their portfolios dynamically around crisis periods.
In this paper, I analyze the quarterly stock holdings of 60 largest hedge funds in U.S. before, during and after the 2008 financial crisis, and document the liquidity composition of their portfolios. For comparison, I do a similar analysis for pension funds. First, I study the changes of hedge funds’ aggregate equity holdings from 2007 to 2010. Figure 1 presents both the total equity holdings of hedge funds and the S&P 500 index. It shows that the equity holdings of hedge funds dropped severely in the second half of 2008 and reversed strongly in 2009 and 2010 Q1. The reversal of hedge funds’ equity holdings started even one quarter before the reversal of the S&P 500 index. Different from hedge funds, pension funds reduced their equity holdings gradually from 2007 to 2010. There was no sudden drop or reversal in their equity holdings. It might be because, unlike hedge funds, pension funds did not face large urgent liquidity needs at that time, and attempt to time the market.
Second, to investigate whether hedge funds trade liquid and illiquid stocks differently around the crisis, I sort stocks into deciles based on their ILLIQ values, a liquidity measure proposed in Amihud (2002). Interestingly, I find that hedge funds sold more liquid than illiquid stocks at the peak of the crisis, and they repurchased a large amount of liquid stocks during the upturn but continued to sell illiquid stocks. In accordance, the portfolio composition of hedge funds shows a delayed “flight to liquidity”. The fraction of relatively liquid stocks held by hedge funds decreased slightly at the peak of the crisis (the second half of 2008), from 40% to 38%, and increased substantially to 48% in 2009. These results are consistent with the predictions in Scholes (2000), Duffie and Ziegler (2003) and Brown, Carlin, and Lobo (2010) for both myopic and long-term liquidity management. Different from hedge funds, pension funds did not trade liquid and illiquid stocks differently around the crisis.
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