The Market Liquidity Timing Skills of Debt‐oriented Hedge Funds

• Author: Ji Luo,Baibing Li,Kai‐Hong Tee
• Published date: 01 January 2017
• DOI: http://doi.org/10.1111/eufm.12090
• Date: 01 January 2017

The Market Liquidity Timing Skills of

Debt-oriented Hedge Funds

Baibing Li, Ji Luo and Kai-Hong Tee

School of Business and Economics, Loughborough University, Loughborough LE11 3TU, UK

E-mails: B.Li2@lboro.ac.uk; J.Luo2@lboro.ac.uk; K.tee@lboro.ac.uk

ABSTRACT

We investigate the liquidity timing skills of debt-oriented hedge funds following the

2008 credit crisis, which demonstrated the importance of understanding liquidity

conditions to manage the market exposure of investments. We base the analysis on

the estimated co-movements of fixed income and equity market liquidity. Our

findings, which are statistically robust, show evidence of liquidity timing ability in

the fixed income market for all debt-oriented hedge fund strategy categories. Joint

market liquidity timing skill, however, is only found in some categories. Our

findings suggest that debt-oriented hedge fund managers use a sophisticated set of

timing strategies in their investment managements.

Keywords: fixed income market, hedge funds, liquidity timing skill, market exposure

JEL classification: G1, G11, G23

1. Introduction

This paper investigates the ability of hedge fund managers to time market liquidity.

Specifically, we test whether debt-oriented hedge fund managers adjust market exposure

when appreciable changes in market liquidity conditions are anticipated. We focus on

liquidity timing for two main reasons. First, there is a clear connection between market-

wide liquidity and fund performance. For example, during the 2008 financial crisis, many

funds experienced large negative returns since they had to contend with a massive

market-wide liquidity squeeze, above normal investor withdrawals, and a simultaneous

and persistent stock market collapse. Fund managers could potentially avoid such

liquidity-induced losses if they had the ability to reliably predict future market liquidity

conditions and adapt their portfolio exposure accordingly. Second, it is clear that

hedge funds have great flexibility regarding their choices of investment classes and

strategies. Indeed, one of the attractions of hedge funds is precisely the ability to adopt

dynamic investment strategies that lead to time-varying market exposure (Fung and

The authors thank Professor Robert Watson, two anonymous referees, and the Editor,

Professor John Doukas for constructive comments, which helped improve the manuscript.

European Financial Management, Vol. 23, No. 1, 2017, 32–54

doi: 10.1111/eufm.12090

© 2016 John Wiley & Sons, Ltd.

Hsieh, 1997, 2001; Patton and Ramadorai, 2013). Kessler and Scherer (2011) confirm

that hedge funds routinely use a wide variety of financial vehicles and investment

strategies specifically tailored to different markets. Nevertheless, irrespective of the asset

class, since the highest returns tend to be associated with the highest risk exposures,

it is inevitable that many hedge funds adopt strategies associated with investing in

(under-valued) assets with low liquidity levels. Obviously, in the absence of a significant

degree of market liquidity timing ability, the long-term sustainability of such funds

would be highly questionable. Such funds would be entirely unhedged with respect to the

major source of risk essential to their investment strategy. Hence, liquidity crises would

be a little more than a risky bet that investors would have sufficient above-average

returns over an extended period to survive the relatively rare but unavoidable occasions

when market liquidity conditions reverse and induce a potentially fatal negative outcome

(Kessler and Scherer, 2011).

The literature on the timing ability of fund managers has traditionally focused on

managers’ability to time market returns and/or volatility. The pioneering market timing

model is based on the market return timing model of Treynor and Mazuy (1966), while

Busse (1999) documents that fund managers demonstrate the ability to time market

volatility by increasing (reducing) portfolio exposure when the market is less (more)

volatile and Chen and Liang (2007) develop two models to investigate the joint timing

ability of market returns and market volatility. Using the quadratic model of Treynor and

Mazuy (1966) and taking into account the estimated costs associated with liquidity

constraints, French and Ko (2007) examine whether long-short equity hedge funds

exhibit market timing skill. Park (2010) further develops the ideas of these above two

papers by dividing hedge fund excess returns into three components: factor timing, asset

selection and the risk premium. However, none of the above three papers find evidence

that hedge funds have any meaningful market timing skills.

In contrast, Chen and Liang (2007) report finding that hedge fund managers are able to

time market returns and volatility. They also report that hedge funds appear to have the

ability to jointly time the first two moments of the return distribution. Cao et al. (2013)

produce evidence that equity-oriented hedge fund managers are able to time equity

market liquidity. These findings are consistent with those of Chincarini and Nakao

(2011), who find some equity hedge funds have the ability to time the market based on

Fama–French size and value factors. Also relevant to the present study are the results of

Chincarini (2014), that quantitative hedge funds, including equity-oriented hedge funds,

are significantly better market timers than qualitative funds, making them better overall

performers.

Our paper focuses on the liquidity timing skills of debt-oriented hedge funds, an area

that has not been previously empirically investigated. The importance of bond market

liquidity cannot be over-estimated, especially during periods of financial crisis, such as

during the default of Russian GKO government bonds in August 1998, an episode that,

according to Khandani and Lo (2011), widened credit spreads, lowered liquidity and

induced extreme losses upon fixed income arbitrage hedge funds, the best known

casualty being Long Term Capital Management. Indeed, Long Term Capital

Management still comprises the seminal case study regarding the importance of

anticipating changes in bond market liquidity and of the necessity of hedge funds to

adjust portfolios in anticipation of future liquidity conditions.

We investigate to what extent (if any) debt-oriented hedge fund managers have the

ability to time fixed income market liquidity by strategically adjusting the underlying

© 2016 John Wiley & Sons, Ltd.

The Market Liquidity Timing Skills of Debt-oriented 33