The Market Liquidity Timing Skills of Debt‐oriented Hedge Funds

Published date01 January 2017
Date01 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
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 xed income and equity market liquidity. Our
ndings, which are statistically robust, show evidence of liquidity timing ability in
the xed income market for all debt-oriented hedge fund strategy categories. Joint
market liquidity timing skill, however, is only found in some categories. Our
ndings 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.
Specically, 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 nancial 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 exibility 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, 3254
doi: 10.1111/eufm.12090
© 2016 John Wiley & Sons, Ltd.
Hsieh, 1997, 2001; Patton and Ramadorai, 2013). Kessler and Scherer (2011) conrm
that hedge funds routinely use a wide variety of nancial vehicles and investment
strategies specically 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 signicant
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 sufcient 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
managersability 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 nd evidence
that hedge funds have any meaningful market timing skills.
In contrast, Chen and Liang (2007) report nding 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 rst 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 ndings are consistent with those of Chincarini and Nakao
(2011), who nd some equity hedge funds have the ability to time the market based on
FamaFrench 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 signicantly better market timers than qualitative funds, making them better overall
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 nancial 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 xed 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 xed income market liquidity by strategically adjusting the underlying
© 2016 John Wiley & Sons, Ltd.
The Market Liquidity Timing Skills of Debt-oriented 33

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