This paper presents evidence on the relation between hedge fund returns and restrictions imposed by funds that limit the liquidity of fund investors. The excess returns of funds with lockup restrictions are approximately 4–7% per year higher than those of nonlockup funds. The average alpha of all funds is negative or insignificant after controlling for lockups and other share restrictions. Also, a negative relation is found between share restrictions and the liquidity of the fund's portfolio. This suggests that share restrictions allow funds to efficiently manage illiquid assets, and these benefits are captured by investors as a share illiquidity premium.

[We analyze whether risk shifting by a hedge fund manager is related to the manager's incentive contract, personal capital stake, and the risk of fund closure. We find that the propensity to increase risk following poor performance is significantly weaker when incentive pay is tied to the fund's high-water mark and when funds face little immediate risk of liquidation. Risk shifting is also less prevalent when a manager has a significant amount of personal capital invested in the fund. Overall, high-water mark provisions, managerial stake, and low risk of fund closure appear to make a hedge fund manager more conservative with regard to risk shifting.]

We measure a stock’s exposure to fire sale risk through its ownership links to mutual funds that anticipate significant outflows during periods of systematic outflows from the fund industry. We find that stocks with higher exposure to this risk earn higher average returns: a portfolio that buys (shorts) stocks with the highest (lowest) exposure outperforms by 3-7% annually. Our findings cannot be explained by several known determinants of average returns and support the ex-ante pricing of the risk of fire sales. We conclude that stocks’ exposures to risks inherited from the constraints of shareholders have important implications for stock prices.

We study the common equity and equity option positions of hedge fund investment advisors over the 1999–2006 period. We find that hedge funds' stock positions predict future returns and that option positions predict both volatility and returns on the underlying stock. A quarterly tracking portfolio of stocks based on publicly observable hedge fund option holdings earns abnormal returns of 1.55% through the end of the quarter. Net of fees, hedge funds using options deliver higher benchmark-adjusted portfolio returns and lower risk than nonusers. The results suggest that hedge fund positions reflect significant timing and selectivity skill.

We use a novel database to study the timeliness of hedge fund monthly performance disclosures. Managers engage in strategic timing: poor monthly returns are reported with delay, sometimes clustered with stronger subsequent performance, suggestive of “performance smoothing.” We posit that propensity to delay could reveal operational risk and/or poor managerial quality. Consistent with this, a portfolio strategy that buys (sells) funds with historically timely (untimely) reporting delivers 3% annual-style-adjusted returns. Investor flows are lower following reporting delays, although there are potential benefits to managers from delaying reporting when performance is sufficiently poor. We conclude that timely disclosure is an important consideration for hedge fund managers and investors.

We analyze whether risk shifting by a hedge fund manager is related to the manager's incentive contract, personal capital stake, and the risk of fund closure. We find that the propensity to increase risk following poor performance is significantly weaker when incentive pay is tied to the fund's high-water mark and when funds face little immediate risk of liquidation. Risk shifting is also less prevalent when a manager has a significant amount of personal capital invested in the fund. Overall, high-water mark provisions, managerial stake, and low risk of fund closure appear to make a hedge fund manager more conservative with regard to risk shifting. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

Hedge funds using Lehman as prime broker faced a decline in funding liquidity after the September 15, 2008 bankruptcy. We find that stocks held by these Lehman-connected funds experienced greater declines in market liquidity following the bankruptcy than other stocks; the effect was larger for ex ante illiquid stocks and persisted into the beginning of 2009. We find no similar effects surrounding the Bear Stearns failure, suggesting that disruptions surrounding bankruptcy explain the liquidity effects. We conclude that shocks to traders' funding liquidity reduce the market liquidity of the assets that they trade.

We examine liquidity transformation by funds of hedge funds (FoFs) by developing a new measure, illiquidity gap, that captures the mismatch between the liquidity of their portfolios and the liquidity available to their investors. We find that higher liquidity transformation is driven by FoFs’ incentives to attract more capital and earn higher compensation. Greater liquidity transformation is associated with higher exposure to investor runs and worse performance during crisis periods. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers.

Abstract We study a sample of Form 13F filings where fund advisors seek confidential treatment for some or all of their 13(f)-reportable positions. Consistent with the hypothesis that managers seek confidentiality to protect proprietary information, we find that confidential positions earn positive and significant abnormal returns over the post-filing confidential period. We also find that managers are more likely to seek confidential treatment of illiquid positions that are more susceptible to front-running. Overall, our analysis highlights important benefits of reduced disclosure that are relevant to the current policy debate on hedge fund transparency.