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Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds

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  • Agarwal, Vikas
  • Aragon, George O.
  • Shi, Zhen

Abstract

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.

Suggested Citation

  • Agarwal, Vikas & Aragon, George O. & Shi, Zhen, 2019. "Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(6), pages 2355-2381, December.
    • Handle: RePEc:cup:jfinqa:v:54:y:2019:i:6:p:2355-2381_3
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    Cited by:

    1. George O. Aragon & Ji-Woong Chung & Byoung Uk Kang, 2023. "Do Prime Brokers Matter in the Search for Informed Hedge Fund Managers?," Management Science, INFORMS, vol. 69(8), pages 4932-4952, August.
    2. Pana, Elisabeta, 2023. "A bibliometric review of liquidity creation," Research in International Business and Finance, Elsevier, vol. 64(C).
    3. Lee, Jennifer Eunkyeong & Cho, Hoon & Ryu, Doojin & Seok, Sangik, 2023. "Does performance-chasing behavior matter? International evidence," Journal of Multinational Financial Management, Elsevier, vol. 68(C).
    4. Mathias S. Kruttli & Phillip J. Monin & Lubomir Petrasek & Sumudu W. Watugala, 2021. "Hedge Fund Treasury Trading and Funding Fragility: Evidence from the COVID-19 Crisis," Finance and Economics Discussion Series 2021-038, Board of Governors of the Federal Reserve System (U.S.).

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