Illiquidity in Intermediate Portfolios: Evidence from Large Hedge Funds

Evaporating liquidity is a central feature of many financial crises. Questions remain about the importance of illiquidity and the distribution of illiquidity exposure across financial market participants. We use regulatory data on hedge funds - who unlike public mutual funds often invest in illiquid markets - to address three empirical questions: how large is the illiquidity premium, how important is it for hedge fund returns, and who ultimately captures the premium, fund managers or investors? We estimate an annual illiquidity premium of 56 basis points for an additional log-day needed to sell assets without price impact, of which investors capture 77%. Portfolio illiquidity explains 27% of alpha, but share restrictions explain 55%. Consistent with compensation for undiversifiable illiquidity risk, managers of illiquid funds charge higher incentive fees. Our findings suggest the costs and risks associated with illiquid assets are substantial and require significant compensation. Moreover, the returns of some funds are highly dependent on the illiquidity premium, which may indicate these funds have significant exposures to illiquidity. However, through share restrictions much of this exposure is passed to fund investors, who are likely better able to diversity across many asset classes.