Liquidity as a risk factor:a study of hedge fund style indices exposures

Abstract

Factor investing has been one of the fundamental alternative investment since Lintner, (1965); Mossin, (1966) and Sharpe, (1964) defined the market risk factor as the systematic risk due to the market in the Capital asset pricing model (CAPM). The premium to these factors means investors are compensated for holding the respective risks. Liquidity factor is important to hedge fund industry given the illiquid nature of it investing. We use the innovation series of Pastor and Stambaugh (2003) to examine Hedge fund style indices from both investable (HFRX) and non-investable (HFRI) of the HFR database to establish differences in exposures as well as confirm the pricing of liquidity factor in investable and non-investable indices. In analysing premium to liquidity factor in individual indices, we estimate the beta coefficients for each style indices and further control for other factor effects by including the 7-factors of Fung and Hsieh (2004). The Fama-Macbeth (1973) two-stage approach is used to price liquidity factor in both investable and non-investable indices and autocorrelation is adequately corrected for using the Newey-West method which employs generalised Method of Moments (GMM) approach. Both investable and non-investable indices of the HFR database showed that exposures of this indices to liquidity factor are largely determined by their characteristics and formation methods. This is further explained by the effect of other factors in the 7-factors of Fung and Hsieh which showed that when specific characteristics are controlled for, the exposures of an index to liquidity factor can be insignificant. Liquidity factor is a priced factor in both investable and non-investable funds with significant liquidity premium even after controlling for autocorrelation. We further establish that the investable indices are poor estimator of the hedge fund universe by rejecting the null hypothesis of test of zero alphas