The Impact of Hedge Funds on Asset Markets

Abstract

This paper provides evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average …rst order autocorrelation coe¢ cient of hedge fund returns, and show that it has strong and robust in-and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We rationalize these …ndings using a simple equilibrium model in which hedge funds provide liquidity in asset markets.We thank Gavin Boyle, John Campbell, Wayne Ferson, Thierry Foucault, Rene Garcia, Andrew Lo, Narayan Naik, Martin Luehrmann, Kevin Sheppard, Denitsa Stefanova, Marta Szymanowska, David Thesmar, Dimitri Vayanos, Mungo Wilson, and seminar participants at the 2014 FMA Napa Conference, the 6th Annual Hedge Fund Research Conference in Paris, Erasmus University, HEC Paris, Imperial College, the Inquire UK and LBS Joint Conference, INSEAD, the Luxembourg Asset Management Summit, the Oxford-Man Institute of Quantitative Finance, Saïd Business School and the University of Sydney for helpful discussions and comments.y Kruttli is at Oxford-Man Institute of Quantitative Finance. Email: mathias.kruttli@gmail.com. Part of Kruttli's work on this paper was completed while being at Department of Economics, Oxford University. Patton is at Department of Economics, Duke University, and Oxford-Man Institute of Quantitative Finance. Email: andrew.patton@duke.edu. Part of Patton's work on this paper was completed while visiting the Discipline of Finance at the University of Sydney. Ramadorai is at Saïd Business School, Oxford University, Oxford-Man Institute, and CEPR. Email: tarun.ramadorai@sbs.ox.ac.uk. The Impact of Hedge Funds on Asset MarketsABSTRACT This paper provides evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average …rst order autocorrelation coe¢ cient of hedge fund returns, and show that it has strong and robust in-and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We rationalize these …ndings using a simple equilibrium model in which hedge funds provide liquidity in asset markets.