Investments, tenth edition

B

 Figure 26.2 

Hedge funds with higher serial correlation in returns, an indicator 

of illiquid portfolio holdings, exhibit higher alphas ( panel A) and higher Sharpe 

ratios ( panel B).   

 Source: Plotted from data in  Table 26.3  .

as 6% annually. Hedge fund performance may therefore reflect significant compensation 

for liquidity risk.  Figure 26.3 , constructed from data reported in his study, is a scatter dia-

gram relating average return for the hedge funds in each style group of  Table 26.2  to the 

liquidity-risk beta for that group. Average return clearly rises with exposure to changes in 

market liquidity.

  

 Returns can be even more difficult to interpret if a hedge fund takes advantage of illiquid 

markets to manipulate returns by purposely misvaluing illiquid assets. In this regard, it is 

worth noting that, on average, reported hedge fund returns in December are substantially 

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  C H A P T E R  

2 6

 Hedge 

Funds 

939

greater than average returns 

in other months.  

10

    The  pattern 

is stronger for lower-liquidity 

funds and funds that are near 

or beyond the threshold return 

at which performance incen-

tive fees kick in. It appears that 

some funds use their discre-

tion in valuing assets to move 

returns to December when that 

will enhance their annual incen-

tive fees. It also appears that 

some hedge funds attempt to 

manipulate their measured per-

formance by buying additional 

shares in stocks they already 

own in an effort to push up their 

prices.  

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   The buying takes place 

just before market close at the 

end of the month when hedge 

fund performance is reported. 

Moreover, the effort is concen-

trated in less liquid stocks where the price impact would be expected to be greater. If, as 

these papers suggest, funds take advantage of illiquid markets to manage returns, then accu-

rate performance measurement becomes almost impossible.