Penn State University

This paper examines how hedge funds manage their liquidity risk by responding to the aggregate liquidity shock. Using a large sample of hedge funds over the period of 1994-2008, we find strong evidence that hedge fund managers possess liquidity timing ability at both investment strategy level and the individual fund level. They increase (decrease) their portfolios ’ market exposure when the equity market liquidity is high (low). More importantly, the liquidity timing evidence is particularly significant among funds with illiquid holdings. In contrast, hedge fund managers who hold liquid assets tend to react to past liquidity conditions strongly. The liquidity timing ability is also asymmetric, depending on market liquidity conditions: it is more pronounced when the market liquidity is low than when it is high. Our results are robust even after we control for return- and volatility-timing abilities