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By Matthias Knab, Opalesque Germany: New research from Melvyn Teo, Associate Professor of Finance and Director, BNP Paribas Hedge Fund Centre at the Singapore Management University finds that hedge funds taking liquidity risk outperform by 4.86 percent per annum, % p.a., however having the option to raise gates may ironically encourage them funds to take on more liquidity risk than they should, creating an asset-liability mismatch.

The study can be downloaded here: www.opalesque.com/files/SMU2009Q2.pdf.

The use of gates by hedge funds has severely dented investor confidence. According to a recent Bank of New York Mellon and Casey Quirk survey, up to 57 percent of hedge fund investors are unlikely to re-invest in fund managers that gated them.

Illiquidy risk pays

This research finds that there is significant variation in the liquidity risk exposure of "liquid" funds. Within this group of funds, those that embrace liquidity risk outperform those that eschew liquidity risk by 4.86 percent per year. As a consequence of the liquidity risk exposure, funds experiencing outflows subsequently earn lower returns than funds receiving inflows. The effects of flows are more pronounced for funds employing leverage, for funds with high liquidity risk exposure, and during a liquidity crunch. These results underscore the importance of funding liquidity (the ease with which traders can o......................

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