Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/313451 
Year of Publication: 
2021
Citation: 
[Journal:] Journal of Banking and Financial Economics (JBFE) [ISSN:] 2353-6845 [Issue:] 16 [Year:] 2021 [Pages:] 91-103
Publisher: 
University of Warsaw, Faculty of Management, Warsaw
Abstract: 
This paper demonstrates how the Sharpe Ratio can be modified by altering the measure of "total risk" in the denominator of the Sharpe Ratio (i.e., the standard deviation) to include liquidity risk, a major risk for investors in hedge funds that is missing from the standard Sharpe Ratio formulation. We refer to our liquidity-risk-adjusted performance ratio as the LRAPR. The results of our analysis of 1186 hedge funds alive in 2012-2020 show that funds with higher liquidity risk exhibit higher Sharpe Ratios and higher Alphas (as estimated in a 7-factor model that does not incorporate liquidity risk). We posit that analysts and investors should not necessarily take these higher Sharpe Ratios and higher Alphas as indications of fund superiority; what appears to be superior manager skill may rather be a compensation for bearing liquidity risk. Our LRAPR is a tool that analysts or investors could use to compare funds on a more equal footing, adjusting for differential liquidity risk across funds.
Subjects: 
liquidity risk
liquidity rist factor
serial correlation
Sharpe ratio
hedge fund performance
JEL: 
G12
G23
C18
Persistent Identifier of the first edition: 
Creative Commons License: 
cc-by Logo
Document Type: 
Article

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