The Behavior of Hedge Funds During Liquidity Crises

To shed light on the empirical relevance of the limits to arbitrage, we study hedge funds’ trading patterns in the stock market during liquidity crises. Consistent with arbitrageurs’ limited ability to provide liquidity, we find that at the time of liquidity crises hedge funds reduce their equity holdings by 9% to 11% per quarter (around 0.3% of total market capitalization). Dramatic selloffs took place during the 2008 crisis: hedge funds sold about 30% of their stock holdings and nearly every fourth hedge fund sold more than 40% of its equity portfolio. We identify two main drivers of this behavior. First, in line with the limits-to-arbitrage theory, we document that lender and investor funding withdrawals explain over half of the equity selloffs. Second, it appears that hedge funds mobilize capital to other (potentially less liquid) markets in pursuit of more profitable investment opportunities. The latter finding suggests that liquidity provision by arbitrageurs is not entirely hampered.[...]