Institutional Investors and Liquidity Risk

I analyze the effects of institutional ownership on liquidity risk in the cross-section of stocks. Using a unique, hand-collected data set of hedge fund ownership, I examine whether stocks held by hedge funds as marginal investors are more sensitive to changes in aggregate liquidity than comparable stocks held by other types of institutions or by individuals. After controlling for institutional preferences for stock characteristics, I find a positive relationship between hedge fund ownership and liquidity risk, and a negative relationship between bank ownership and liquidity risk. In addition, stocks held by hedge funds experience significant negative abnormal returns during liquidity crises, whereas stocks held by banks experience significant positive abnormal returns. These findings support the theory of Brunnermeier and Pedersen (2009) that funding constraints of leveraged speculators lead to a greater liquidity risk, and the theory of Gatev and Strahan (2006) that banks have a unique ability to hedge against market-wide liquidity shocks.