The procyclicality of hedge fund alpha and beta

Abstract

François-Éric Racicotis Associate Professor of Finance at the Telfer School of Management, University of Ottawa. His research interests focus on the problems of measurement errors, specification errors and endogeneity in financial models of returns. He is also interested in developing new methods used for forecasting financial time series − especially hedge fund risk. He has published several books and many articles in quantitative finance and financial econometrics. Raymond Théoretis Full Professor of Finance at École des sciences de la Gestion, University of Quebec − Montreal (UQAM). His research focuses on banking systemic risk and hedge fund risk. He has published many books in asset pricing and many articles in the banking and hedge fund areas in well-known journals.Correspondence: François-Éric Racicot, Telfer School of Management, CGA-Canada Accounting and Governance Research Centre, University of Ottawa, 55 Laurier Avenue East, Ottawa, ON, K1N 6N5 Canada E-mail: Racicot@telfer.uottawa.ca ABSTRACT Traditional financial institutions as banks follow procyclical risk strategies, that is, they increase their leverage in economic expansions and reduce it in contractions, which leads to a procyclical behaviour for their betas and other risk and financial performance measures. We study the cyclical aspects of hedge fund strategies, an issue quite overlooked in the literature. We rely on two procedures: conditional modelling and Kalman filtering of hedge funds' alpha and beta. We find that hedge fund betas are usually procyclical. Our results also show that the alpha is often high at the beginning of a market upside cycle but, as the demand pressure increases, it progressively shrinks, which suggests that the alpha puzzle ought to be analysed in a dynamic setting.

Procyclicality and diversification in the hedge fund industry in the aftermath of the subprime crisis

“…Procyclicality thus seems to decrease in the hedge fund industry, a good news for investors in search for higher yields like pension funds (Racicot and Théoret, 2013). One promising avenue for further research is to model the co-movements of the returns, α's and β's of the hedge fund strategies.…”

Hedge fund strategies: A non-parametric analysis

“…This may be due to the correlation between factors and/or to their time-varying dimensions. Racicot and Theoret (2013) find that the hedge fund exposure to these factors may change substantially over the business cycle. portions of the probability distribution.…”

The Behavior of Hedge Funds and the Theory of the Business Cycles

“…The mentioned study of Racicot and Theoret (2013) showed that the alphas and betas of hedge funds were pro-cyclical, and another study of Ang et al (2011) discussed the counter cyclical behavior of the leverage of hedge funds. According to the study of Ang et al (2011), the hedge fund leverage tended to be predictable by economic factors.…”

“…In particular, decreases in interest rates and rising market values predict increases in hedge fund leverage. The study of Racicot and Theoret (2013) revealed that the alpha of hedge funds was increasing during upswing cycles on the market. During downturn cycles the alpha is decreasing, which shows that there is a cyclical response of the hedge fund performance.…”

“…The two authors (Racicot & Theoret, 2013) discovered that there is a relationship between the variables of industrial production, unemployment rate, rate of vacancy, and the cyclical behavior of hedge funds. In the study conducted in 2012, the authors pointed out that there were no previous studies on this topic.…”