Macroeconomic Shocks, Forward-Looking Dynamics, and the Behaviour of Hedge Funds

Abstract

We investigate how hedge funds’ strategies react, as a group, to macroeconomic risk and uncertainty. Adopting the methodology of Beaudry et al. (2001), we track the behaviour of the cross-sectional dispersions of hedge fund strategies’ returns, betas and alphas over the business cycle. The pattern of strategies’ betas supports Beaudry et al.’s conjecture: hedge funds reduce their risk-taking (betas) during economic slowdowns, which makes their strategies more homogeneous and thus contributes to increase systemic risk in the financial system. However, the cyclical behaviour of the cross-sectional dispersions of strategies’ returns and strategies’ alphas is not in line with Beaudry et al.’s conjecture. These dispersions increase during times of rising macroeconomic uncertainty, which suggests the prevalence of the Black’s (1976) leverage effect during times of financial turmoil and the fact that the exposure of hedge fund strategies to risk factors is quite different. Finally, although remaining important, procyclicality seems to recede in the hedge fund industry, which suggests that a learning process is at play.