Risk Procyclicality and Dynamic Hedge Fund Strategies

It is well-known that traditional financial institutions like banks follow procyclical risk strategies (Rajan 2005, 2009, Shin 2009, Jacques 2010) in the sense that they increase their leverage in economic expansions and reduce it in recessions, which leads to a procyclical behaviour for their betas and other risk and financial performance measures. But it is less known that the spectrum of the returns of many hedge fund strategies displays a high volatility at business cycle frequencies. In this paper, we study this unknown stylized fact resorting to two procedures: conditional modelling and Kalman filtering of Funds alphas and betas. We find that hedge fund betas are usually procyclical. Regarding the alpha, it is often high at the beginning of a market upside cycle but as the demand pressure stems from investors, it eventually fades away, which suggests that the alpha puzzle documented in the financial literature is questionable when cast in a dynamic setting.