Cyclical Dependence and Timing in Market Neutral Hedge Funds

Abstract

We explore a new dimension of the dependence of hedge fund returns with the portfolio by examining linear correlation and tail dependence conditional on the financial cycle. Using a large sample of hedge funds that are considered market neutral, we document that the low correlation of neutral hedge funds with the is composed of a negative correlation during bear periods and a positive one during bull periods. In contrast, the remaining styles present a positive correlation throughout the cycle. We also find that while they present tail dependence during bull periods, we cannot reject tail neutrality in times of financial turmoil. Consistent with these results, we show that neutral hedge funds present state timing ability that cannot be explained by other forms of timing ability. Using individual hedge fund data, we find that funds that implement share restrictions are more likely to time the state.