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

Abstract

Using an updated database that extends after the subprime crisis, we revisit the asymmetries of hedge fund behavior in recession compared with economic expansion. In this respect, we study the time-varying α' sa ndβ's associated with strategy returns using an inno- vative framework based on the Kalman filter and the multivariate GARCH. We find that hedge fund managers reduce drastically their risk exposure during financial crises while their behavior is much smoother in normal times. We also find that hedge funds continue to provide good prospects for investors in terms of risk-adjusted returns. Actually, the procyclicality of hedge fund strategies' returns seems to decrease through time. Moreover, the strategies' behavior in terms of α and β tends to become more heterogeneous in times of crisis. The strategy exposure to adverse shocks seems to recede even after accounting for the subprime crisis. Finally, many hedge fund strategies benefit from an increase in the volatility of stock market returns. Hedge fund strategies may thus constitute a way to offset the lower expected returns observed in the conventional financial markets and may contribute to portfolio diversification.