The procyclicality of hedge fund alpha and beta

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.