Procyclicality and Diversification in the Hedge Fund Industry

Abstract

The apparent structural decrease in interest rates and market risk premia induces investors to search for alternative sources of investments. This new regime is particularly problematic for pension funds that are pre-committed to actuarial cash-outflows growing faster than their inflows. In this paper, we show 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’ behaviour in terms of alpha and beta 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.