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Macroeconomic shocks, forward-looking dynamics, and the behavior of hedge funds

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  • Racicot, François-Éric
  • Théoret, Raymond

Abstract

We investigate how hedge funds’ strategies react, as a group, to macroeconomic risk and uncertainty. Adopting the methodology of Beaudry et al. (2001), we track the behavior of the cross-sectional dispersions of hedge fund strategies’ returns, market betas and alphas over the business cycle. The pattern of strategies’ betas supports Beaudry et al.’s conjecture: hedge funds reduce their risk-taking (betas) during times of macroeconomic uncertainty, which makes their strategies more homogeneous and thus contributes to increased systemic risk in the financial system. However, the cyclical behavior of the cross-sectional dispersions of strategies’ returns and strategies’ alphas is not in line with Beaudry et al.’s conjecture. These dispersions tend to increase during episodes of rising macroeconomic uncertainty, which suggests the prevalence of the Black’s (1976) leverage effect during financial turmoil and the fact that the exposure of hedge fund strategies to risk factors is quite different from each other. Finally, although remaining important, procyclicality seems to have declined through time in the hedge fund industry, which suggests that a learning process is at play.

Suggested Citation

  • Racicot, François-Éric & Théoret, Raymond, 2016. "Macroeconomic shocks, forward-looking dynamics, and the behavior of hedge funds," Journal of Banking & Finance, Elsevier, vol. 62(C), pages 41-61.
  • Handle: RePEc:eee:jbfina:v:62:y:2016:i:c:p:41-61 DOI: 10.1016/j.jbankfin.2015.10.004
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    Keywords

    Hedge fund; Shadow banks; Systemic risk; Macroeconomic shocks; Kalman filter; EGARCH; GMM;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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