Do Hedge Funds Add Value?

Despite the growing popularity of passive investing, active hedge fund managers are still adding value to their investors’ portfolios. While passively managed funds can be a great option for some investors, active management can provide added benefits for those who are looking for better risk-adjusted returns and diversification, especially during market downturns.

A recent study [1] showed that the correlation between market-neutral hedge funds and the stock market changes according to the market regimes. Specifically, the correlation is negative in bear markets and positive in bull markets. This result is unique to market-neutral hedge funds, as others exhibit similar characteristics in terms of trading strategies.

In this paper, we explore dependence between hedge funds and the market portfolio. As opposed to previous papers, we study this question conditional on financial cycles. This dimension is important, as it has been shown that hedge funds are one of the most dynamic investment vehicles, and thus, their performance is affected by market conditions.

We find evidence that market neutral and other hedge fund styles exhibit tail dependence during bull periods, but not during bear periods. Moreover, we find that as opposed to other hedge fund styles, the correlation between market-neutral hedge funds and the stock market changes with the economic state. We link this behavior to the ability of hedge fund managers to time market regimes, and find evidence that market neutral hedge funds are able to adjust their strategies according to the financial cycles. We illustrate how disregarding changes in dependence might lead to inaccurate risk management practices. Finally, we find that our results on dependence and state timing hold in individual fund data. The evidence that we find underscores the importance of understanding and incorporating financial cycle conditions in asset management and investment decision making.

The result from this study showed that investing in active funds is beneficial. Active hedge fund managers add value to the portfolio by executing market-neutral strategies. Hedge funds performance was shown to be negatively correlated with the market during bear cycles. Thus they could be great diversifiers to investors’ portfolios.

References

[1] Crego, Julio and Galvez, Julio, Cyclical Dependence in Market Neutral Hedge Funds (2021). Banco de Espana Working Paper No. 2141, https://ssrn.com/abstract=3970564

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