Cyclical dependence and timing in market neutral hedge funds∗ Julio A. Crego Julio Galvez´ Tilburg University CEMFI <
[email protected]> <galvez@cemfi.edu.es> May 9, 2018 Abstract We explore a new dimension of dependence of hedge fund returns with the market portfolio by examining linear correlation and tail dependence conditional on the financial cycle. Using a large sample of hedge funds that are considered “market neutral”, we doc- ument that the low correlation of market neutral hedge funds with the market is composed of a negative correlation during bear periods and a positive one during bull periods. In contrast, the remaining styles present a positive correlation throughout the cycle. We also find that while they present tail dependence during bull periods, we cannot reject tail neu- trality in times of financial turmoil. Consistent with these results, we show that market neutral hedge funds present state timing ability that cannot be explained by other forms of timing ability. Using individual hedge fund data, we find that funds that implement share restrictions are more likely to time the state. Keywords: Hedge funds, market neutrality, state timing, tail dependence, risk management. JEL: G11, G23. ∗We would like to thank Dante Amengual, Patrick Gagliardini, Ramiro Losada, Javier Menc´ıa, Andrew Pat- ton, Guillermo Tellechea, Rafael Repullo, Enrique Sentana, Javier Suarez, Andrea Tamoni, and numerous sem- inar and conference audiences for helpful comments. We thank Vikas Agarwal for providing the option factor data. Crego acknowledges financial support from the Santander Research Chair at CEMFI. Galvez´ acknowledges financial support from the Spanish Ministry of Economics and Competitiveness grant no.