The Asymmetrical Behavior of Hedge Funds across the State of the Business Cycle: The q-factor Model Revisited

We study the performance of the five-factor model recently proposed by Fama and French (2015) in the setting of hedge funds’ strategies. Given the dynamic dimension of the strategies followed by hedge funds, we adopt a Markov regime switching setup where the factor loadings vary according to the regime, high or low. We find that the addition of the factors which drive returns in the q-model – i.e., the investment factor (CMA) and the profitability factor (RMW) – does not improve the global performance of the classical hedge fund return model. However, we find that CMA and RMW span risk dimensions which are not captured by the size factor (SMB) and the value factor (HML). In other respects, some strategies succeed in anticipating shocks and “time” the risk factors over the two regimes while other strategies are less successful in controlling risk during the low regime. All in all, consistent with other empirical studies, we find that risk factors are generally more at play in the low regime.