Correspondence: François-Éric Racicot, University of Quebec (Outaouais), (UQO), 283 Alexandre Tache Boul., Gatineau, Quebec, Canada J8X 3X7. Tel: +1 819 595 3900 ext. 1727; E-mail: francoiseric.racicot@uqo.ca

¹PhD, holds a joint doctorate in Business Administration (Finance) from UQAM. He also holds an MSc in Economics (Econometrics) from University of Montreal where he also received his BSc in Economics (Quantitative Economics). He is Associate Professor of Finance at the Department of Administrative Sciences of the University of Quebec, Outaouais (UQO). He was Professor of Finance at the Department of Strategic Business of ESG-UQAM. He is a permanent member of the Laboratory for Research in Statistics and Probability (LRSP) and a research associate at the Chaire d'information financière et organisationnelle located at ESG-UQAM. He is also a consultant in Financial Engineering for various financial institutions in Quebec. His research fields include the theory of fixed income securities, the theory of derivative products, the empirical analysis of hedge funds and project financial engineering. Presently, his research focuses on the development of new econometric techniques for correcting and detecting specification errors in financial models, especially in the context of estimating the alpha of hedge funds. This research should be useful, especially for improving the selection of hedge funds used in the construction of fund of funds. He has published many books in financial engineering used at the graduate levels in universities and also in financial institutions.

²PhD, holds a doctorate in Economics (financial economics) issued by the University of Montreal. He is Professor of Finance at l'École des Sciences de la Gestion (ESG) of the University of Quebec, Montreal (UQAM). He was previously Professor in financial economics at l'Institut d'Économie Appliquée located at HEC Montreal. He was an economic and financial consultant at various financial institutions in Quebec and the Secretary of Campeau Commission on the improvement of the situation of financial institutions in Montreal which led to the foundation of Institut de Finance Mathématique de Montreal. He has published many articles and many books on financial engineering, especially in the fields of numerical methods and computational finance. Moreover, he is the founder of DESS (finance) issued by UQAM and a co-founder of the Maîtrise en finance appliquée at the same university. He teaches portfolio management theory and computational finance. His research focuses on modelling hedge fund returns, especially in its link with specification errors. He is an associate member of the Chaire d'information financière et organisationnelle located at ESG-UQAM.

Received 15 February 2007; Revised 15 February 2007.

Abstract

Ferson and Schadt (1996) observed a beta puzzle in the mutual fund industry, which is a negative link between their beta and the market risk premium. The objective of this study is to verify if such a relation is present in the hedge fund industry. Our contribution is threefold. First, we use an instrumental variable method to estimate our conditional version of the Fama and French (F&F) model, conditional models being usually estimated by ordinary least squares. Secondly, we resort to a new set of performing instruments to estimate our conditional model: the higher moments of the risk factors that constitute the augmented version of the F&F model. Finally, we resort to a GMM panel procedure to estimate the excess returns of the HFR hedge funds pooled by strategy over the period 1997–2005. Our study reveals that there is generally no beta puzzle in the hedge fund industry. There is an apparent beta puzzle for the distressed securities and short seller strategies, but it seems rational for those strategies to increase their beta when the market risk premium is low: business opportunities are then much more important for them.