Do Hedge Funds Destroy Investor Value?

/Do Hedge Funds Destroy Investor Value?

Do Hedge Funds Destroy Investor Value?

By | 2017-08-18T17:06:21+00:00 June 3rd, 2014|Research Insights|24 Comments

The Cost of Capital for Alternative Investments

Abstract:

We document that the risks and pre-fee returns of broad hedge fund indices can be accurately matched with simple equity index put writing strategies, which provide monthly liquidity and complete transparency over their state-contingent payoff profiles. This nonlinear risk exposure combines with large allocations, typical among investors in alternatives, to produce required rates of return that are more than twice as large as those implied by popular linear factor models. Despite earning annualized excess returns over 6% between 1996 and 2010, many hedge fund investors have not covered their proper cost of capital.

Alpha Highlight:

The authors show that broad hedge fund returns can be captured via a simple equity index put writing strategy. If you’d like to implement a form of this strategy, CBOE has an index on it: http://www.cboe.com/micro/put/.  You’ll have to do your own research on the product, but seems interesting. Here is the CBOE backtest on the strategy:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The authors post a great summary of various hedge fund returns:

hf ret

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

How does the replication work?

hfreplication

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Comments:

Wow. Replicated by a simple model. Gonna be harder and harder to justify “2/20” these days. Thoughts?


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About the Author:

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

24 Comments

  1. Sam Y June 3, 2014 at 12:30 pm

    Interesting. ALPS introduced a Put/Write ETF (HVPW) last year. http://www.hvpwfund.com/index.php . It tracks the NYSE Arca US Equity High Volatility Put Write Index https://indices.euronext.com/en/content/nyse-arca-us-equity-high-volatility-put-write-index-methodology .

    • Wesley Gray, PhD
      Wesley Gray, PhD June 3, 2014 at 1:34 pm

      there is your hedge fund allocation for 95bps.

      • Jason Gingerich May 14, 2017 at 11:29 pm

        except for that it returned 0.55% per year for the last 3 years.

        • Wesley Gray, PhD
          Wesley Gray, PhD May 15, 2017 at 7:20 am

          True. Except this isn’t bad compared to the HFRI global hedge fund index, which is down 50bps per year the last years.

  2. Doug June 4, 2014 at 4:14 pm

    I read the papera while back. Fascinating stuff here. I am concerned about overfitting – at some of the leverage levels, the margin for error is very small, particularly in a downturn. Current implied volatility is SO low right now, that you have to write options with a) more moneyness and/or b) higher leverage to maintain returns. I can see a big fat tail on the distribution of future returns!
    Notwithstanding my quibbles, the paper actually deepens the analysis of the so-called “beta puzzle,” (google for paper) which shows that option writers actually earn a positive return over time, as compensation for their taking the other side of the hedge during crashes. The return profile is similar to that of a catastrophe insurance company, which earns high returns over time but has a few years with very large losses.

    • Wesley R. Gray, PhD June 5, 2014 at 4:22 pm

      Doug, I’ll check it out. Thanks for sharing.
      And I agree with your comment on a low VIX. People are begging for a massive face-rip if they are using options to generate “income”

  3. Tom Austin June 23, 2014 at 3:14 pm

    Agree 100% that VIX is so low now that it’s a crazy time to make a large portfolio level allocation to selling volatility. As far as the summary from the paper (I didn’t read it…I admit that)…there are so many forms of hedge fund/alternative strat’s that it’s very hard with a straight face (and a huge oversimplification) to compare them all to a put-write index on the SP500. Maybe long-bias or long-only US equity focused hedge funds. Which definitely can’t justify 2/20 very easily. (They are small port’s typically, with either a) short histories or b) drastic changes in AUM…or strategy…when the underlying manager would require very long time periods doing one thing to really gauge investor skill).

    However, put-write or call-write is highly correlated with the underlying SP500 and does little in terms of portfolio diversification – when blended into an equity type portfolio. It might knock out some of the equity ETF allocation. But…they ‘zig and zag’ together…and DD’s tend to happen at the same time – and general return profile is very similar. So…it doesn’t add all that much blending into a port. There are many other trading system strategies or hedge fund/alternative styles that don’t typically exhibit this same level of hi-correlation in extreme market events, but instead tend to be negatively (or even highly negatively) correlated in periods of peak market stress. For example, many CTA’s have a long volatility return profile. Trend ‘breakout’ systems on Gold, Oil and US Long-term bonds can/do have a similar profile. Long VIX intraday or day trading systems can also have this profile.

    Additionally…Asset backed lending with ‘safe underwriting’ (say 60% lending to asset value) safeguards…is another example not replicated easily by public market vehicles. And not easy for any institution to do well or ‘clone’ with the same real underlying return stream. So…alternative can still make a ton of sense for smart and patient institutions. Having said that…for most retail investors…and perhaps many institutions, hedge funds likely not a great (or even good) idea.

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