Comments on: Hedge funds should rue the day that the term “absolute returns” was coined http://allaboutalpha.com/blog/2008/10/19/hedge-funds-should-rue-the-day-that-the-term-absolute-returns-was-coined/ Hedge funds, portable alpha, 130/30 and alpha-centric investing Wed, 17 Mar 2010 03:10:00 +0000 http://wordpress.org/?v=abc hourly 1 By: Oana http://allaboutalpha.com/blog/2008/10/19/hedge-funds-should-rue-the-day-that-the-term-absolute-returns-was-coined/comment-page-1/#comment-139491 Oana Tue, 21 Oct 2008 22:34:31 +0000 http://allaboutalpha.com/blog/?p=3561#comment-139491 Eliminating the beta in one's HF is/was an expensive proposition. We've been doing an overlay of puts on part of our HF portfolio. Nobody expected such a huge decline so whatver we hedge didnt help much in % terms more like a bandaid. Its a sad thing that us as investors had to hedge the hedgers. Except if a manger chose to allocate disproportionally this year (at the cost of cutting returns if this year had turned out to be "normal") to short biased funds nothing was spared. I can tell you from what I know from various managers - plain vanilla out of the money puts on indexes to hedge PART of the market exposure used to run at a minimum about 1-1.5% and above cost from assets to be hedged all about this year up until august. It wasnt quite cheap. Fat tail risk hedging (how fat is your "fat" and what is the worst assumption?) using knock down options (in retrospect would have been a brilliant idea if only anyone implemented it). That was the cost in June this year (we split the amounts of exposure/correlations to various markets at that point in time): " -5-10 MM notional for each underlying -Maturity - 4 month "Down & In" Puts - the options only become effective if the index trades below the barrier during the life of the trade: -EEM a. 95% strike price, 61.75% barrier, up front premium paid = 3% b. 90% strike price, 64.0% barrier, up front premium paid = 3% -EFA a. 95% strike price, 72.75% barrier, up front premium paid = 3% "Up & Out" Puts - the options no longer exist if the index trades through the barrier during the life of the trade -EEM a. 95% strike price, 103.2% barrier, up front premium paid = 3% b. 90% strike price, 104.3% barrier, up front premium paid = 3% -EFA a. 95% strike price, 103.1% barrier, up front premium paid = 3% Vanilla put options struck at 90% or 95% range from about 3 - 7% assuming a 4 month maturity. Introducing the barrier takes down the cost by 30 - 50% depending on the underlying / structure." Yes the cost of holding protection to for such extreme environments is a numbers killer. Bottom line seems to be - you want extreme protection you have to give back in returns, maybe ending up with bond like returns with unknown vol instead of stocklike returns with supposedly less vol. All in all i think if an investor didnt come in with the preconceived idea that HF should be 100% absolute returns one could be somewhat at peace with the recent performance overall. Also it seems to me that ballpark common sense measures actually worked better as predictor than sophisticated theories, in essence what i've seen is: - you see a 2 digit stdev in a HF and cant take a 2 digit decline a month dont invest there. Period. - you see stock like returns or a bit better with higher stdev or equal to the index (for L/S equity or EM/foreign oriented funds) - you see a fund going down close to or 2 digit in a month be prepared for the worst to happen I have had some results with an omega ratio calculator which for some reason this year in Aug. seemed to point that some funds were struggling and raised some red flags. For what is worth it also had some "fakes" in other years when we had drops in omega and nothing important happened. Overall funds with constant prior to Aug. or improving omega did best compared to peers during this "episode". I can also say that even funds that were in cash at 30-40% in March (i was complaining at that time that we dont pay them to hold cash) were still caught in Sept-Oct avalanche and dropped anywhere between 5-8% despite the cash, despite the defensive stance. Nothing helped except being net short or 100% cash. On the bright side whoever will survive this will likely stand to make a lot of money, plus less competition if we indeed see a rather large # of funds closing will also be beneficial. Eliminating the beta in one’s HF is/was an expensive proposition. We’ve been doing an overlay of puts on part of our HF portfolio. Nobody expected such a huge decline so whatver we hedge didnt help much in % terms more like a bandaid. Its a sad thing that us as investors had to hedge the hedgers. Except if a manger chose to allocate disproportionally this year (at the cost of cutting returns if this year had turned out to be “normal”) to short biased funds nothing was spared.

I can tell you from what I know from various managers – plain vanilla out of the money puts on indexes to hedge PART of the market exposure used to run at a minimum about 1-1.5% and above cost from assets to be hedged all about this year up until august. It wasnt quite cheap.

Fat tail risk hedging (how fat is your “fat” and what is the worst assumption?) using knock down options (in retrospect would have been a brilliant idea if only anyone implemented it).

That was the cost in June this year (we split the amounts of exposure/correlations to various markets at that point in time):

” -5-10 MM notional for each underlying
-Maturity – 4 month

“Down & In” Puts – the options only become effective if the index trades below the barrier during the life of the trade:
-EEM
a. 95% strike price, 61.75% barrier, up front premium paid = 3%
b. 90% strike price, 64.0% barrier, up front premium paid = 3%

-EFA
a. 95% strike price, 72.75% barrier, up front premium paid = 3%

“Up & Out” Puts – the options no longer exist if the index trades through the barrier during the life of the trade
-EEM
a. 95% strike price, 103.2% barrier, up front premium paid = 3%
b. 90% strike price, 104.3% barrier, up front premium paid = 3%

-EFA
a. 95% strike price, 103.1% barrier, up front premium paid = 3%

Vanilla put options struck at 90% or 95% range from about 3 – 7% assuming a 4 month maturity. Introducing the barrier takes down the cost by 30 – 50% depending on the underlying / structure.”

Yes the cost of holding protection to for such extreme environments is a numbers killer.

Bottom line seems to be – you want extreme protection you have to give back in returns, maybe ending up with bond like returns with unknown vol instead of stocklike returns with supposedly less vol.
All in all i think if an investor didnt come in with the preconceived idea that HF should be 100% absolute returns one could be somewhat at peace with the recent performance overall.

Also it seems to me that ballpark common sense measures actually worked better as predictor than sophisticated theories, in essence what i’ve seen is:
- you see a 2 digit stdev in a HF and cant take a 2 digit decline a month dont invest there. Period.
- you see stock like returns or a bit better with higher stdev or equal to the index (for L/S equity or EM/foreign oriented funds)
- you see a fund going down close to or 2 digit in a month be prepared for the worst to happen

I have had some results with an omega ratio calculator which for some reason this year in Aug. seemed to point that some funds were struggling and raised some red flags. For what is worth it also had some “fakes” in other years when we had drops in omega and nothing important happened. Overall funds with constant prior to Aug. or improving omega did best compared to peers during this “episode”.

I can also say that even funds that were in cash at 30-40% in March (i was complaining at that time that we dont pay them to hold cash) were still caught in Sept-Oct avalanche and dropped anywhere between 5-8% despite the cash, despite the defensive stance.
Nothing helped except being net short or 100% cash.

On the bright side whoever will survive this will likely stand to make a lot of money, plus less competition if we indeed see a rather large # of funds closing will also be beneficial.

]]> By: Peter Urbani http://allaboutalpha.com/blog/2008/10/19/hedge-funds-should-rue-the-day-that-the-term-absolute-returns-was-coined/comment-page-1/#comment-139366 Peter Urbani Mon, 20 Oct 2008 23:01:01 +0000 http://allaboutalpha.com/blog/?p=3561#comment-139366 Whilst I agree that the term 'absolute returns' has been misinterpreted as applying to all hedge funds as a FoF manager it pains me to admit that Prof. Kat's comments in this regard are accurate. I would hope that, to the extent that there is some level of 'hedging' or embedded optionality in HF distributions, this is not a one to one comparison due to the distribution of returns being hopefully truncated in the case of HF as opposed to Equities where the assumption of normality is less egregious. To some extent this is the same as Taleb's recent comments about extreme risks and representative of the 'hedges' not being held far enough out of the money or in the tail to provide sufficient protection against such extreme market moves. The failure to adequately hold sufficient protection against the possible impact of such excess Kurtosis is as much due to a failure of imagination (How bad can it get ?) as to the commercial realities of the cost of holding such protection in a competitive environment where not everyone does so. Whilst I agree that the term ‘absolute returns’ has been misinterpreted as applying to all hedge funds as a FoF manager it pains me to admit that Prof. Kat’s comments in this regard are accurate. I would hope that, to the extent that there is some level of ‘hedging’ or embedded optionality in HF distributions, this is not a one to one comparison due to the distribution of returns being hopefully truncated in the case of HF as opposed to Equities where the assumption of normality is less egregious. To some extent this is the same as Taleb’s recent comments about extreme risks and representative of the ‘hedges’ not being held far enough out of the money or in the tail to provide sufficient protection against such extreme market moves. The failure to adequately hold sufficient protection against the possible impact of such excess Kurtosis is as much due to a failure of imagination (How bad can it get ?) as to the commercial realities of the cost of holding such protection in a competitive environment where not everyone does so.

]]> By: Harry M. Kat http://allaboutalpha.com/blog/2008/10/19/hedge-funds-should-rue-the-day-that-the-term-absolute-returns-was-coined/comment-page-1/#comment-139361 Harry M. Kat Mon, 20 Oct 2008 21:29:49 +0000 http://allaboutalpha.com/blog/?p=3561#comment-139361 It is interesting to see how eager people still are to continue the hedge fund myth. Over the last couple of days alone, I have heard several people say: “my hedge funds came down 10%, but that is still a lot better than the 30% I lost on my stocks”, suggesting that hedge funds did deliver on their promise. Unfortunately, this is another nonsense argument. An average stock portfolio has 15% volatility, while an average hedge fund portfolio has a volatility of 5%. Under those assumptions, the probability of an equity portfolio losing 30% is more or less equal to the probability of a hedge fund portfolio losing 10%. In other words, taking into account the difference in risk profiles, hedge fund performance has been as extreme as that of the stock market. Now who would ever have predicted that? It is interesting to see how eager people still are to continue the hedge fund myth. Over the last couple of days alone, I have heard several people say: “my hedge funds came down 10%, but that is still a lot better than the 30% I lost on my stocks”, suggesting that hedge funds did deliver on their promise. Unfortunately, this is another nonsense argument. An average stock portfolio has 15% volatility, while an average hedge fund portfolio has a volatility of 5%. Under those assumptions, the probability of an equity portfolio losing 30% is more or less equal to the probability of a hedge fund portfolio losing 10%. In other words, taking into account the difference in risk profiles, hedge fund performance has been as extreme as that of the stock market. Now who would ever have predicted that?

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