Academic study breaks with pack on one of the most common assumptions about hedge fund returns
Mar 9th, 2009 | Filed under: Performance, Analytics & Metrics, Today's Post
Those new to the hedge fund industry often find the concept of “buying volatility” and “selling volatility” to be somewhat confusing. Volatility, after all, is not a tangible thing that can be bought and sold (save for the VIX), but is rather a description of tangible assets (a “volatile stock” or a “low-volatility fund”).
Yet hedge funds are often accused of simply “selling” volatility to generate returns, resulting in them being “short volatility”. A short position in a stock implies that you would gain if the stock went down and lose if the stock went up. Similarly, a short position in volatility implies you would gain if volatility went down and lose if it went up.
So how could you construct a position that would gain when volatility goes down and lose when volatility goes up? Sell (i.e. write) options contracts.
Not unlike writing an insurance contract, writing options generates a steady stream of premiums with no apparent cost – until the judgment day comes. In other words, if volatility unexpectedly jumps (as it does in severe market downturns), then you’d have to pay the piper. Obviously, this could erase all of the apparently risk-free returns you seemed to be receiving by writing options over the the years.
Some say that’s how hedge fund managers really make their money. Last year, we told you about a paper by Wharton’s Dean Foster and Peyton Young of Oxford University that claimed, among other things, that hedge fund managers routinely “fake” their alpha by simply writing puts and collecting the premiums (see post). Wrote Foster and Young: More…
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This result is very different from every study I’ve seen or conducted myself. Thank goodness for peer review…
[...] Academic study breaks with pack on one of the most common … [...]
To detect the presence of a particular risk factor, that factor needs to be paying off, otherwise it doesn’t show up in the data. If you look at a bull market, you are unlikely to find the presence of a short put factor. It is there in the background, but because it doesn’t pay off, it doesn’t show from the data. When the market starts to go south, this changes. The short put pays off more and more often and then you can see that it is there. The Foster and Young comment is a bit naive as well. A short put factor isn’t meant to model the actual writing of puts by hedge funds. It is meant to capture the negative skewness in hedge fund returns, which may result from a variety of causes, including leverage (or maybe better collateralized borrowing), investment in illiquid assets, and steamroller-type strategies.
This paper misses the point of the Foster and Young criticism, i.e. funds induce negative-skewness to game investors. Short-put exposure does this, but there are virtually unlimited other instruments and positions that also give highly negatively skewed outcomes.
Examples: short calls, short straddle, short binary options, short earthquake insurance, writing CDSs, bets in merger arb. These can be synthesized by dynamic strategies as well.
The space for gaming strategies is vast, so running some common factor returns against HF returns is not going to settle the question. If you’re a gaming HF manager, you probably want to avoid writing puts since everyone thinks about that. You’d want to pick something exotic and uncorrelated to the market, like hurricane/earthquake insurance.