I can't make up my mind about hedge funds.
On the one hand, the fees strike me as excessive. Call me Scrooge if you like, but I do not want to pay anyone 2 plus 20 for the privilege of losing my money. And, as Simon Lack, CFA, pointed out in his book The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, there is a lot of evidence that, after fees, the average hedge fund underperforms a traditional balanced stock/bond portfolio in up as well as down markets.
No wonder that in recent months, we have seen a barrage of critical news reports taking aim at hedge funds — even from renowned hedge fund managers like Steve Cohen. More and more institutional investors have started to pull their money out of the asset class after experiencing disappointing results.
On the other hand, whenever I listen to my colleague Bill Fung at Maple Financial Group, I start to believe in hedge funds again because there seem to be fund characteristics that allow you to select the better performing funds ex ante. Hedge funds, then, appear to be similar to all other forms of active management. If you can identify superior managers, you have a chance to reap great rewards in the form of superior performance or increased downside protection.
But if you invest in the “average" hedge fund, you pay a lot of fees for underperforming a traditional portfolio.
Aiming for the Average Hedge Fund
Of course, no pension fund or wealthy individual would ever admit that they want to invest in the "average" hedge fund. Everyone tries to find the few superior managers, even though as a group they inevitably end up with the aggregate market.
So put yourself in my shoes. I would be very happy owning a hedge fund with superior performance after fees, but I don’t think I have the expertise to select the best managers. Also, I am so stingy that it hurts me to pay fees in excess of 2% even if the fund manager is a genius. If only I could invest in the average hedge fund, but at much lower fees. With what I saved in fees, I would create superior hedge fund returns.
Selling Puts to Replicate the Average Hedge Fund
Luckily, Jakub W. Jurek, Erik Stafford, and the good people at GMO have provided a dumb alpha idea on how to do exactly that. Jurek and Stafford have demonstrated that it is possible to replicate the typical hedge fund index performance by selling out-of-the-money puts and using a little bit of leverage. Ben Inker at GMO has gone one step further, and shown that one can just as well sell at-the-money puts and use no leverage.
The following chart illustrates my take on these ideas.
The purple line shows the performance of the HFRI Weighted Composite Hedge Fund Index since late 1995. The green line was constructed by following a simple investment strategy. At the beginning of each month, I sold a one-month put option on the S&P 500 index that was about 1% out of the money. The exact rule varies a little bit, because I set the strike one tenth of the monthly volatility of the S&P 500. This way, the put option will be a little further out of the money if volatility is high, and a little bit closer to the current index reading if volatility is low. The money I would normally invest in hedge funds I simply put into a one-month Treasury bill.
After one month, this strategy has earned the interest on the Treasury bill and the premium on the sold put option. Of course, if markets go down, I will have to pay money on the put option that expired in the money, which reduces the return of the strategy. This simple procedure is repeated each month.
The Result? An Above Average Hedge Fund
The performance without any costs or fees is shown in the green line in the chart. The green line looks very similar to the purple line, especially at first, so it seems like this systematic put selling is able to qualitatively replicate the performance of hedge funds. In practice, one has to incur transaction costs, etc., but currently these costs tend to be very low. The fun fact is shown in the blue line. If one follows the simple put selling strategy and deducts 2% fees per year, one ends up pretty much exactly as the overall hedge fund index. Or, to put it another way, if one can systematically sell put options each month and invest money in Treasury bills for an annual cost of less than 2%, one can replicate the average hedge fund at much lower fees. The result is an investment strategy that performs better than the average hedge fund net of fees, and with lower fees overall.
It gets even better.
The similarities between the put selling strategy and the performance of the average hedge fund diverged in 2011. Since then, the average hedge fund has performed even worse than the put selling strategy after 2% costs. This is the very best dumb alpha can offer: a simple, low-cost investment method that outperforms more sophisticated and expensive strategies.
Sometimes one can have the cake and eat it too.
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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19 Comments
Hi. Could you clarify what do you when you assigned with underlying? Do you sell it right away by fixing losses and write another put uding the rest of the cash in your portfolio? How we should think about money in/outflow in your portfolio?
Thanks
Hi Alex
In my model I use S&P500 put options and they are cash settled. In case of a physical delivery of the underlying one would assume instant sake of the inderlying and investment of the proceeds in T-Bills.
Hi Joachim,
A model based upon selling puts (leveraged or unleveraged) works until it doesn't. You may recollect Victor Niederhoffer, the hedge fund manger who was carried out on stretcher (metaphorically) after selling leveraged puts on SPX.
Question: Why not a bull put strategy for insurance?
I'm not fully on board with this. I've always seen the purpose of hedge funds as providing a relatively uncorrelated return stream. The free lunch of diversification and re-balancing are what add value.
This strategy is definitely uncorrelated when equities rise any or fall sightly. However it is going to be nearly perfectly correlated when equities fall sharply. That's exactly when you want an uncorrelated hedge in your portfolio.
Alas, these are counterfactual results. Had an investor actually done this, he would have impacted pricing of the options, particularly as his position got larger and larger in such a way as to bascially nullify the results, particularly the period of significant outperformance late.
The problem is always that these returns aren't dollar weighted and the impact of success - which is that you outgrow the money that can be realistically deployed in nearly every strategy - is never factored in (how can it be, really).
Isn't there already something like this? The CBOE S&P 500 PutWrite Index?
Sorry, I hit the button too early...Isn't this product similar to what you're talking about? WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW)?
"PUTW invests in one- and three-month Treasury Bills and sells or “writes” S&P 500 Index put options. The number of put options sold is chosen to ensure full collateralization, meaning the total value of the Treasury account must be equal to the maximum possible loss from the final settlement of the put options at expiration."
If one were to implement this strategy, lets say with $1,000,000. How would you derive how many contracts to sell short?
My guess would be: If the S&P was trading at 2,200 you could buy ~454 shares, thus in this strategy you would have sold 45 contracts?
Hi Joachim,
The strategy of changing the moneyness in response to recent volatility is similar to the strategy of Moreira & Muir (2017), Volatility-managed portfolios, Journal of Finance.
The issue with this type of volatility timing in the market is that most of the results come from avoiding a small number of bad events and historical performance relies on getting the timing right for those historical events (I have a breakdown of these timings in a draft/note here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3832340).
In your strategy the size of the periodic drawdown is going to be very sensitive to the moneyness of the puts sold when the music stops and a market crash happens.
I found with the vol timing strategy, if historically you re-balance mid-month rather than at the end of the month, then the performance disappears. Is this because there is something special about end-of-month re-balancing that guarantees this timing or is it because the timing just happened to line up with a few negative market events historically?
If it's the latter there is a good chance the next crash might not be timed correctly, you will be writing closer to the money puts, and past performance will not reflect future returns!