Studying the performance of hedge funds over the period 1996-2010, the authors came to the following conclusions:
- Simple strategies that write naked put options on equity indexes can be used to replicate broad hedge fund indexes. They found that “the put-writing strategies match the losses during the fall of 2008 and the LTCM crisis, the flat performance during the bursting of the Internet bubble, as well as the strong returns during boom periods. While the put-writing strategy fails to explain some of the return variation in economically benign times like the bull market between 2002 and 2007, it captures the variation in economically important times remarkably well.” In other words, there’s no reason to pay high fees for accessing the attributes of hedge funds.
- Once returns are properly adjusted for risk, hedge funds earned returns that are statistically indifferent from zero—in other words, they don’t generate alpha. The results indicate that sophisticated investors have barely covered their properly computed cost of capital. And that result comes with the caveat that the data set used has survivorship bias.
- Put options could be said to be “expensive” in that they generate alpha in typical models of about 4 percent. However, that could simply be a function of high risk aversion of investors, meaning they’re concerned about the severe losses possible in the left tail. That, in turn, explains the high returns to strategies that accept left tail risk—at least high before adjusting for the risk.
The authors concluded: “The risks borne by hedge fund investors are likely to be positive net supply risks that are unappealing to average investors, such that they may earn a premium relative to traditional assets. A distinguishing feature of many of these risks is that their payoff profiles have a distinct possibility of being nonlinear with respect to a broad portfolio of traditional assets. These nonlinearities can arise either directly from the underlying economic risk exposure (e.g. credit risk, merger arbitrage), or through the institutional structure through which they are borne (e.g. funding liquidity).”
The takeaway from that somewhat-technical verbiage is this: Forewarned is forearmed.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.