Dumb Alpha: How to Build an Above Average Hedge Fund
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.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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