By James Saft
Feb 14 Here's a choice: take the typical hedge
fund return and pay 2 percent annually and 20 percent of the
spoils or use a derivative strategy so simple it doesn't even
need an elevator pitch.
Many investors would probably be better off ditching the
manager. Hedge funds, according to a 2012 research paper by
Jacob Jurek of Princeton and Erik Stafford of the Harvard
Business School, just don't deliver on their promise of superior
"Despite the seemingly appealing return history of
alternative investments, many investors have not covered their
cost of capital," suggest the calibrations used in the research,
Jurek and Stafford write.
The authors discovered that by using a really basic strategy
of writing naked puts against the S&P 500 they could
produce results which closely track the hedge fund universe in
risk characteristics, while actually performing better. Sellers
of puts promise to buy a given security at a specific price any
time until the option expires. Naked sellers are unhedged,
meaning they don't own any of the security they are selling
This strategy works okay if stocks fall slightly, does very
well if stocks go up and loses spectacularly - but rarely - if
stocks fall out of bed. Let me stress that this is a strategy so
naive and with so little value-added that no pitchman would even
try to sell it on late-night television, much less to
Jurek and Stafford found that their strategy returned 9.7
percent in excess of a market return annually between 1996 and
2010, as compared to the 6.3 percent excess annual return
produced by the universe of hedge funds. It also closely matched
the risk profile of hedge funds on a variety of criteria.
The point here isn't that investors should be rushing to
write puts on the equity market, but rather that they should
understand that the hedge fund industry isn't delivering alpha.
It's peddling an expensive way to take on more risk.
RISK HIDING IN PLAIN SIGHT
These findings don't mean that all hedge funds don't produce
alpha, or outperformance. Clearly many do, although whether they
do so on a sustained basis is a different argument. Nor does the
research imply that there are a lot of hedge funds out there
simply writing puts and collecting premiums.
Rather, this is a lesson in the old adage that there is
rarely extra return to be found in this world without extra
risk. When you are offered extra return, you should assume this
is in compensation for taking on risk, not the result of
I think it is fair to say that the hedge fund industry, in
aggregate, isn't really earning its fat fees. Instead it is, in
myriad ways, delivering returns that when they are good, are
very good, but when they are bad, they are awful. A naked put is
a good way to think about this: it does well in most
circumstances but then, if things turn bad, it can be truly
awful. The excess return for the good times is nothing more than
compensation for the big losses that come along once in a while.
Paying a manager to do this for you is self-defeating.
Federal Reserve Board of Governors member Jeremy Stein touches
on this in his recent speech about overheating in credit
"A fundamental challenge in delegated investment management
is that many quantitative rules are vulnerable to agents who act
to boost measured returns by selling insurance against unlikely
events - that is, by writing deep out-of-the-money puts," Stein
writes, citing Jurek and Stafford's work. ()
The problem, in both credit markets and hedge funds, is that
investors don't adequately understand the tail risks or the
risks of unlikely events, and they pay managers well until the
panic comes along and the investor is left paying the price. The
promise of the hedge fund industry to is produce outperformance
over a sustained period. The reality is long periods of
outperformance which aren't really sufficient payment for the
Jurek and Stafford also believe they have shown that many
investors, especially those with large allocations to hedge
funds, will not have covered their cost of capital even if they
are able to get returns equal to those of the hedge fund
That's an important distinction: it can be difficult to do
as well as even the hedge fund indices because they have what is
called a survivorship bias, meaning that poor-performing funds
drop out or never reveal their returns in the first place.
If you think you, or your advisers, are good at picking
hedge funds, by all means pick away. Just recognize that a
strategy based on exposure to the industry as an asset class
looks like an expensive way to take on risk.