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(Reuters) - 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 risk-adjusted returns.
"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 options on.
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 sophisticated investors.
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.
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 managerial excellence.
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 markets.
"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. (here)
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 occasional crash.
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 indices.
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.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at: blogs.reuters.com/james-saft)
Editing by Jennifer Merritt