Wednesday, May 13, 2015

Paper: "Re-Thinking Risk: What the Beta Puzzle Tells Us about Investing"

I can't find a PDF link, but this was from a GMO whitepaper by David Cowan and Sam Wilderman:

"These results suggest that hedge funds as a group earn steady returns by underwriting extreme downside market moves. Remarkably, an asset class that purports to be an 'alternative' source of returns, with low correlation to equity markets, turns out to be simply another way to take downside equity market risk. Individual funds and strategies certainly vary greatly, but in aggregate, once fees are taken into account, hedge funds appear to offer nothing beyond a way to sell insurance against sharp market declines. This is a perfectly reasonable way to earn a return, but from a risk perspective offers less diversification than many investors expect.

In addition, the returns required to justify the real risks being taken by hedge funds are higher than people usually realize. When investors give hedge funds credit for having low beta, they will tend to think the funds are adding a lot of value, generating high returns relative to their risk. When they see them as earning a return for taking downside equity exposure, investors will tend to think the funds are generating a reasonable return, but nothing beyond what they should be getting given the risk they are taking."
In other words, hedge funds as a class are selling put options. This reminds me of John Porter quoted in Inside the House of Money:
"[H]edge funds in general are all about leveraged selling of volatility"
If a hedge fund manager makes money while consistently being long volatility, there's a much better chance that he's not just a monkey than if he's consistently short volatility.

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