You Must Hedge Your Portfolio's Tail Risks
Hidden risks of most traded hedge funds
The hedge fund world is living in a bubble. We have seen hedge funds' assets under management (AUM) increase year by year for more than a decade. The excellent performance of the financial markets has indeed helped this to happen.
The vast majority of these assets promise alternative management of the unitholders' funds where Long/Short strategies are interleaved. This type of strategy allows increasing the Sharpe Ratio of the portfolio in exchange for a reduction in volatility and, usually, a (substantial) decrease in performance.
But does this work? The easy answer would be it depends. Most hedge fund managers' sole objective is to raise funds. The more, the better, and it generally doesn't work for all of them.
And in which hedge funds do people invest? Generally, those that offer a better return/risk are commonly called a higher Sharpe Ratio. To increase this ratio, these are funds that they do to buy PUTs very close to the money (10%) to rebalance their portfolio and avoid large drawdowns.
Generally, this type of strategy tends to lose money in the long term because of the time decay and the cost of buying and selling commissions. Several academics in this study have already demonstrated this.
Our objective has never been to raise funds but to help you build an asymmetric portfolio with low risk that benefits substantially from the asymmetries of the markets. In that sense, we can tell you that the further you move away from the market with the PUTs and CALLs purchased, the more you will benefit from the market's inefficiencies.
“I believe the solution to these biases is to follow a strategy of delegation and precommitment — in other words, combine cash-based hedging with “renting” a process and hardwire it so that the plans are implemented when optimal to do so. The options, markets achieve this precommitment and delegation strategy” — Vineer Bhansali
As we can see in the graph below, those strategies that tend to buy PUTs very close to the money generally tend to lose a lot of money over time.
This tells us that managers who generally perform this type of strategy lose alpha compared to a Buy and Hold strategy of a passive index.
We can also see that we can obtain superior results by rolling these PUTs instead of holding them until expiration.
One of the challenges for managers is knowing how to monetize options. Many create simple strategies such as, for example, selling when there are three months to expiration. But today, there are much more sophisticated strategies that can help us improve this performance.
On the other hand, we can see below how PUTs behave when we move a little further out of the money (30%), and we can see how the performance is favorable compared to PUTs closer to the capital also that the long-term performance is positive.
This allows us to have liquidity when the rest of the market needs it most. When banks are not lending, and people have to liquidate their positions. This allows us to find many companies at a discount and can make us a lot of money in the long term.
“However, on a relative basis, the tail hedge allows the investor to scale up her exposure to risky assets, which also have risk premium” — Tail Risk Hedging
It is a strategy that is not easy to implement, but it is worthwhile, especially in the unique market situation in which we find ourselves.
We can make a massive return by systematically buying OTM PUTs and CALLs.
It knows when to monetize options, and not waiting until expiration can earn us a higher return.
At the end of the options' life, time decay can cause us to lose a lot of capital in a short time.
Most hedge fund managers prefer to achieve a high Sharpe Ratio instead of a better return for participants.