Hedge Funds

hedge funds: In that article, I also talked about some research by Vikas Agarwal and Narayan Naik from the mid-2000s showing that many hedge funds had returns that looked a lot like selling out-of-the-money puts on the Standard Poor 500 Index. I suggested that maybe these funds were -- consciously or unconsciously -- playing to investors put-option illusion. But there is another reason for hedge funds to adopt an investment strategy that has many small gains and a few big disastrous losses. As it turns out, this kind of strategy can be used to boost Sharpe ratios, according to Bloomberg. In 2004, finance professors William Goetzmann, Jonathan Ingersoll, Matthew Speigel and Ivo Welch published a paper showing exactly how this can be done. The paper is very dense and technical, but heres the basic idea. Suppose a hedge fund has some investment strategy that involves picking a bunch of stocks. The fund can increase its Sharpe ratio by selling out-of-the-money puts and out-of-the-money calls on its own portfolio. The former means that returns become more consistent, at the cost of running a small risk of very big losses. The latter means that very good returns become less likely, but, again, the average return goes up and In an earlier article for View, I described a danger facing investors: the put-option illusion. This is when investors, who tend to extrapolate too much from recent trends, are fooled into thinking that a string of good returns means an investment has very little risk. Often the risk is just lurking way out in the tail of the distribution, ready to jump out and crush your wealth. Sharpe ratios are the most common way that we measure the performance of a fund or other investment. Under some conditions, they are the best measurement of the tradeoff between risk and return. But when you throw options into the mix, Sharpe ratios suddenly have some issues. (news.financializer.com). As reported in the news.