Psst– want to earn a 41% annual return over a decade? Then read on.
Originally, “hedge fund” was used to describe a fund that simultaneously buys and sells related securities, constructing a portfolio with desired risk-return characteristics or profiting from subtle differences in returns. Today, the term may refer more broadly to any unregulated private investment pool that adopts unconventional or aggressive investment strategies
such as
short selling, leveraged positions, program trading, swaps, arbitrage, and derivatives trading.
The Big Picture calls attention to this story from this weekend’s New York Times:
Mr. Simons, who got into the hedge fund business after abandoning a stellar career in mathematics, has a track record that is jaw-dropping…. from 1990 to 2004, Renaissance’s primary hedge fund, called Medallion, has delivered annualized returns of 33.21 percent. (The Standard & Poor’s 500-stock index has returned, on average, 10.98 percent during those same years.)
I do not know anything about the investment strategy of Renaissance or Medallion. But let me tell you about one fund I do know about called CDP, which was described by MIT Professor Andrew Lo in an article published in Financial Analysts Journal in 2001.
1992-1999 was a good time to be in stocks– a strategy of buying and holding the S&P 500 would have earned you a 16% annual return, with $100 million invested in 1992 growing to $367 million by 1999. As nice as this was, it pales in comparison to CDP’s strategy, which would have turned $100 million into $2.7 billion, a 41% annual compounded return, with a positive return in every single year.
Want to learn more? CDP stands for “Capital Decimation Partners”, a hypothetical fund created by Professor Lo in order to illustrate the potential difficulty in evaluating a fund’s risk if all you had to go on was a decade of stellar returns. The strategy whereby CDP would have amassed a hypothetical fortune was amazingly simple– it simply sold put options on the S&P 500 stock index (SPX).
Buying put options is a way that an investor can buy insurance against the possibility of a big loss. For example, the S&P 500 index is currently valued around 1250. You can buy an option (the 1150 March 2006 put) that will pay you $100 for every point that the S&P is below 1150 on a specified date in March. Such an insurance policy would today cost you about $750. If you’ve bought enough puts to balance the equity you have invested long, you have nothing to fear if the market goes below 1150, because every dollar you lose on your main holdings you can gain back from your put option.
But what about the person who sold you that put? They have now assumed all of your downside risk. Lo’s Capital Decimation Partners would use its capital to meet the margin requirements (which guarantee to the exchange that CDP could in fact make the payments to the buyer of the put), and roll over the proceeds to make even bigger bets. Essentially it was thus using leverage to turn the relatively small proceeds from selling these puts into a huge return on the capital invested.
Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements gets completely wiped out, giving you a long-run guaranteed return on your investment of -100%. But over the 1992-99 period, Lo’s hypothetical fund dodged that bullet and ended up turning in a whopping performance.
Lo gives a variety of other examples of funds that could go for a long period with very high returns and yet entail enormous risks. They all have this feature of pursuing investments that have a high probability of a modest return and a very small probability of a huge loss. By leveraging such investments, one can achieve a very impressive record as long as that low probability disastrous event does not occur. It is certainly possible that some strategies along these lines would, unlike Capital Decimation Partners, earn a higher return than the market on average if you stuck with them forever. However, you should view that higher return as coming at the expense of much higher risk.
My discussion of Lo’s hypothetical hedge fund should not be construed as a specific critique of any currently operating actual hedge fund. But suppose that all you know about a fund is that it has earned exceptional returns every year for the last decade, and you don’t have access to information about the specific trading or asset holding strategy that netted those returns. Is it a good investment for your money? My advice would be no.
“Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements gets completely wiped out, giving you a long-run guaranteed return on your investment of -100%. But over the 1992-99 period, Lo’s hypothetical fund dodged that bullet and ended up turning in a whopping performance.”
a) What would convince you, if anything, that forgetting quasi religious belief about Black Scholes pricing.. that “puts on broad based indices” were dramatically over priced over the time horizon discussed and certainly since then.. too..?
Actually looking at Lo’s data, with a simple modification the stupid thing never loses…whatever the ostensible risk the probability of decline seems to be overpriced … by the way..sadly after most people see data like Lo’s and have seen it for the past 5 years or so.. their only response is.. HOW CAN I Invest in this????
Seeing as most of them are already overlong equities to begin with..taking on the same risk with a proportion of their assets seems like a great pick up… same risk.. more return…and I can only die once …..
b)The same data set by the way shows that selling put spreads (self insured bets) also produces the same type of returns.. and without the penultimate risk of being wiped out by margin calls…in point of fact you never get a margin call ..
c)Its the net investor in stocks who is short all those puts.. he just doesn’t notice it ..after all when stocks go down.. you’re supossed to average in …
Investors look at short-term results and assume it’ll continue forever. We’re barraged with the info, from 3-yr fund performance records printed in magazines and on websites. Investors chase the funds that have done the best most recently. And as you know, past results are no guarantee of future results… I suppose that’s why contrarian strategies work. Sometimes.
http://www.janegalt.net/blog/archives/005567.html
James Hamilton has a post that illustrates why it’s as important to look at risk as return: Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements g…
Just shows that timing is everything. Cue Kenny Rogers’ “The Gambler.”
According to my calculator a 41% return over an 8 year period produces a value of 15.62 X, rather than the 27 X you cite.
The problem with models of this nature is that as the size of the investment position increases, it begins to affect the overall market by a product of its size, and the attraction of new competitors. The equity dreivative market is as you characterize it an insurance product, and as more dollars compete for any product, the premiums are ultimately driven down.
Bill
Bill, you’re correct that (1.41)^8 = 15.6, but I was using continuous compounding e^(0.41 x 8) = 26.6. Actually, the cumulative growth by factor of 27.2 is what’s reported by Lo, and I converted this to continuously compounded annual growth by (1/8) ln(27.2) = 0.41.
As technically executed, the returns from this strategy were compounded monthly rather than continuously. I quoted this using continuous compounding because that’s the quickest and easiest, and it’s often more convenient to do most finance calculations using log returns. Certainly continuous compounding is a better approximation to the true return here than annual compounding. Makes a difference when you’re talking about returns like these.
Any way you want to summarize it, the CDP strategy would have generated a whole lot of profit.
Professor –
Due to my audit training I had to check CDP, LP’s numbers. On page 16 of the report a schedule of the transacitons for 1992 is presented. This schedule has an overstatement in the profit of $755,406.25, being a product of an $805,000 overstatement of the profit on the first 2,300 put position, and an understatment of the profit on the last 529 put position of $49,593.75.
What a real to life example. A hedge fund manager that overstates his results!
Bill
it might sound ironic given the absolute return hype.
perhaps the right metric is still relative returns…that is relative to the rest of the industry : the right question is how many other big fund there’s out there that have a 10 year 32% a year compounded ROIC.
I remember, in high-school I believe, being told the following strategy for turning a series of bets on a fair coin into a “certain” way to make money. That basic idea is that each time you lose, you double the bet. Say you bet $1 on the first toss, and lose. So you bet $2 on the second, and say you chance to lose again. So now you bet $4. Sooner or later, you are certain to win, and let’s say it’s at the $4 bet. So now your winnings are $4-$2-$1 = $1. In general 2^n – Sum(2^i,i=1,i=n-1) = 1. So if you keep doubling, you are bound to win $1 eventually, and then you just start the process over. Thus you have a guaranteed way to make money from betting on a fair coin.
Or not – the issue is the same one Prof. Hamilton alludes to. It only really works if you have an infinite capital pool. For any finite pool, the day will come when you will lose it all. The amount you are betting on a sequence of n tails is exponential in n (2^n), while the probability of getting n tails is negative exponential (2^-n). The effect is that the contribution to your expected loss from sequences of n doesn’t decline with n — it’s constant — and the total expected loss exceeds any finite amount (ie it’s infinite).
Such an analysis assumes a perfectly weighted coin. Is there such a thing?
It really depends on the adequacy of their risk management. High returns for an extended period of time do tend to lull managers into a sense of complacency as their success is obviously due to their brilliance while their loss is due to an irrational market. It would provide greater confidence to see performance in up and down markets.
Suart – Be careful with your coin toss. The defiinition of insanity is doing the same thing over again and expecting a different result:-)
Bill
Prof. Hamilton:
Your advice reminds me of a joke about an economics prof. and his student on seeing money on the ground. As the joke goes, the economics prof. rationalizes that the money on the ground cannot be real money because if it was real money someone would have already taken it …. I am sure you know this joke.
However, a comment by a reader of that joke, I thought, was even better; he wrote:
“Is this the reason economics profs. are mostly poor?”
Thought to share it with you! 😉
-Madan.
Stuart,
That’s called Martingale.
Interesting that Taleb, does the opposite thing, and makes a bundle too. He bets on very unlikely occurrences, which have a very low cost, but pay handsomely when they do fall in the money…
Here is a lengthy article on Taleb for those unfamiliar:
http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm
Dan,
Great article!
Thanks
Joe Rotger,
Funny that you say that Taleb “makes a bundle” on being positioned for unlikely occurences. In actuality, he most likely makes his money writing books and giving speeches about his “black swan” than actually implementing it (I think he had to close his fund recently).
pg,
You may be right. I haven’t heard of him as of late, –not that I follow him either…
But, I read he made a bundle in 1987 and 911…
I guess slow bleeding can kill you too.
It’s just that his philosophy on trading, which has a strong probabilities background, is so fascinating…
Just imagine what it means to state that possibly the few guys that make it in the markets are plain lucky …and that they may get wiped out any day due to a black swan …like Niederhoffer did …Larry Williams …Soros had big setbacks –and retired. I understand Buffet was short USDs…
James–
If put-call parity holds, could one buy calls instead of shorting puts?
Exceptionally high returns mean usually exceptionally high risk. And you can take the risk if you can afford the loss. The popularity of hedge funds tell about availability of “loose” capital that somebody can afford to lose.
The coin tossing example will bring certain return only if you set the rules and can stop when you like. If there are other players that don’t allow that it no longer works.
From macroecomomic viewpoint we can see hedging and derivatives as tying the sectors of the economy together, to a tight block that moves as one. It seems to increase security, stability and predictability but it has a price – less flexibility. No part can fall off at its own, and this means less risk for the individual investor or fund. That is why more risk can be taken. But this increases the overall risk – we could say that the amount of risk is constant but the distribution of it can vary.
If the economy loses its flexibility, it cannot adjust itself enough to changing conditions. I think that we can see this in the US economy. In this kind of economy everything seems to be well – to the end. We could expect it not reacting to growing imbalances. This is where the real risks are.
It’s tough out there…
http://www.forbes.com/2005/11/07/buffett-dollar-euro-cx_gl_1107autofacescan02.html
Bob –
Buying calls requires the buyer to pay the premium for the insurance. Thus, you continually suffer a cash outflow until the market abberation occurs. In selling naked calls, the seller receives the premium and thus earns income except when the market abberation occurs.
By definition, an abberation is some event that is not likely to happen. While almost all investors assume that on some occassions the market will fall significantly, in buying an out of the money call you are betting that the abberation will occur within a limited time frame.
Many predictions come true, but most are not timely.
Bill
Not 100% sure, but I don’t think Simons is an options guy. Also, be sure to take federal and state taxes out of your CDM model (derivative gains taxed as 50% LT gain/50% ST gain), and fees too, if not deducted already.
Role of Internal Audit and Future SEC Examinations
Lori Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, delivered prepared remarks to the S
Madan,
“Is this the reason economics profs. are mostly poor?”
If they’re tenured, then they aren’t poor as a rule. Otherwise, it’s supply and demand.
Stuart and others,
Ever wonder why the Casinos in Vegas have table limits? I was with my cousin once in Tahoe when he thought he had the system beat following simpleton double-downing. He’d won twice before, on weekend outings, and was flashing cash that New Years Eve. But he lost that night, as I told him he would eventually. When I examined the probabilities, I found that the Casinos placed table limits strategically to keep the odds in their favor, thwarting double-downers in attempts to stack the odds in their favor.
The Casinos know that they don’t want to risk too much on someone’s string of luck running too long. It might be interesting to see some ‘table limits’ placed on some of our other casino-like institutions..
I too foresaw the LTCM meltdown coming, and lost a little of my retirement portfolio on a wrong bet that Greenspan and CO. would use the event to spank wildcat players. They didn’t do it then and haven’t yet. Thanks Dan for the Taleb feed. It’s a good read..
We should be long on the markests in the long run. If a castrophe of castrophies occurs, I’m sure money, paper assets will be of no value anyways.
Just make sure you have an AK47, water, bread, duct tape, good clothing, and medicine on hand.
Those presently inxpensive items will appreciate in personal utility.
Caseblue,
Can you tell me how long it would have taken you to recover if you’d invested your wad, all at once, in the DOW in, say, Sept 1929? Or even if you’d begun then, as a new employee in a neoCon world and invested in the DOW for your 30 year employment?
So while I agree that markets are a place to be most of the time. There are times and places where one ought to approach them with utmost caution. Right now, the US market, in terms of broad averages, may be one of those times and places. And if an impending crunch, shold it come relatively soon, is ‘hard’ instead of ‘soft,’ then other security markets may be hit even harder than US ones.
Still, the old adage pertains: ‘Those who think they know, don’t know. Those who know they don’t know, know!’
That is the main massage from Taleb, I believe. Although Taleb, evidently believed he could predict close enough, the timing of big-enough market corrections that would cover his bets. Some above have suggested that he too may have been ‘Fooled by Randomness,’ as evidently was Jesse Livermore, the notorious bear in a bygone ‘depression era.’
I totally agree with the previous poster,
what are the Taleb guy’s real metrics.
Niederhoffer lost his fortune and he gave very
graphic and vivid details on his website of exactly what happened and the consequences.
Response——–
pg,
You may be right. I haven’t heard of him as of late, –not that I follow him either…
But, I read he made a bundle in 1987 and 911…
I guess slow bleeding can kill you too.
It’s just that his philosophy on trading, which has a strong probabilities background, is so fascinating…
Just imagine what it means to state that possibly the few guys that make it in the markets are plain lucky …and that they may get wiped out any day due to a black swan …like Niederhoffer did …Larry Williams …Soros had big setbacks –and retired. I understand Buffet was short USDs…
Be careful how you reinvest
In a recent article, Econobrowser takes look at hedge funds, and how rate of return is insufficient to understand the risk and reward involved. One interesting point that doesn’t come up in the article or the comments that follow is…
You wrote:
“It is certainly possible that some strategies along these lines would,…, earn a higher return than the market on average if you stuck with them forever. However, you should view that higher return as coming at the expense of much higher risk.”
My comment:
This statement runs contrary to the arbitrage assumption, unless you additionally assume that investors cannot for some reason actually take advantage of such a winning strategy due to transaction costs or other frictions. If there actually were a perpetuity that yielded an above average market return over time, any excess returns would quickly get arbitraged away. Or perhaps I have read your statement incorrectly?
Brian, if investors are not risk neutral, then an investment with nondiversifiable risk should earn higher than average return.
Hedge fund management and information security
Been a long time since I posted anything. I’m trying to get back into the swing. I was struck by
this post on Econbrowser about this paper. We often hear “Well, we haven’t had a successful
break in for the last ten years”. Perhaps that doesn’t matterwe…
Keep up the great work on your blog. Best wishes WaltDe