Working Paper: CEPR ID: DP7676
Authors: Paolo Guasoni; Gur Huberman; Zhenyu Wang
Abstract: Ratios that indicate the statistical significance of a fund?s alpha typically appraise its performance. A growing literature suggests that even in the absence of any ability to predict returns, holding options positions on the benchmark assets or trading frequently can significantly enhance performance ratios. This paper derives the performance maximizing strategy - a variant of buy-write - and the least upper bound on such performance enhancement, thereby showing that if common equity indexes are used as benchmarks, the potential performance enhancement from trading frequently is usually negligible. The enhancement from holding options can be substantial if the implied volatilities of the options are higher than the volatilities of the benchmark returns.
Keywords: Alpha; Hedge Funds; Mutual Funds; Options; Portfolio Management
JEL Codes: G11; G12; G13; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trading options (G13) | performance of funds (G23) |
| frequent trading (G14) | performance enhancement (D29) |
| implied volatility of options > benchmark volatility (G17) | performance enhancement from trading options (G13) |
| buy-write strategy (G13) | higher appraisal ratio (G32) |
| optimal strategy (L21) | low values of appraisal ratio (G32) |
| implied volatilities of options > benchmark assets volatilities (G15) | optimal strategy delivers low appraisal ratio (L21) |