Working Paper: NBER ID: w19643
Authors: Jakub W. Jurek; Erik Stafford
Abstract: We document that the risks and pre-fee returns of broad hedge fund indices can be accurately matched with simple equity index put writing strategies, which provide monthly liquidity and complete transparency over their state-contingent payoff profiles. This nonlinear risk exposure combines with large allocations, typical among investors in alternatives, to produce required rates of return that are more than twice as large as those implied by popular linear factor models. Despite earning annualized excess returns over 6% between 1996 and 2010, many hedge fund investors have not covered their proper cost of capital.
Keywords: hedge funds; cost of capital; alternative investments; put writing
JEL Codes: G11; G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Hedge fund investments (G23) | Required rates of return (G19) |
| Nonlinear payoffs of hedge funds + Large allocations (G40) | Elevated required rates of return (G19) |
| Traditional linear factor models (C38) | Underestimation of true cost of capital (G31) |
| Methodology for replicating hedge fund returns (C59) | Better estimation of required rates of return (G17) |
| Hedge fund investors earning annualized excess returns (G11) | Not covering proper cost of capital (G31) |
| Statistically unreliable alphas (C46) | Underperformance relative to proper cost of capital estimates (G31) |