Option-like properties in the distribution of hedge fund returns

Abstract

In recent years hedge funds have become more popular because of their low correlation with traditional investments and their ability to generate positive returns with a relatively low volatility. However, a closer look at those high performing hedge funds raises the question if the performance is truly superior and if the high management fees are justified. Incurring no alpha costs, so-called passive hedge fund replication strategies raise the question if they can lead to similar performance in a more efficient way at lower costs. This paper investigates two different model approaches for the equity long/short strategy, where weighted segmented linear regression models are employed in combination with two-state Markov switching models. The main finding is evidence of a short put option structure, i.e. short the equity market volatility, with the put structure present in all market states. We obtain evidence that the hedge fund managers decrease their short-volatility profile during turbulent markets.