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How well does your hedge fund hedge?

By Peter Urbani

So what is a perfect hedge and how do you create one anyway? A perfectly hedged fund is one which

has no downside risk. Its payoff relative to the market or some other benchmark is the same as that of

the fund plus a put option that provides protection against the downside.

In the real world, however, this tail protection is not costless and the costs of implementing your hedge

tend to come either out of your upside in the form of lower upside return capture or in terms of not

providing a perfect hedge or full downside protection. The art of hedge fund management is thus largely

managing these competing forces and trying to generate sufficient excess returns or alpha to offset the

costs of implementing whatever downside protection, if any, is put in place whilst at the same time

performing as well or at least partly as well as the market or benchmark when it is up. Ideally the hedge

fund manager will need to add alpha in both up and down market regimes in order to be able to achievethis. The manager who is able to do so will have the aforementioned option like payoff and a positively

skewed probability distribution (since the left tail of the distribution is truncated at or around zero) . It is

these differential sensitivities to upside and downside movements that are largely responsible for the

non-linearity inherent in hedge fund payoffs. Using traditional linear methods to measure these

sensitivities thus makes little sense for hedge funds that do any hedging because of their implied

embedded optionality. How then to measure this?

Fortunately there are pre-existing models which enable us to do so. For example, the Henriksson

Merton (HM) model, which has been around since the 1980s, seeks to separate the ability of a portfolio

manager into selection and timing abilities by introducing a dual alpha and beta formulation of the

familiar CAPM Alpha and Beta model. The model essentially posits that an ability to have a low or

zero downside beta is evidence of the managers ability to exit (time) the market ahead of downside

moves. Similarly a higher upside Beta and Alpha are taken as evidence of superior stock picking orselection skills.

mailto:peter.urbani@gmail.commailto:peter.urbani@gmail.com

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In a recent paper on Attribution Analysis of Bull/Bear Alphas and Betas with Applications to

Downside Risk Management, Andreas Steiner approached this dual alpha and beta model and how it

can be used to examine the sensitivities to different market regimes after the fact. The efficacy of this

method in an out-of-sample subsequent period forecast sense has yet to be examined fully, but the

mere fact that it is capturing the non-linear attributes and providing a deeper insight into the managers

ability to protect the downside makes it a more useful metric than the single index model.

The straitjacketed restrictions of the long-only paradigm of the original CAPM Alpha and Beta models

do not apply to the hedge fund manager due to his/her ability to short or otherwise hedge out the risks of

his long positions rather than by having to follow the risky ( and unwise ) practice of physically exiting

and entering or timing the market. In contrast the hedge fund manager will in general seek to maintain

a permanent hedge.

There are probably no more used ( and abused ) words in finance than Alpha and Beta and their

meanings and intended definitions are not always consistent. For Hedge funds the generally understood

( by the public ) meaning of Beta as being your sensitivity to movements in the broad equity market

( typically the S&P500, MSCI World or some other suitable Equity Index ) only really applies in the

context of Long Short Equity, Dedicated Short and Market Neutral strategies and obviously has no direct

relationship to Credit Strategies and the like which require that alternative benchmarks be used. In

those cases some or other multi-factor model can be used. These typically take the form of the models

suggested by Fung and Hsiehetc.

Portfolio managers in general, and active ones especially, generally dislike the whole concept of

benchmarking but by comparing the performance of a hedge fund against an idealised primitive trading

strategy or other suitable benchmark consistent with what the manager says he does additional insights

can be gained in particular into the managers ability to hedge.

Hi All

Those of you that have not yet seen it may be interested in today's guest post onAllaboutalpha -How well does your hedge fund hedge ?

Kind regards,

Peter Urbani

http://nz.linkedin.com/in/peterurbani+64 21 0255 2816

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1864240http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1864240http://faculty.fuqua.duke.edu/~dah7/HFData.htmhttp://faculty.fuqua.duke.edu/~dah7/HFData.htmhttp://allaboutalpha.com/blog/2011/07/05/how-well-does-your-hedge-fund-hedge/http://allaboutalpha.com/blog/2011/07/05/how-well-does-your-hedge-fund-hedge/http://nz.linkedin.com/in/peterurbanihttp://nz.linkedin.com/in/peterurbanihttp://nz.linkedin.com/in/peterurbanihttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1864240http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1864240http://faculty.fuqua.duke.edu/~dah7/HFData.htmhttp://allaboutalpha.com/blog/2011/07/05/how-well-does-your-hedge-fund-hedge/http://nz.linkedin.com/in/peterurbanihttp://nz.linkedin.com/in/peterurbani