Would you invest in a hedge fund which returned 41% annualized over a decade?

It may seem naive to question the capability of a hedge fund manager who has a record of returning close to 50% annually over a decade. You might be labeled a moron if you were to question his investment skills. Below is an insightful article written by James Hamilton in 2005. It talks about the research of MIT Professor Andrew Lo (published in Financial Analysts Journal in 2001) who established a fictional hedge fund called Capital Decimation Partners (CDP!) whose only strategy was to sell put options in the great bull run of S&P 500 during 1992-99. The fund returned an astounding 41% annualized with positive returns in every single year.

Read on ...

Hedge fund risk

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.