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Taking the Sting out of Hedge Funds


  • Harry. M Kat

    () (ICMA Centre, University of Reading)


Although the inclusion of hedge funds in an investment portfolio can significantly improve that portfolio’s mean-variance characteristics, it can also be expected to lead to significantly lower skewness and higher kurtosis. In this paper we show how this highly undesirable side-effect can be neutralized by allocating a fraction of wealth to out-of-the-money put options on the relevant equity index. Based on monthly return data over the period 1994-2001 we show that investors who want to fully eradicate the negative skewness of portfolios containing stocks, bonds and hedge funds will have to sacrifice a not insignificant part of their expected return. Investors who limit themselves to neutralizing only the additional skewness caused by the inclusion of hedge funds will be able to do so at much more favourable terms, however. The latter only need to allocate a small fraction of wealth to index puts and accept a drop in expected return that is unlikely to exceed 1% per annum, depending on the hedge fund allocation. This means that in the current low interest rate environment the costs of eliminating the unwanted skewness effect of hedge funds need not be prohibitively high.

Suggested Citation

  • Harry. M Kat, 2002. "Taking the Sting out of Hedge Funds," ICMA Centre Discussion Papers in Finance icma-dp2002-22, Henley Business School, Reading University.
  • Handle: RePEc:rdg:icmadp:icma-dp2002-22

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    References listed on IDEAS

    1. Ackert, Lucy F. & Tian, Yisong S., 2001. "Efficiency in index options markets and trading in stock baskets," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1607-1634, September.
    2. Michael J. Aitken & Alex Frino & Amelia M. Hill & Elvis Jarnecic, 2004. "The impact of electronic trading on bid‐ask spreads: Evidence from futures markets in Hong Kong, London, and Sydney," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 24(7), pages 675-696, July.
    3. Chris Brooks & Olan T. Henry & Gita Persand, 2002. "The Effect of Asymmetries on Optimal Hedge Ratios," The Journal of Business, University of Chicago Press, vol. 75(2), pages 333-352, April.
    4. Wing H. Chan & Denise Young, 2006. "Jumping hedges: An examination of movements in copper spot and futures markets," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 26(2), pages 169-188, February.
    5. Alizadeh, Amir H. & Nomikos, Nikos K. & Pouliasis, Panos K., 2008. "A Markov regime switching approach for hedging energy commodities," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1970-1983, September.
    6. Blennerhassett, Michael & Bowman, Robert G., 1998. "A change in market microstructure: the switch to electronic screen trading on the New Zealand stock exchange," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 8(3-4), pages 261-276, December.
    7. Lucy F. Ackert & Yisong S. Tian, 2000. "Arbitrage and Valuation in the Market forStandard and Poor's Depository Receipts," Financial Management, Financial Management Association, vol. 29(3), Fall.
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