IDEAS home Printed from https://ideas.repec.org/p/rdg/icmadp/icma-dp2002-22.html
   My bibliography  Save this paper

Taking the Sting out of Hedge Funds

Author

Listed:
  • Harry. M Kat

    () (ICMA Centre, University of Reading)

Abstract

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
    as

    Download full text from publisher

    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2002-22.pdf
    Download Restriction: no

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:rdg:icmadp:icma-dp2002-22. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marie Pearson). General contact details of provider: http://edirc.repec.org/data/bsrdguk.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.