Investments, tenth edition

A

B

Exercise

Price

Stock Value

Exercise

Price

Stock Value

Stock with Written Put

Stock with Written Call

 Figure 26.5 

Characteristic lines of stock portfolio with writ-

ten options.  Panel A,  Buy stock, write put. Here, the fund 

writes fewer puts than the number of shares it holds.  Panel B,  

Buy stock, write calls. Here, the fund writes fewer calls than 

the number of shares it holds.  

 

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 But the fund that writes options would at least receive fair compensation for the unattractive shape of its char-

acteristic line in the form of the premium received when it writes the options.

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  C H A P T E R  

2 6

 Hedge 

Funds 

941

   

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 Not all the hedge fund categories exhibited this sort of pattern. Many showed effectively symmetric up- and 

down-market betas. However,  Figure 26.6 , panel A shows that the asymmetry affects hedge funds taken as group. 

  

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 Nassim N. Taleb,  Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets   (New  York: 

TEXERE (Thomson), 2004); Nassim N. Taleb,  The Black Swan: The Impact of the Highly Improbable   (New 

York: Random House, 2007). 

  Figure 26.6  presents evidence on these sorts of nonlinearities. A nonlinear regression 

line is fitted to the scatter diagram of returns on hedge fund indexes plotted against returns 

on the S&P 500. The fitted lines in each panel suggest that these funds have higher down-

market betas (higher slopes) than up-market betas.  

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 This is precisely what investors do  not  want: higher market sensitivity when the market 

is weak. This is evidence that funds may be  writing  options, either explicitly or implicitly 

through dynamic trading strategies (see Chapter 21, Section 21.5, for a discussion of such 

dynamic strategies). 

 Just as hedge fund betas may be unstable, so may be other aspects of their risk profile, for 

example, total volatility of returns. Because they have great discretion to use leverage and 

to trade in derivatives, these funds have tremendous capacity to alter their risk exposures. 

Recall from Chapter 24 that when portfolio managers can change risk within any measurement 

period, they can also manipulate standard measures of risk-adjusted return. Thus, one would 

like them to compute and report manipulation-proof performance measures such as Morning-

star’s risk-adjusted return.