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In the past few years close to 8,000 hedge funds have started operations in the U.S. The impact on the financial markets of such a large number of funds with a mandate somewhat unconventional is little understood, and/or appreciated. A clear example of such impact can be seen in a real life example that took place week ago. Aegean Capital Group, Inc., provides research and consulting services to institutional investors such as hedge funds, and to other financial services companies. One of them is Hamzei Analytics (www.hamzeianalytics.com) Aegean Capital combines $weighted put/call data provided by HA, with its own research, in order to construct a portfolio for H.O.T.S (Hamzei Options Trading System). The individual positions are chosen not only for their own individual merit, but also for their contribution to the weighted average delta, the alpha, and the expected return of the "mini-portfolio" per unit of risk. The success of the methodology is based on the weighted average delta, the alpha, and the expected return of the "mini-portfolio" per unit of risk, it is NOT based on the returns of each position on an individual basis (see www.hamzeianalytics.com/HOTS_general.asp). The approach mimics the approach followed by many hedge funds, but it is applied on a much smaller scale in order to make it applicable for individual accounts. If I was to tell someone that we have a portfolio that is made up of short-sales and put/call options, very few -if any- would associate such portfolio with "conservative investment strategy." Yet, that was exactly the case. Below is the portfolio that we constructed on behalf of HA for 1-9-05:
As you can see, according to RiskGrades, the portfolio's risk has been lowered by 86%, and its beta is lower than the one of the SP500!
Imagine the impact on the financial markets from thousands of hedge funds employing similar approaches on a much larger scale in order to accommodate multi-million dollar portfolios. First of all, raw put/call ratios are irrelevant. A large number of puts/calls are bought/sold not because of conviction with regard to the directional move of a stock/index, but because of the very lack of it! Second, when everything is already pre-sold or pre-bought, there is very little urgency to sell/buy, which reduces volatility, and volatility premiums. Third, the existence of this type of hedging strategies results in plenty of "uncompleted" break-outs or breakdowns. As soon as a stock/index appears to break-out or break-down, the hedge strategy kicks in, and the "break" gets negated. This has been much more prevalent in the indices, where funds can make multi-million dollar bets due to the available liquidity. In an environment like this, the chances for success are precious few for individual investors who do not know how or can't play the same game. In my view, those few chances for success -for individual investors- can be found in ETFs/stocks that have little following by hedge funds. In case you wonder how the portfolio performed as of the close on 1-14-05, it is up 6.36% in a matter of six days. Investors ought to think twice before they play against the hedge funds! (Please note, some positions have already been closed.)
Ike Iossif
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