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Monday, February 02, 2009

Econbrowser on Hedge Fund Risk

James Hamilton at Econbrowser gives a good example of "tail risk" from a Financial Analyst's Journal article by MIT's Andrew Lo:
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).

Read the whole post here

And if you want to see another study on the returns of put-writing strategies, here's an older post. It documents what Lo (and Hamilton) discuss - consistently good returns in the overwhelming majority of periods along with rare massive losses.

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