Options: When Skewness is Not on the To Do List

Options: When Skewness is Not on the To Do List

Which options do hedge funds employ in their portfolios? A recent paper concludes that hedge funds as a trader/investor class prefer liquid high-embedded leverage options without lottery-like skewness.

The paper also finds that they are good at what they do. Their equity options plays “deliver superior performance unobtainable by trading in [the] stock market.” In short, they find that hedge funds are good at employing the options markets to boost directional trades that would otherwise not be profitable.

The paper, “Information Content of Hedge Fund Equity Options Holdings, was inspired by the common observation that hedge funds tend to generate options-like payoffs that closely resemble those that would arise from a strategy shorting index put options. William Fung and David Hsieh, for example, made this observation at the turn of the millennium.

The scholars are Juha Joenväärä, Mikko Kauppola, and Pekka Tolonen, each affiliated with the University of Oulu in central Finland. Joenväärä is also with the Imperial College Business School.

Unanswered Questions

The point of the observation, for Fung and Hsieh, was simply one of modeling and predictive value. But for Joenväärä et al., it raised the question: what kind of options do hedge funds prefer to hold? And they found that this point had not been addressed in the literature.

To understand their answer to this question, we need to recall the notion of lottery skewness. Skewness is the asymmetry of a distribution in the historical pattern of its returns versus those of the symmetrical bell curve. A government-run lottery ticket, in circumstances in which the government pays out only 50% of what the bettors ante up, so it can use the rest to build schools, roads, etc., offers a classic example of skewness. The expected return is low, but investors/bettors hope for the big payoff anyway.

The result is a large number of very-low-return results, and a regular decrease in the number of outcomes observed as one moves to the right (toward the higher hypothetical pay-outs). That is a positive skew. That investor often like opportunities that have this same pattern, this positive skew, shows that investors are often irrational.

What Joenväärä et al. contend, then, is that hedge funds are not irrational—not in that sense, anyway. They avoid lottery skewness.

Not Harvesting the Illiquidity Premium

They also have a strong preference for liquidity. Not only do they hold liquid options, on highly liquid underlying stocks, but they do so even in a situation where (intuitively) it might not seem imperative to do so: the butterfly straddle. They are not in the business of harvesting an illiquidity premium: not within the option asset class at any rate. The trick of selecting options, for hedge funds, seems to be one of combining these two avoidances, of skewness and of illiquidity, with the embrace of leverage, especially embedded leverage. Quite often skewness, illiquidity, and leverage come as a package. Hedge funds don’t buy them as a package.

Hedge funds, these authors also conclude, are quite good at this. Directional option portfolios “outperform non-directional option portfolios, which suggests skillful trading on non-directional information,” our authors say.

The paper also considers the hypothesis that for many hedge funds the options positions are only a small part of the overall portfolio, so such positions and the fund managers’ skill in constructing them is not economically important. They consider that view, only to reject it. Based on their data, options “add significant value to the total industry-level portfolios in terms of month-ahead and quarter-ahead risk-adjusted returns.”

Option Performance Not Redundant of the Underlying Stock’s Performance

The authors consider also the hypothesis that the hedge fund managers’ ability to pick profitable directional plays for options is simply a reflection of their ability to pick directional plays on the underlying stocks. But this hypothesis, too, they reject. Joenväärä et al., check for the predictability of stock returns. If hedge funds were especially good at deciding the direction of stock price moves, one would be able to predict those moves by knowing the positions held by hedge funds as of a given moment. In fact, though, the predictability of stock moves in this way is “much less robust” than is the positive return from the options.

“In other words,” they conclude, if hedge funds had implemented their directionally informed trades via stock-only portfolios, they would not have obtained the returns they did via the respective options.”

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