Last Updated on 10 February, 2024 by Rejaul Karim
In the groundbreaking work “The Cost of Capital for Alternative Investments,” authored by Jakub W. Jurek and Erik Stafford, a probing inquiry into the enigmatic terrain of hedge fund and put-writing strategies unfurls with resounding profundity.
As the traditional risk factor models signal the capture of pre-fee alphas by hedge funds, inconspicuously mapping returns akin to mechanical S&P 500 put-writing strategies, a veritable labyrinth of paradoxes emerges.
This paper submits a compelling thesis, postulating that the lofty excess returns tethered to hedge funds and put-writing strategies can be explicated through an equilibrium, where a cadre of investors specializes in bearing downside market risks.
This equilibrium, in turn, engenders required rates of return that markedly diverge from those advocated by traditional models, thereby exerting a profound influence on the assessment of the allure of these investments.
Abstract Of Paper
Traditional risk factor models indicate that hedge funds capture pre-fee alphas of 6% to 10% per annum over the period from 1996 to 2012. At the same time, the hedge fund return series is not reliably distinguishable from the returns of mechanical S&P 500 put-writing strategies. We show that the high excess returns to hedge funds and put-writing are consistent with an equilibrium in which a small subset of investors specialize in bearing downside market risks. Required rates of return in such an equilibrium can dramatically exceed those suggested by traditional models, affecting inference about the attractiveness of these investments.
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Jakub W. Jurek
University of Pennsylvania – Finance Department; National Bureau of Economic Research (NBER)
Harvard Business School – Finance Unit
In a resplendent denouement, “The Cost of Capital for Alternative Investments,” emerges as an imperious clarion, resonating with the dialectics of alternative investment strategies.
Jakub W. Jurek and Erik Stafford’s exposition adroitly unravels the abstruse conundrums underlying hedge funds and put-writing strategies, shedding light on the elusive calculus of required rates of return in an equilibrium dominated by the adept navigation of downside market risks.
This seminal undertaking casts into relief the imperatives of performance evaluation, risk management, and the endowment model, thus propounding a paradigm shift in the discourse surrounding the allurement of alternative investments.
1. What is the main focus of the research paper “The Cost of Capital for Alternative Investments,” and how does it challenge traditional risk factor models in the assessment of hedge funds and put-writing strategies?
The main focus of the research paper is to delve into the perplexing realm of hedge funds and put-writing strategies, challenging the conclusions drawn by traditional risk factor models. The authors question the apparent high excess returns observed in hedge funds and put-writing strategies and aim to provide an alternative explanation. They propose a thesis suggesting that these lofty excess returns are consistent with an equilibrium where a subset of investors specializes in shouldering downside market risks. The paper challenges traditional models by contending that required rates of return in this equilibrium can significantly deviate from those indicated by conventional models, influencing the assessment of the attractiveness of these alternative investments.
2. How does the paper reconcile the seemingly high excess returns of hedge funds and put-writing strategies with the hypothesis that a subset of investors specializes in bearing downside market risks?
The paper posits that the high excess returns observed in hedge funds and put-writing strategies can be explained by the presence of a subset of investors who specialize in shouldering downside market risks. In this equilibrium, these specialized investors are willing to bear the brunt of downside risks, leading to elevated required rates of return. The paper suggests that traditional risk factor models may not adequately capture this nuanced equilibrium and, as a result, may underestimate the actual attractiveness of hedge funds and put-writing strategies.
3. How does the research paper contribute to the understanding of alternative investments, particularly in terms of performance evaluation, risk management, and the endowment model?
The research paper contributes significantly to the understanding of alternative investments by offering a novel perspective on their performance evaluation, risk management, and alignment with the endowment model. By challenging traditional models and emphasizing the role of specialized investors in bearing downside risks, the paper prompts a paradigm shift in how these alternative investments are perceived. It underscores the importance of considering the unique dynamics of downside risk management in the assessment of hedge funds and put-writing strategies, providing a more nuanced and comprehensive framework for evaluating their allure and potential returns.