Replicating Smart Money - A Derivative-Based Approach

Abstract

An option strategy, which writes short-dated out-of-the-money put options on the S&P500, is able to replicate the risk and return characteristics of broad hedge fund indices. Further, by extending the Carhart four factor model with this put-writing strategy, we are able to explain the alpha of a factor which goes long low-beta stocks and shorts high-beta stocks. Traditional risk factor models estimate annual alphas in the range 6-7% for hedge funds, and 9% for the betting-against-beta factor. Our results suggest that both hedge funds and betting-against-beta exhibit nonlinear risks which traditional factor models fail to capture. While betting-against-beta suffer during stressed markets, the quality-minus-junk portfolio does not have the same crash risk. Our results suggest that the abnormal returns to BAB is fair compensation for downside risk exposure, while the returns to QMJ remains a puzzle.