Why are Hedge Funds considered option like (high skewness)?

CFA Level III Portfolio Management
#1

CFA Vol 6 Top of page 146.

I remember seeing this on a mock or something and I got it wrong. Does option-like = potential for very high returns?

#2

Or is it because hedge funds’ fee structure is option like? Anyone care to answer this? Thanks

#3

As far as I understand hedge fund returns tend to be negatively sweked which means:

> high number of small positive returns;

> a very low number of very large losses;

Except for the above is the Global Macro HF which tend to provide positvely skewed returns.

How to avoid negative skewness ?

  1. Adopt a mean variance approach which means combining different fund strategies e.g. invest in Global Macro HF + Market Neutral HF

  2. Invest in futures which show positive skewness return distribution (i.e. small number of large postiive returns and a high number of small negative returns)

Being sure of the above, I should assume option outcomes might distribute specularly…

#4

So I think the quote in question is saying that some hedge funds incorporate “a high degree of optionality (skewness).”

What this means is that they have investments with highly binary outcomes. They might be betting on early stage drug company, for example, that is either going to be worth a ton of money (because they discovered a cure for cancer) or worthless (because the drug gets rejected by the FDA).

If you have a bunch of investments like that, you’re not going to have a normal distribution of returns. Therefore, standard deviation isn’t a good measure of risk and you can’t use the Sharpe ratio.

#5

Sounds about right, Thank you.

#6

Agreed