Option-like features and volatility risk in hedge fund returns

We study the risk-return characteristics in the time series of a broad collection of hedge funds from the TASS database, especially their exposure to aggregate volatility risk and whether their returns resemble a position in index options. Earlier research has suggested a non-linear relation between the returns of hedge funds and those of the market index akin to a short position in an index put option. We find no evidence of such a relation, as hedge funds have no exposure whatsoever to factors proxying for the returns of call or put index options. However, hedge funds exhibit non-linearity with respect to the market in way of a negative aggregate volatility beta, where volatility risk is proxied by an index straddle. Earlier literature having established a negative volatility risk premium, our results suggest that hedge funds perform well during times of low and expected volatility, while performing poorly when the volatility of the market rises. The volatility exposure is both statistically and economically significant, with one standard deviation change in the monthly return of the straddle factor being associated with 0.25 percentage points in the monthly return of the aggregate hedge fund index. We also study whether hedge funds’ direct use of options as investments has an effect on these measures. We divide funds into option users and non-users and find that, in the aggregate, option users have a larger (less negative) volatility beta. This suggests options being used with a hedging purpose, although our binary measure of option use leaves much to be desired in determining the exact source of this difference. Finally, we sort funds into deciles based on their historical volatility betas, and find that funds with more negative volatility exposure consistently beat their less-negative counterparts in terms of both Sharpe ratios and alphas, with a spread portfolio of low-minus-high beta funds having an annual alpha of 5.3%