Bloomberg reports that 36 South Investment Managers, a New Zealand based hedge fund, gained 236% in the last 12 months. This is a terrific record in a year where hedge funds lost 19% on an average.
How did 36 South manage to put up such an impressive performance? It has to do with the trading strategy. 36 South buys long-dated options it considers cheap - in currency, bond, equity and commodity markets, betting that rare and unforeseen events would generate unusually large profits. The premium it pays on those options are relatively small - but when the direction of the bet is right, the pay-off is huge.
36 South had profited from bets on interest-rate cuts in Australia and New Zealand, and the purchase of put options on major stocks around the world, including BRIC nations. The fund had also bought put options on commodities.
The risk premium on most of the financial instruments has risen significantly over the last few months, making such a trade not so lucrative these days. Volatility indices have risen substantially and consequently the options premia have shot up. So, a trade similar to what 36 South entered into last year, is unlikely to be lucrative this year.
What is 36 South going to do next? It will start a fund that will bet on inflation around the world going up significantly. With governments around the world planning to tackle recession by printing money and pumping it into their economies, 36 South is likely to make a killing once again.
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2 comments:
Actually this is a high risk strategy than say writing a put every month. There was this whole empirical study in ET when Taleb's book started getting famous. The study compared the return on two strategies
a) buying deep out of the money puts in Nifty every month
b) writing the near month put in Nifty every month..
And guess what it was strategy b that came out on top. And we have had like a lot of black swans in india - 04 elections, 07 p notes after hour presser by PC, 08 meltdown(s).
It basically boils down to position sizing and our ability to bear drawdowns as we found out to our cost ;-)
"It basically boils down to position sizing and our ability to bear drawdowns" - exactly the point....
Hedge funds do need to take on quite a bit of leverage to be able to generate sufficient returns that can justify the relatively high fees and share in profits. Now, the ability to bear drawdowns will depend on having a high safety margin - which basically means lower leverage (which will diminish returns for sure)....
That being the case, even for a 10x leverage (some hedge funds do take on 30x leverage), the strategy of writing put options will wipe out the capital when there is just a 10% fall in the index.... so, the "ability to bear drawdowns" might be theoretically convenient, but practically difficult to implement for funds focused on absolute rather than relative returns
Moreover, if you look at what the Black Swan fund is doing, they don't buy out of the money options all the time... they buy it only when they are ready to take a directional bet, based on underlying macroeconomic fundamentals... so, comparing Black Swan fund's strategy with the trading strategy mentioned in ET's study is comparing apples with oranges!
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