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Friday, April 29, 2016

Know What You Own: Alternative Funds Edition

Warning... I got way too wonky in this post. If you want a streamlined version of the below, go here.

Below are the objectives / investment strategies of two different “alternative” funds pulled from the prospectus and/or annual report of each, along with detailed analysis of how they were actually positioned as of their most recent semi-annual reports on 12/31/15. In this post I'll leave their actual performance out of it (one has been horrific, one has been solid - which makes sense when you realize they are opposing strategies), as this post is meant to highlight the importance of looking under the hood, only allocating to strategies that you understand, and ensuring that the manager follows what has been outlined in their prospectus, This is especially important when it comes to alternative funds with less defined limitations (though in the case of Fund A... they seem to simply ignore these limitations).


Fund A: 
Objective: The Fund seeks to achieve long-term capital appreciation, with added emphasis on the protection of capital during unfavorable market conditions. It pursues this objective by investing primarily in common stocks, and uses hedging strategies to vary the exposure of the Fund to general market fluctuations (page 1).  
Investment strategy: The investment manager expects to intentionally “leverage” or increase the stock market exposure of the Fund in environments where the expected returns from market risk is believed to be high, and may reduce or “hedge” the exposure of the Fund to market fluctuations in environments where the expected return from market risk is believed to be unfavorable (page 3). 
To make it abundantly clear how this fund defines leverage and hedging, the prospectus states.
Leverage: "The maximum exposure of the Fund to stocks, either directly through purchases of stock or indirectly through option positions is not expected to exceed 150% of its net assets" (page 3). 
Hedging: "The total notional value of the Fund’s hedge positions is not expected to exceed the value of stocks owned by the Fund, so that the most defensive position expected by the Fund will be a “fully hedged” position in which the notional values of long and short exposures are of equal size" (page 3).

Fund B: 
Objective: The Fund seeks income and growth of capital (page 1).  
Investment strategy: "The Fund's core strategy has been and will always be to purchase an underlying hedge at 100% of the notional value of the underlying through corresponding LEAPS put options and proportionally write shorter-term options against the long underlying equity ETFs and LEAPS puts. Premiums received from writing options represent income-type positions that are designed to take advantage of time decay and help pay for the cost of the hedge"(page 2). 
Elsewhere, Fund B is described as:
  • "Always hedged, all the time, using put options" (source)
  • "With no reliance on market timing or stock selection" (source)

To summarize... fund A states the fund can have exposure ranging from 0% to 150% (i.e. cannot go short), while Fund B is described as always being hedged the the market (i.e. implies a 0% market exposure) and uses the time decay (i.e. they are long theta) to pay for the hedge.


While I hoped to stay out of the weeds with regards to option pricing, the tables below break down the fund exposures inclusive of the options bought or written as of 12/31/15. While funds often mark options at market value (i.e. how much you can buy or sell them at that day's close), economic exposure is what matters to an investor (i.e. if the market moves up or down, what is the impact to the portfolio). As an example, stock futures are marked-to-market every day, meaning they have a market value of ~$0 at the end of the day. Yet I think we can all agree that a fund with 3x notional exposure to stocks (i.e. triple levered ETFs) have 300% exposure to the stock market, not 0%.

To calculate the real exposure, you first need to calculate the notional exposure of the options and delta adjust them to account for how in or out of the money the options are (delta is the degree to which an option is exposed to shifts in the price of the underlying asset). Walking through the table columns from left to right...
  • Contracts: # held or written as of 12/31/15
  • Expiry: when the option contracts expire
  • Index Value: the value as of 12/31/15
  • Strike: the level at which the stock is in- or out-of-the money; puts are in-the-money when they are below the strike, calls when they are above
  • Notional: contracts x 100 (notional value of $100 times the index value per the terms of these option contracts)
  • Delta: the degree to which an option is exposed to shifts in the price of the underlying asset (a deep in the money call option has a delta of 1 meaning it provides the same exposure as the underlying stock market, while a negative sign indicates it is short that exposure which results from buying puts or selling calls); note I assumed an 18% volatility figure to calculate the options for all periods, which is right around where the VIX was as of 12/31/15 as is close enough for this.
  • Delta Adjusted Exposure: this is the economic exposure that investors are actually exposed to

Now let's take a look at what exposure the two funds had as of 12/31/15 (if anyone sees an issue with any of my calculations, please let me know).

Fund A (source)

Delta adjusted option exposure of -$900 million relative to the $600 million market value of the fund's stocks as of 12/31/15 = net -$300 million market exposure (i.e. it was 50% short the market as fund AUM was ~$600 million).

Fund B (source)

Delta adjusted option exposure of around -$500 million relative to the ~$1.27 billion market value of the fund's stocks as of 12/31/15 = net $777 million market exposure (i.e. it was ~60% long the market as fund AUM was ~$1.3 billion).

Long Option Exposure

Short Option Exposure / Net Fund Exposure

The chart below is my attempt to simplify the payoff structure of each, ignoring the time decay of options held (time decay is a huge drag on Fund A and a substantial tailwind for Fund B). Fund A sold deep-in-the-money calls that effectively neutralized the stocks held, leaving only the puts and a net short position. Fund B is a bit more complex, but is long the market on the way up (though less than 100%) and exposed to the market (though less than 100%) on the way down (with a relatively neutral position when the market is down ~5-10%).


  • Fund A, which states it can have market exposure between 0% to 150%, was materially short the market 
  • Fund B, which implies it is has 0% market exposure, was materially long the market
So the two funds basically have:
  • The exact opposite stated investment strategies as one another
  • The exact opposite positioning as one another
  • The exact opposite positioning as their own stated investment strategy
And we wonder why there is investor confusion / disappointment?

As an aside... I find Fund B's strategy interesting.