The Cost of Capital for Alternative Investments

Abstract:     
We document that the risks and pre-fee returns of broad hedge fund indices can be accurately matched with simple equity index put writing strategies, which provide monthly liquidity and complete transparency over their state-contingent payoff profiles. This nonlinear risk exposure combines with large allocations, typical among investors in alternatives, to produce required rates of return that are more than twice as large as those implied by popular linear factor models. Despite earning annualized excess returns over 6% between 1996 and 2010, many hedge fund investors have not covered their proper cost of capital.

Number of Pages in PDF File: 49

Keywords: hedge funds, downside risk, replication, performance evaluation, risk management, endowment model

JEL Classification: G12, G23, G31

working papers series