In an earlier article for Bloomberg View, I described a danger facing investors: the put-option illusion. This is when investors, who tend to extrapolate too much from recent trends, are fooled into thinking that a string of good returns means an investment has very little risk. Often the risk is just lurking way out in the tail of the distribution, ready to jump out and crush your wealth.
In that article, I also talked about some research by Vikas Agarwal and Narayan Naik from the mid-2000s showing that many hedge funds had returns that looked a lot like selling out-of-the-money puts on the Standard & Poor’s 500 Index. I suggested that maybe these funds were — consciously or unconsciously — playing to investors’ put-option illusion. But there is another reason for hedge funds to adopt an investment strategy that has many small gains and a few big disastrous losses. As it turns out, this kind of strategy can be used to boost Sharpe ratios.
More here – Bloomberg View