It's one of the elementary rules of finance: When pension fund managers turn nervous about the equity market, they gobble up Standard & Poor's 500 put options. As a result, equity index put options almost always trade at a premium volatility price.

While many arbitrage-oriented hedge funds try to take advantage of this phenomenon via so-called dispersion trading (buying individual equity put options vs. selling relatively expensive index options), a San Francisco-based hedge fund group called Derivative Consulting Group LLC opts for a different path. The company, through its Arcas Covered strategy, combines short-selling of equities with short index put positions.

John Frazer and David Hammond, two former Pacific Stock Exchange and Chicago Board Options Exchange market-makers, launched the Arcas Covered strategy back in 1996, developing a variety of short-biased onshore and offshore hedge funds around it.

The strategy starts with Hammond and Frazer separating approximately 9,600 individual equity issues into two camps: stocks that they deem trade on a mostly fundamental basis, and a second list they categorize as momentum stocks. They then apply two separate filtering processes to glean a select list of short-selling candidates. To their fundamental list of names, they apply short interest statistics, merger and convertible arbitrage adjustments, and various other fundamental filters, including analyst activity. To their momentum list of names, they apply another set of filters that are based in part on short interest, the ratio of public to institutional ownership, and Internet stock bulletin board activity. Finally, they remove low-priced and illiquid stocks from both groups and apply certain filters to appropriately distribute stocks by industry group.

After all that work, Hammond and Frazer end up with 80 to 150 stocks that they short, making sure on a capitalization-weighted basis that no single holding within their funds represents more than 3 percent of assets under management. They hold these short positions for an average of six to nine months. Hammond and Frazer then overwrite this short equity exposure by selling an equal nominal dollar amount of out-of-the-money equity index puts. With the index put sale, a long component is added to the portfolio, which normally reduces overall market risk and smoothes portfolio returns. Hammond claims that this sale of overpriced puts achieves an added alpha (crudely defined as a better return for the same level of risk) of approximately 5 percent per annum, and changes the distribution of returns for his firm's funds from 100 percent short to a short bias of approximately 80 percent. Through stock picking alone, the firm also hopes to achieve 10 percent of added alpha against the inverse performance of the major equity indexes, with the strategy further benefitting from the short rebate received on stocks sold.

Arcas Covered Strategy's Expected Returns Against the Market This chart shows the expected returns (the red line) that Derivative Consulting believes it can achieve, net of all fees and expenses, from the Arcas covered short investment strategy. This line assumes current interest rates and a 10-percent alpha generated from the Arcas selection process. The returns for an investor that is 100 percent long the market (the blue line) are displayed for comparison purposes. For example, in an up 10-percent equity return year, an investor in Arcas should expect 6 percent returns. Actual returns may be higher or lower than those depicted, depending on how well Derivative Consulting's stock-filtering process performs. The graph is meant to provide some guidance on what investors should expect based on the strategies and methodologies used by Derivative Consulting.

In layman's terms, all this means that if the S&P 500 falls 15 percent for the year, Derivative Consulting would hope that its Arcas Covered strategy shows a return substantially greater than 15 percent. In an up-market, the strategy would likely lose money, but would at least be cushioned by the put premiums received. Derivative Consulting combines all of this, net of fees and expenses, in the theoretical chart (benchmarked vs. 50 percent short the S&P 500 and 50 percent short the Nasdaq Composite) that appears above.

"The option equivalent of what we create in Arcas Covered is a deep in-the-money short index call that trades at a very high volatility,” explains Hammond. "We short stocks, creating a minus-one beta portfolio and we then sell a basket of out-of-the money puts. A short-stock and short-put combination is synthetically a short call. It just so happens that the call we are synthetically selling trades at a very high volatility. Therefore, the Arcas Covered portfolio itself can be a valuable overlay to a traditional long portfolio.”

Although the Arcas Covered strategy has not been without significant month-to-month volatility (it had particular problems during the 1999 bull market when it lost 33 percent for the year), it was profitable in 1997, 1998 and 2000. Months like January 2001 show the sweet side of the strategy. Even though the major equity indices rallied during that period, equity index volatility waned after the Federal Reserve Board cut interest rates. As a result, the Arcas Covered strategy actually advanced 9.83 percent while other short-selling hedge fund managers suffered.

One way investors can compare the value of the strategy is to create their own market-neutral portfolio using futures or SPDRS on the long side and Arcas Covered on the short side. According to Hammond, if an investor had borrowed money to create a market-neutral portfolio that was $1 long and $1 short, and rebalanced it each month back to neutral, the combined portfolio would have returned an average annual compounded gain of 22.7 percent from 1996 through 2000. That return is well in excess of what many broadly diversified fund-of-fund portfolios returned during that period. "Since the long side of the portfolio is just an index in this example, the Arcas Covered portfolio, by definition, is creating all the positive alpha,” explains Hammond.

Frazer, Hammond's partner, loves this upside-down way of running money. "While most traditional fund managers are long the equity market, struggling to create alpha and buying expensive index puts as a hedge, we're taking the completely opposite approach,” he says. "We focus our efforts on the short side of the market where we believe we can achieve much higher alpha. Then we complement that short alpha with a source of long alpha by shorting the out-of-the-money index puts. The result, in our opinion, is an ideal hedging or blending portfolio for investors who need to diversify their investments by adding a hedging component.”

If the S&P 500 falls 15 percent for the year, Derivative Consulting would hope that its Arcas Covered strategy shows a return substantially greater than 15 percent.

Although that kind of talk may trigger skepticism among some, at least one option-savvy manager believes the Arcas strategy is theoretically more sound than other historical fund manager norms—particularly if the stock market continues to wallow. "For many years, there's been a group of managers making steady returns by buying stocks and selling cheap calls against them,” says Mark Spitznagel, the head trader at Empirica Capital. "These managers leverage themselves up and create the deceiving appearance of constant 17 percent returns. But in a rally, these guys underperform outright longs. And in a sharp sell-off, they risk getting massacred.”

"If you want a short biased-type manager, I can see why some might be attracted to this strategy,” says Spitznagel. Nonetheless, he remains worried about the many correlation risks being taken: "This style of trading certainly has significant correlation risk between the equity short positions and the index put shorts. You will likely make money in a down market, but you give up the home-run potential during a market crash. Indeed, returns might actually disappoint in such an environment if correlations go awry—as they invariably do during periods of market stress.”

So does the Arcas strategy truly create downside alpha?

Some may question the methodology behind the strategy, but from the firm's Bush Street offices atop San Francisco's financial district, Hammond and Frazer clearly think it does.

For more information, see www.ArcasFunds.com.