options and hedge funds

The original idea of "hedge" funds is that they're hedged; it's not exactly that they're "market neutral", though it can be that, and many of them claim to be.  (I expect somebody has gone back and looked at the correlation of the performance of some hedge funds for which they were able to get data and the performance of, say, the S&P 500, but I have no idea whether they actually got a result that was more or less zero or not.)  Hedge-fund performance, though, is often compared to the S&P 500, and I imagine the average hedge-fund investor might be slightly miffed over long periods of time not to beat the S&P 500, though over three to five years in a strong bull market the more sophisticated ones might not be.  In any case, what the relevant comparison is is a crucial part of the description of a particular hedge fund; in a bear market, a fund trying to beat the S&P 500 is doing better than a fund with the same performance that is supposed to be market neutral, while if they have the same performance during a bull market, the latter is doing better.

Over some time frame, though — I have an intuitive sense it's 3 to 5 years, but wouldn't be shocked if that were very wrong — if you were to buy an option (with a running rather than up-front payment) on a basket option paying the best of the S&P 500 (or some broader index), treasury bills, and some long bond index, the market-implied price on that option is going to be on the order of 100bp or something — in particular, is going to be low enough that no hedge fund would want to admit being unable to generate that much in excess return.  If you were going to do this, you might need to have even stricter than usual redemption rules to avoid adverse selection problems, but perhaps a "no-regret target hedge fund" would be attractive to some group of hedge fund investors.

(As a practical matter, it occurs to me that perhaps the "long bond index" should be "whatever we can hedge with CBOT bond futures", which is to say cheapest-to-deliver 15+y treasury bonds, which maybe aren't much of an index.  I imagine the hedge fund would largely view generating alpha and synthetically constructing the option as separate tasks.)