William N. Goetzmann Yale School of Management Hedge Funds William N. Goetzmann Yale School of Management

Overview Background Industry Performance Management Styles Hedge Funds as Portfolio Assets Manager Track Records

History and Background Alfred Winslow Jones Sociologist Fortune Editor Fund Manager 1949 Partnership market-neutral position high incentive fee leverage

Theory of Hedge Funds “Arbitrage in expectations” Short position’s exposure matches long position’s Short finances long Market neutral investment

Basis of Hedge Fund Returns Manager skill in identifying opportunities Not derived from passive long position Focused on “imperfect” market sectors Depend critically upon special skills and knowledge

Defining Hedge Funds Freedom from ICA (1940) controls on: leverage short-selling cross-holding 10% limits incentive compensation derivatives positions

Defining Hedge Funds Limitations on: Information problems: number of U.S. investors (99 maximum) solicitation of U.S. investors public advertising and disclosure Information problems: no public performance records data vendors only maintain “live fund” data

A Sample of Hedge Funds Survivorship issues U.S. Offshore Hedge Fund Directory Annual returns, 1989 - 1995 Net of fees and expenses Includes defunct funds Brown, Goetzmann & Ibbotson, Offshore Hedge Funds, Survival and Performance, 1997 Yale Working Paper

Offshore Funds Based in tax havens Invest alongside major domestic entities Represent a substantial portion of the industry 399 Funds with $40 Billion in 12/1995

Manager Compensation Fixed fee 1% to 2% Incentive fee 10% to 30% [20% typical] of positive return High water mark provision

Industry Performance

Summary Statistics 1989 - 1995

Manager Styles Event-Driven Market Neutral Market Trend/Timing Opportunistic Investing Multi-Strategy Short Sellers Sector Funds Global Macro Fund of Funds Derivatives

Event-Driven Distressed Securities Risk Arbitrage bankruptcy reorganization equity and debt Risk Arbitrage position in acquired and acquirer trade on collars and other options hedge with derivatives

Market Neutral Classic Hedge Fund true arbitrage on convertibles & derivatives index arbitrage fixed income arbitrage pairs trading APT arbitrage in expectations

Market Trend/Timing Timing U.S. Markets Timing Global Markets exploit technical analysis Timing Global Markets seek country opportunities

Opportunistic Investing Largest Category of Hedge Fund Value liquidation value, book value, out-of-favor Growth future earnings potential Short-Term Hold active trading to exploit opportunity

Short Sellers Seeks overvalued equities to short may hedge market exposure or may not

Global Macro Soros style Currency speculation with futures instruments Forecast influence of global macro trends on liquid instruments

Fund of Funds Select multiple managers Use track records for choice Promote diversification major issue, since good funds are closed to small investors.

Commodities/ Options/ Futures Distinction from CTA’s is blurred Speculate in commodities markets

Performance by Style

Risk-Adjusted Performance 1989-1995

Hedge Funds as a Portfolio Asset Low Correlation to U.S. Market Negative Correlation to GS Commodity Index Positive Correlation to Fixed Income Low Correlation Across Styles Neutral Position Attractive to Diversified Investor

Net Exposure: S&P 500 Beta

Hedge Fund Correlation to Bonds and Commodities

Market Neutral in Portfolio 1989 - 1995 Data Inputs

Minimum Variance Portfolio

Manager Track Records Does survivorship matter? Does positive performance persist? Is bigger better? Do benchmarks matter?

Fund and Manager Survival

Survivor Bias in Track Record Chance of surviving six years <20% Managers survive more than funds Bias in annual return estimates for the index are 100 to 300 BP May be higher for individual fund

Do Winners Repeat?

Same Results For: Winner defined as positive alpha Winner defined as positive information ratio Pre-fee performance Style-adjusted performance Size as predictor of performance

Conclusions Positive risk adjusted performance even with survival bias considered alphas, Sharpe ratios, information ratios Excellent portfolio asset some styles have low correlations ideal for institutional investors Funds of Funds not that successful track records are misleading hard to identify consistent top performers