Hedge Funds and Financial Frontiers William N. Goetzmann Yale School of Management

What Are Hedge Funds? “Unregulated investment companies.” – SEC. “You cannot define us, we all do such different things.” – Industry participants.

Hedge Funds as Explorers Operate on the frontiers of markets. – They discover, and define the frontiers of knowledge in finance. They exploit temporary deviations from economic value. – Discovering something new can have great value. – Once discovered analyzed and “cleared”, the frontier recedes, the extraordinary profit replaced by modest gains.

Long-Only, Passive Investing The “farmers” in the financial system. Profit from the equity (or another) risk premium. Their return and risk can be forecast. Their strategies can be classified in a stable manner. The active part of their portfolios is only a little bit of exploration – residual “Alpha”.

Hedge Funds: 1. Define the frontiers of finance. 2. Develop the knowledge to understand markets. 3. Must constantly re-adapt to new frontiers. 4. Will never be entirely transparent. 5. Will never be benchmarked well by factor models - - “Alpha.” 6. Provide some academics with a constant flow of research topics -- real anomalies!

Frontiers New Places New Assets Event Horizon Information Frontier The Macro-Frontier The Micro-Frontier

New Places Russia – Debt, equity, governance. Eastern Europe – Liquidity, transformation. Asian markets – Emergence. Next? Do hedge funds set prices in these markets?

New Assets Options (late 1970’s) Mortgage-backed securities (1980’s) Warrants (1980’s) Index derivatives (1980’s and 1990’s) Credit derivatives (late 1990’s) Mutual fund pricing (1990’s and 2000’s) Issues: mispricing must still exist, or else hedge funds are simply market-makers. Financial industry relies upon hedge funds to launch trade in new securities.

Event Horizon Hold event risk that others do not naturally want to hold. M&A Risk Arbitrage – Small chance of a deal blowing up in your hands. Distressed Investing – Most don’t want to go through the sewer-pipe of bankruptcy to get to the other side.

Information Frontier Information is entropic. – It diffuses through markets. – Not uniformly: waves and turbulence in the transmission. Second Law of Thermodynamics. – Information is energy, and thus costly. Law of One Price – Depends upon perfect diffusion.

Information Frontier Hedge funds analyze the structure of the information frontier. – Behavioral finance creates dams in the flow. – Regulatory constraints (e.g. short-sales) affect flow. – New investment by funds creates new information. Hedge funds “surf” on the flow. Price impact means that they facilitate diffusion. They cannot remain forever out in front of the information flow. – Must look for a new wave all the time.

An Example: Statistical Arbitrage Pairs Trading – Take two similar stocks. When their prices diverge, bet on convergence. Efficient market theory implies a random walk and no profits. Profits may be explained by delayed information diffusion from one stock to the other. Profits may also be due to market over-reaction to news, and a reversal of reaction effects.

Pairs Profits Historically

The Macro-Frontier Understanding the structure of the financial universe. – Global supply and demand for money. – Political economy of sovereign debt. Develop models or intuition for making links across borders and markets. – Exploit local focus (narrow valuation models). – Exploit imperfect diffusion across borders.

The Micro Frontier Each market itself is a frontier. Micro-structure of how each price is formed. – Supply and demand in a complex, strategic time-series of interactions. – Process involves people and financing issues. Game theorists and game players at the same time. – Should a sequence of sells followed by a sequence of buys be profitable? Micro-traders can make hundreds of daily trades. – They play a vital role in process of price discovery and efficiency.

An Example: Sequential Price Impact Trades reflect private information. – The way they impound it makes a difference. Micro-structure theory says a sequence of share purchases should have the same net impact a block trade. Theory also says 300 share purchase should affect the price equally to a 300 share sell. Empirical evidence suggests these do not always hold, and sequential arbitrage strategies may be possible.

The Expanding Frontier Financial engineering and hedge funds. – Funds adapt new technology, test it, refine it apply it. – Valuation based upon financial modeling. Models get out – Even proprietary models ultimately diffuse. – Price impact propagates their effects. If the model is right, market drives prices to model. – Farmers move in, explorers move out.

New Frontiers Some funds have capacity to keep exploring new frontiers. Why? – Personality? Lateral thinking? – Technological advantage? Good models for new frontier? – Superior R&D skills? – An urge to explore and willingness to risk?

Transparency A trade-off between transparency and access to external capital. Current situation indicates that there is plenty of capital comfortable with current transparency. Transparency works for farmers not for explorers. Transparency removes motivation to explore and develop the financial frontier. Investors should know they are putting money into frontier ventures.

Performance Evaluation Standard approach uses benchmarks – Stock index (large stocks) – Fixed income index (actively traded bonds) Funds trade in the marginal securities in these universes. Funds react quickly to opportunity. – Any given benchmark may only be valid for a matter of days. Flexible benchmark models? Absolute return?

Flexible Benchmark Models Time-varying factor models Mamaysky, Spiegel and Zhang (2002) Skill is persistent once dynamic betas are estimated.

Share Valuation Funds trade in securities that, by their very nature, are not efficiently valued. Example: International mutual funds – Hedge funds used economic value, mutual funds used yesterday’s value. – No market price available to settle the question. – Which price would you use to mark to market? Marking to model vs. market.

Classification Style classifications rely upon steady performance expectations from specific activities. These activities have a limited shelf life. Styles will emerge and disappear as the frontier shifts. Stylistic analysis needs to allow for these changes. Non-linear exposures are also evident.

Hedge Funds Depend upon an expanding universe of markets. Depend upon the tendency of markets towards efficiency. Rely upon the creation and use of proprietary knowledge. Eventually pass this knowledge on. Ultimately push the frontier beyond current boundaries and must follow it.

Future Frontiers will always exist. – Profits will always be made from opening up new markets. Information production is not free. 2nd Law of Thermodynamics. – Diffusion may or may not be compensated at the same rate, however. – Pairs trading models on the web, for example. Competition may increase or decrease. – Will depend on the relative attractiveness of farmland vs. frontier. – Will also depend on tolerance for uncertainty.