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

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

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

Yale School of Management 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

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

Yale School of Management Defining Hedge Funds Limitations on: –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

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

Yale School of Management 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

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

Yale School of Management Industry Performance

Yale School of Management Summary Statistics

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

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

Yale School of Management Market Neutral Classic Hedge Fund –true arbitrage on convertibles & derivatives –index arbitrage –fixed income arbitrage –pairs trading –APT arbitrage in expectations

Yale School of Management Market Trend/Timing Timing U.S. Markets –exploit technical analysis Timing Global Markets –seek country opportunities

Yale School of Management 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

Yale School of Management Short Sellers Seeks overvalued equities to short may hedge market exposure or may not

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

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

Yale School of Management Commodities/ Options/ Futures Distinction from CTA’s is blurred Speculate in commodities markets

Yale School of Management Performance by Style

Yale School of Management Risk-Adjusted Performance

Yale School of Management 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

Yale School of Management Net Exposure: S&P 500 Beta

Yale School of Management Hedge Fund Correlation to Bonds and Commodities

Yale School of Management Market Neutral in Portfolio Data Inputs

Yale School of Management Minimum Variance Portfolio

Yale School of Management Manager Track Records Does survivorship matter? Does positive performance persist? Is bigger better? Do benchmarks matter?

Yale School of Management Fund and Manager Survival

Yale School of Management 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

Yale School of Management Do Winners Repeat?

Yale School of Management 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

Yale School of Management 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