Behavioural Finance

Hedge Funds Big gains, big losses –(Amaranth loss 2006: $6bn – 66%; –T. Boone Pickens management fee: $1.4 bn; 650% return) Unregulated and not allowed to advertise publicly for business; or limited to knowledgeable high-net-worth individuals Total invested in hedge funds 2006 exceeded $1 billion, more than 10% of all mutual funds in US But individual hedge funds are smaller than most mutual funds ($10 bn is a big hedge fund; $100 bn is a big mutual fund)

Hedge Funds Most mutual funds do not have short positions; do not borrow and make little use of derivatives. Most mutual funds announce simple strategies Using these features, hedge funds employ complex and often secret strategies Cf. Stulz: Journal Economic Perspectives, 2007

Hedge Fund fees Standard mutual fund fees are not low: USA: Magellan Fund 0.57% +/- 0.2% But hedge fund fees are larger and asymmetric (e.g. 2% plus 20% of profits) Though “high watermark” rule gives some downside (Amaranth trader made $100 million before crashing – and he went off to set-up another hedge fund with his winnings)

Only high-wealth clients “Long Term even refused to give examples of trades, so potential investors had little idea of what they were doing.” The Long Term Capital Fund: 1995–1997, average yearly return net of fees was 33.4 percent). Beginning of 1998: Capital $5 bn; Assets $120 bn In the aftermath of the Russian crisis in August 1998, the fund lost almost all its capital in one month. Secrecy helps hedge fund managers protect strategies from imitators;...but: secrecy makes it harder to assess the risk of a fund. Typical hedge fund investor may spend $50,000 investigating a fund before investing

Hedge fund strategies Long–short equity hedge fund (31%) [alpha not beta] Event-driven hedge fund (20%) Macro hedge fund (10%) Fixed-income arbitrage hedge funds (8%) Many have mixed strategies Other strategies: emerging markets funds, funds that trade futures contracts Long-Term Capital Management: “vacuuming pennies” — though maybe better to say picking up pennies in front of a steamroller.

Cumulative Hedge Funds Returns Graph to end-October 2008

Hedge funds returns and risk Average of funds looks good: –Long-term return about the same as market –Lower volatility of average fund and –Uncorrelated with big market moves (alpha not beta) But: –Individual funds more volatile; also risk of losing everything – variance not an adequate measure –Fund of funds – was not available in the past; more fees! –Survivor bias, reporting bias Summary of evidence: –On average hedge funds earn about 3% per annum alpha (after fees). –The randomly chosen hedge fund earns positive but statistically insignificant return (after fees) –Good performance predicts more good performance

US University endowment funds

Passive management Why pay high mutual fund fees when only 28% of managed funds beat the market? Much lower fees Much less risk Almost all economists recommend for small-to-medium investors in the markets of advanced economies But: can’t work for the market as a whole May be opportunities outside the organized markets