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

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

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

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

5. 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

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

7. 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

8. 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

9. 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

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

11. Industry Performance

12. Summary Statistics

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

14. 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

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

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

17. 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

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

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

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

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

22. Performance by Style

23. Risk-Adjusted Performance 1989-1995

24. 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

25. Net Exposure: S&P 500 Beta

26. Hedge Fund Correlation to Bonds and Commodities

27. Market Neutral in Portfolio 1989 - 1995 Data Inputs

28. Minimum Variance Portfolio

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

30. Fund and Manager Survival

31. 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

32. Do Winners Repeat?

33. 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

34. 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