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Hedge Funds

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

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Hedge Funds

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  1. 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: • 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, 1989 - 1995 • 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 1989 - 1995

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

  14. 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

  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 • 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 Portfolio1989 - 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

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