Hedge Funds and Financial Frontiers

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

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

3. 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.

4. 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”.

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

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

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

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. Pairs Profits Historically

14. 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.

15. 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.

16. 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.

17. 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.

18. 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?

19. 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.

20. 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?

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

22. 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.

23. 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.

25. 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.

26. 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.