Hedge Funds

1. Hedge Funds John H. Cochrane University of Chicago Booth School of Business

2. What are hedge funds? • Legal/Fee: “A compensation structure disguised as an asset class” • Strategies/Marketing: “Absolute returns,” “Alternative asset class," "market-neutral," "alpha," "providing liquidity," "arbitrage," "leverage," “exploit inefficiency.” • An insider view: “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.” -Cliff Asness, Journal of Portfolio Management

3. Returns (1990-2009) Mean Std Dev Sharpe HF Index 5.74 7.76 0.74 Market Index 5.35 16.12 0.33

4. Returns – Skill vs. luck? • It is nearly impossible to measure skill from past hedge fund returns. • Many hedge fund investors chase funds with good past returns, and are perpetually disappointed. • Why is it so hard? …

5. The Tyranny of σ/√T • Uncertainty about average return = volatility(σ) / √ horizon • Hedge fund: 15%/√5=6.7%! Mutual fund: 1%//√5= 0.4%

6. Return example • Test: Find the good funds? 1 = make money 0 = lose money A B C D E F G H I J K L M N O P Q R S T 2007 1 0 1 0 1 0 0 1 0 0 0 0 1 0 0 1 0 1 0 1 2008 1 0 0 0 0 0 0 0 1 1 0 1 0 1 0 0 0 1 1 1 2009 0 1 0 1 1 0 1 1 0 1 1 1 1 1 0 0 1 0 0 1 2010 1 1 0 1 1 1 1 1 1 1 1 1 0 1 0 0 0 0 1 1 2011 1 1 0 1 1 0 1 1 1 0 0 0 1 1 1 0 1 1 1 1

7. Return example • Test: Find the good funds? 1 = make money 0 = lose money A B C D E F G H I J K L M N O P Q R S T 2007 1 0 1 0 1 0 0 1 0 0 0 0 1 0 0 1 0 1 0 1 2008 1 0 0 0 0 0 0 0 1 1 0 1 0 1 0 0 0 1 1 1 2009 0 1 0 1 1 0 1 1 0 1 1 1 1 1 0 0 1 0 0 1 2010 1 1 0 1 1 1 1 1 1 1 1 1 0 1 0 0 0 0 1 1 2011 1 1 0 1 1 0 1 1 1 0 0 0 1 1 1 0 1 1 1 1 • Survivor bias. A) in databases B) in your office (4-5!) A B C D E F G H I J K L M N O P Q R S T 2007 1 0 1 0 1 0 0 1 0 0 0 0 1 0 0 1 0 1 0 1 2008 1 0 0 0 0 0 0 0 1 1 0 1 0 1 0 0 0 1 1 1 2009 0 0 1 1 0 1 1 1 1 0 0 0 1 2010 1 1 1 1 1 1 0 1 0 1 1 2011 1 1 1 1 1 0 1 1 1 1 wins 4 4 4 3 4 3 3 4 3 5

8. Return Biases and Statistics • Backfill bias in mean returns : • Survivor bias in mean returns : • Fraction of Top half hedge funds that repeat: 51.56% →Chasing recent performance is a terrible strategy! • These are databases! “In your office” bias is much worse. T statistic is useless. • → You can’t “Evaluate this fund’s skill.” At best you can “evaluate this strategy for picking funds.” No known rule works. -Source: Malkiel and Saha Financial Analysts Journal

9. Risk?

10. Return smoothing or illiquidity value • Reported • True • Variance and sensitivity to market (beta) are understated • Sharpe ratio mean/std. dev is overstated • Reported returns are serially correlated time

11. Return smoothing or illiquidity return autocorr. v(12)/12xv(1) --------------------------------------------------------------------- HFIndex 0.20 1.554 ConvArb 0.56 2.820 ShortBias 0.09 0.787 EmergMkt 0.31 1.899 EquitMktNeut 0.06 1.184 EventDriven 0.36 2.122 Distress 0.39 2.401 Multi-Strat 0.30 1.918 RiskArb 0.27 1.179 BondArb 0.53 2.453 GlobalMacro 0.08 1.316 LongShtEqty 0.20 1.346 MgdFuture 0.05 0.621 1993-2010

12. Alphas and betas • We break returns in to two components • β : tendency of return to rise if the market rises • β x rm: • Return you can get in an index fund. (“Style”) • Return = Skill vs. luck, now index exposure. • No need to pay fees. • Risk management. • α + ε : Return earned in excess of style. (“Selection”) • Mutual fund: α = +/-1%; β=1; ε = 1-2% • Hedge fund: α = big?; β=0?; ε = 10-15% • “Market neutral,” “Alternative investment,” “Absolute return?”…

13. Hedge fund index and market return

14. Long/short equity: zero portfolio weight doesn’t mean 0 exposure

15. Emerging markets. Names are not betas!

18. Alpha or “exotic beta”? • Many semi-passive styles earn premiums for bearing new dimensions of risk • Equities: Value, small cap, momentum,…; • Fixed income: term spread, credit spread, currency carry…; • Dynamic trading, “liquidity provision”: writing put options or straddles • Just as important for fee, skill, risk management…

19. Value-growth factor: Mechanical using book/market ratios Good return, uncorrelated with market.

20. Momentum—buy winners, short losers

21. Credit spread factor (BAA-AAA returns)

22. Term: Borrow short, lend long

23. Writing put options • You collect a fee, only pay off if the market goes down a lot. • Provide “disaster insurance” Most of the time, stock ends up here. You make a small profit independent of stock price. Looks like “alpha”, “arbitrage”. Fee (put price) Stock price Today’s price Rarely, the stock ends up here. You lose a huge amount Writing put profit

24. Put-writing returns • “Pennies in front of a steamroller” • “Writing catastrophe insurance” • “Providing liquidity to markets” • “Short volatility” • Large chance of not seeing loss in track records • Standard volatility risk metrics fail miserably

25. “Equity market neutral” hedge fund returns

26. Bond “Arbitrage”. (Really a credit spread put)

28. Dynamic Trading = Options! Writing put profit Stock price “Contrarian” – more stocks at lower price Put value • “We don’t trade those dangerous derivatives” • Maybe you do and you don’t know it!

29. Option-like return example: Merger “arbitrage”. Price • Large chance of a small return if successful. (Leverage: a large return) • Small chance of a large loss if unsuccessful. • The strategy seems unrelated to the overall market, “beta zero” • But…offer is more likely to be unsuccessful if the market falls! • Payoff is like an index put!

30. Quiz: Is this a good fund? (Real data)

31. Quiz: Is this a good fund? (Real data)

32. Quiz answer: Fairfield Sentry (Madoff Feeder)

33. Implications and challenges Summary: • Need to know “alternative betas” for risk management if not benchmarking, “skill.” • Regressions won’t work. Need portfolio analysis/disclosure Alpha vs. “exotic beta”: • The whole style/selection alpha/beta inefficiency/risk concept is outdated. • Manager: “that’s not passive/style, that’s my alpha!” • Alpha/inefficiency is a zero-sum game, and should be diversifiable. • Alternative beta: Bets all move together. OK to share risks. “Beta is earned from people who think they are earning Beta, Alpha is earned from people who think they are earning Alpha. With Beta, it's possible for both sides to be correct and happy, …. With Alpha, one side is wrong.” (Aaron Brown) • There is no alpha vs. beta. There is only beta you understand and beta you don’t.

34. Fees, incentives, and options Management fee 2% + 20% 2% Portfolio value • Quiz: Name this payoff

35. Fees, incentives, and options • (0), 2%, 20% = a call option. • Incentive for needless volatility/option writing. (Financial crisis more generally) • Responses? Coinvest, “Reputation,” High water marks. Do they work? • Hot money and magic alpha: Liquidity, withdrawals, Catch 22, lockups. • A stop loss order is not a put option. • Maybe you want to keep the others from leaving! • The contract structure matters!

36. HF as part of a portfolio A large institutional investor’s portfolio • The Absolute Return portion of the portfolio is primarily invested in non-directional hedge funds. That is, returns should be independent of the direction of global equity, fixed income or currency markets. Strategies include Global Convertible Arbitrage, Global Merger Arbitrage, Long/Short Equity and Blended Strategies….

37. Hedge funds as part of a portfolio • Problem 1: Risk management. • Will all HF go down together? • Will HF lose when everything else loses? • Betas! • Problem 2: Cost and fee explosion. • Is HF short something you own? • Portfolio is (10 A, 10 B). HF is long A short B. • Is (11A, 9 B) worth short cost, 2+20 fee? • Are HF offsetting? • HF #1 long A, short B. HF #2 short A, long B. • You pay ½ ( 2 + 20 ) for sure, plus short costs for nothing. • Cost explosion – portfolio of options ≠ option on portfolio. • 100 mean zero stocks in one fund: 2% for sure. • 100 stocks in 100 funds: 2% + ½ (20%) for sure!

38. Silliness in HF portfolios/investing • “Hedge funds give us diversification” • You can’t be more diversified than the market portfolio. If you have A and B, adding (long A, short B) does not make you more diversified. • “We need to add ‘alternative investments,’ ‘new asset classes’ to ‘make our rate of return targets.’” • Most HF are not a new asset class. They trade in exactly the same stuff you already own. And you can’t wish returns. • “We hold a lot of funds to diversify across managers” • And get back to the market portfolio. • If so, 2+20 is a disaster! • Hedge style betas with passive, not multiple active investments! • “If things get bad we’ll sell on the way down, limit tail risk” • Fallacy 101. A stop order is not a put option. Sell to who?

39. HF: A brilliant marketing success in a marketing business. • “Absolute Returns,’’ ”Market-Neutral,” “Alternative asset,” “Near-Arbitrage”… “Alternative beta,” • They separate rich people, money! • 2% + 20% “We only charge if we win.” • Names, fees: Good “framing” to ignore portfolio, evaluate as standalone investments. • “Business model” is the biggest key to success!

40. Many opportunities • Complex products, trading strategies need expert investors (HF). • There are rewards to new “style” risks. • HF organizational form can be a useful way to access these investments. • Lots of opportunities to run better funds, form portfolios, manage risks, write better contracts, better marketing/business model, just avoid silliness.

41. Summary I Returns • Skill vs. luck? Hard to tell. Survivor bias – in your office bias • Smoothing: more risk than you think • Betas: More beta than you think • Many alternative betas. Option-writing and hundred-year floods • Alpha/beta is outdated. Many exotic betas. II Fees, incentives, options, and contracts • Incentives for risk, managing losses, liquidity. III Hedge funds in a portfolio. • Is one short what the other is long? IV Silliness in HF investing. Marketing. Opportunities/challenges if you get it right.

42. Extra slides

43. Returns? • Skill vs. Luck? • Survivors / backfill / self-reported? • “Is this fund good?” • Portfolios of funds to study styles

44. Returns—survivor bias

45. Source: Mitchell and Pulvino, using CFSB/Tremont merger-arb index • News: 1) “occasional catastrophes’’ 2) catastrophes more likely in market declines

46. Return benchmarks SPPo = return from rolling over out-of-the-money puts Source: Agarwal and Naik RFS, using HFR data • Morals: • Including option benchmarks can reveal big betas. • And hence alphas a lot less than average returns.

47. Bottom line so far • Return statistics: Short, selected, managed. • Betas on many new styles; Option-like returns with big tails. • Standard view of investor-manager relation. • Both sides understand betas • Clear “style” (no fee) vs. “selection” (fee, information,skill) separation. • Investor has already optimized “style” choice in passive investments. • Our world • HF sketchy on betas, premiums, investors have no clue. • Investors have not thought about multiple betas, passive “styles.” • There is no alpha, there is only beta you know and beta you don’t know. • Alpha based on track record, statistical analysis is close to hopeless. • Large rewards for figuring out how to answer these questions!