Transcript Slide 1

Hedge Funds
John H. Cochrane
(I-Can’t-Get-You-A-Job-At) AQR Capital
Management Professor of Finance
University of Chicago Booth School of
Business
What are hedge funds?
• Legal / Fee
• Strategies: “Abolute returns,” “Alternative asset class,"
"market-neutral," "alpha," "providing liquidity,"
"arbitrage," "leverage," "long-short“
Strategies
•HF do lots of different things.
•Strategy gobbledygook. Who knows what any of this means?
•Obscure strategies seems an important part of HF marketing
What are hedge funds?
• Legal / Fee
• Strategies
• 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 2004.
• Big employer of Booth Grads!
• Let’s use your Booth training to think about them!
Returns
Annualized returns 1990-2009
Mean σ Sharpe t stat
HFIndex
5.74 7.76 0.74 ( 2.96)
ConvArb
4.18 7.19 0.58 ( 2.33)
ShortBias
-4.63 16.90 -0.27 (-1.10)
EmergMkt
5.46 15.59 0.35 ( 1.40)
EquitMktNeut
2.62 10.74 0.24 ( 0.98)
EventDriven
6.47 6.05 1.07 ( 4.28)
Distress
7.39 6.67 1.11 ( 4.43)
Multi-Strat
6.08 6.42 0.95 ( 3.79)
RiskArb
3.70 4.15 0.89 ( 3.56)
BondArb
1.40 6.05 0.23 ( 0.93)
GlobalMacro
8.78 10.25 0.86 ( 3.43)
LongShtEqty
6.84 10.00 0.68 ( 2.74)
Market Index
5.35 16.12 0.33 (1.33)
Returns
Returns?
•
•
Skill vs. Luck? -> Portfolios
Survivors / backfill / self-reported?
Returns—survivor bias
Return Biases and Statistics
•Backfill bias:
Backfill
Not Backfilled
14.65%
7.34%
•Survivor bias:
Live
Defunct
Both
Hedge
13.74%
5.39%
9.32%
Mutual
9.73%
5.20%
8.49%
•Good funds?
•Fraction of Top half that repeat: 51.56%
-Source: Malkiel and Saha Financial Analysts Journal
Risk??
•Quiz… How do we measure risk?
Alphas and betas – a reminder
• We often characterize returns for fund i by
rti  i  i rt m   ti
E  r i    i  i E  r m 
• Beta: tendency of return to rise if the market rises
• Beta times rm: How much of the return can you get in
an index fund. (“Style”)
• Alpha: average return earned in excess of this.
(“Selection”)
• Epsilon: extra risk beyond index fund.
Why do we care about beta so much?
rti  i  i rt m   ti
E  r    i  i E  r
i
•
•
•
•
•
•
•
m

Beta: how much adding a bit of i raises the portfolio variance
No point to paying fees for beta x rm that you can get in an index fund.
With beta, you or fund can short beta x rm to remove market risk
Beta: two managers doing the same thing?
Index futures as an “alternative asset” to get diversification?
Names don’t matter! Only betas matter!
In fact, you want to know betas corresponding to all passive strategies!
rt  i   r  i (valuet )  i (bondst )  ...  
i
m m
t
i
v
b
i
t
Returns and betas
Option betas?
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
Put writing returns
Return
Write OTM put returns
Time
Option-like returns: beware averages (even more)
• If the return is (1, 1, 1, 1, 1, -10, 1, 1, 1, -10, 1, 1, 1, 1,…) you are
likely to see only +1, “we consistently outperform the market.’’
• The actual mean return depends on how likely the disaster -10 is.
You need a long history to figure that out based on statistics.
• Like writing earthquake insurance.
• The distribution of profits from writing puts is very far from normal:
Probability
Put expires out of money; pocket put price
Stock falls more than, say, 20%. Lose big!
0
Profit
Dynamic Trading = Options!
Writing put profit
Stock price
“Contrarian” – more stocks at lower price
Put value
Option-like return example:
Merger “arbitrage”.
Price
Merger announced
Merger completed
Offer price
Buy
Merger fails
Time
• 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!
•Source: Mitchell and Pulvino, using CFSB/Tremont merger-arb index
•News: 1) “occasional catastrophes’’ 2) catastrophes more likely in market declines
Return benchmarks
rti  i  isp rt sp  iSPPo SPPot  si SMBt  hi HMLt  ti
ER
(%/mo)
alpha
SPPo
(puts)
SMB
(size)
HML
(value)
Event Arb
1.03
0.04
-0.92
0.15
0.08
Restructure
1.29
0.43
-0.63
0.24
0.12
Event driven
1.33
0.20
-0.94
0.31
0.12
Rel. value arb
1.15
0.38
-0.64
0.17
0.08
SPPo = return from rolling over out-of-the-money puts
Source: Agarwal and Naik RFS, using HFR data
• Morals:
1. Including option benchmarks can reveal big betas.
2. And hence alphas a lot less than average returns.
Hedge fund index and market return
Multi-Strategy index and market return
Long-Short equity index and market return
Global-macro index and market return
Event-driven index and market return
Equity-market-neutral index and market return
Emerging-market hedge fund index and market return
Distressed investing index and market return
Convertible-Arbitrage index and market return
Bond-Arbitrage index and market return
Next: compare to alternative passive strategies
Momentum
Value-Growth
BAA – AAA
(see bond, convertible)
Term premium (borrow short, lend long)
Implications and challenges
•
Need lots of factors = benchmarks.
1. Market, value, size, momentum, term, default, currency…
2. Plus options on all of these.
3. (Next: + mechanical timing strategies.)
•
Standard regression method is strained to the limit.
1.
2.
3.
4.
More right hand variables than data points.
HF styles shift – betas not constant over time.
HF style groups mean little.
Beta is still the right question but we need better ways of
getting the answer. Portfolio analysis!
Implications II
• Whole style/selection concept is outdated.
1. “Style” (beta x E(f), passive, beta known and hedged, no
fee) vs. “selection” (alpha, active, fee)
2. “You could get HF return with xyz mechanical strategy.” (e.g.
write put.) -- But most investors don’t.
3. How many investors know their exposures to value, size,
momentum, put options, etc.; understand the premiums, and
can program the computer?
4. Maybe “style” is “selection,” worth a fee! “This is my skill”
5. There is no alpha vs. beta. There is only beta you
understand and beta you don’t understand.
6. Challenge = opportunity!
Fees
•
Management + performance.
– Often 2% + 20% of gains.
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Funds of funds charge 2% + 20% too!
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→ Massive number of new funds!
→ How do they attract money, and
maintain such high fees?
Fees, incentives, and options
Management fee
2% + 20%
2%
Portfolio value
•Quiz: Name this payoff
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
• Liquidity, withdrawals, Catch 22, lockups.
• The contract structure matters!
• Challenge = opportunity!
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….
Hedge funds as part of a portfolio
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Problem 1: Risk management.
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Will all HF go down together?
Will HF lose when everything else loses?
Betas!
Problem 2: Cost and fee explosion.
1.
Is HF short something you own?
a. Portfolio is (10 A, 10 B). HF is long A short B.
b. Is (11A, 9 B) worth short cost, 2+20 fee?
2. Are HF offsetting?
a. HF #1 long A, short B. HF #2 short A, long B.
b. You pay ½ ( 2 + 20 ) for sure, plus short costs for nothing.
3. Cost explosion – portfolio of options ≠ option on portfolio.
a. 100 mean zero stocks in one fund: 2% for sure.
b. 100 stocks in 100 funds: 2% + ½ (20%) for sure!
Silliness in HF portfolios/investing
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“Hedge funds give us diversification”
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“We need to add ‘alternative investments,’ ‘new asset
classes’ to ‘make our rate of return targets.’”
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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.
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.
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If so, 2+20 is a disaster!
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Hedge style betas with passive, not multiple active investments!
“If things get bad we’ll sell on the way down, limit tail risk”
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Fallacy 101. A stop order is not a put option. Sell to who?
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
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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!
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!
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, help form
portfolios, manage risks, write better contracts, better
marketing/business model, just avoid silliness.
The end
• More? Take Advanced Investments 35150
• Questions?