Transcript George Constantinides

The Premium for Hedge Fund
Lockups
Emanuel Derman
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Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Overview of Derman
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Claim: annual hedge fund returns are
predictable by past returns
Absent a lockup provision, investors should
annually re-allocate assets across hedge
funds to chase predictable abnormal returns
Lockup provisions hinder asset re-allocation
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Equilibrium Implications
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Derman calibrates a model of correlated
hedge fund returns
He compares two funds with 1-year and 2year lockups
Claim: in equilibrium, the fund with 2-year
lockup should command an annual
premium of ~ 90 bps
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Nun Lectures Hedge-Fund Managers
on Sex Education (and Alphas)
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Are annual returns predictable?
What annual premium, if any, should the fund
with 2-year lockup command?
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Methodological issues
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Survivorship bias—dead funds are dropped
from a data base
Practically all studies account for it
See: Brown S., W. Goetzmann, R. Ibbotson
and S. Ross, 1992, “Survivorship Bias in
Performance Studies”, Review of Financial
Studies 5, 553-580
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Methodological issues continued...
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Backfill bias—successful funds bring their
history when they join a database
Self reporting—ailing funds stop reporting
Self reporting—funds closed to new
investors stop reporting
Serial correlation due to stale NAV reporting
Dynamic strategies result in skewed returns
Betas are underestimated
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Empirical Evidence—1
Brown, Goetzmann, Ibbotson (1999)
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Off-shore funds
No persistence in annual raw returns: in 3
yrs, positive slopes, in 3 yrs negative slopes
Same results with style benchmarking
Same results with risk-adjusted returns
See: “Offshore Hedge Funds: Survival and
Performance: 1989-1995”, Journal of
Business 72, 91-118
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Empirical Evidence—2
Agarwal and Naik (2000)
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On-shore and off-shore funds
Pre-fee and net-of-fee returns
Persistence of quarterly returns
Insignificant persistence in annual returns
Persistence is unrelated to fund strategy
See: “Multi-Period Performance Persistence Analysis
of Hedge Funds” Journal of Financial and
Quantitative Analysis 35, 327-342
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Empirical Evidence—3
Baquero, ter Horst, Verbeek (2005)
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Account for self selection bias
Highest persistence in quarterly returns but
statistically weak in annual returns
The winners-minus-losers deciles annual
premium is 8%, but t-statistic is ~ 1
See: “Survival, Look-Ahead Bias, and Persistence in
Hedge Fund Performance”, Journal of Financial and
Quantitative Analysis 40, 493-517
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Why Do We Observe HighFrequency Persistence?
Annual only reporting—stale NAV
 Illiquid fund assets—stale NAV
 Fund performance smoothing
Therefore:
 High-frequency persistence not due to
unexploitable investment opportunities
 It is impractical for fund investors to switch
funds on a monthly or quarterly basis
 High-frequency persistence may be
unexploitableDiscussion
by investors
of
George Constantinides
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Emanuel Derman
University of Chicago
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See: Getmansky, M., A. Lo and I. Makarov
(2004) “An Econometric Model of Serial
Correlation and Illiquidity in Hedge Fund
Returns”, Journal of Financial Economics 74,
529-609
See: Chan, N., M. Getmansky, S. M. Haas
and A. W. Lo 2006, “Systemic Risk and
Hedge Funds”, Journal of Financial
Economics, forthcoming
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Empirical Evidence—4
Jagannathan, Malakhov, Novikov (2006)
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Account for all three biases:
-backfill
-self selection
-serial correlation
Find persistence in annual returns
See, “Do Hot Hands Persist Among Hedge
Fund Managers? An Empirical Evaluation”
NBER Working Paper
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Jagannathan et. al. Results
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Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Implied Probability of Fund Transition
from Superior to Neutral
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Transition probability from superior to
neutral: p
Transition probability from superior to
superior : 1-p (I follow Derman’s assumption
that a superior fund cannot become inferior
in 1 year)
0.051 x p + 1.277 x (1-p) = 0.797
p ~ 39 %
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Annual Premium on Fund with 2-year
Lockup
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Without lockup, 2nd-period alpha: 0.797 %
With lockup, superior fund becomes neutral
with probability 39% and has 2nd-period
alpha 0.133
With lockup, superior fund remains superior
with probability 61% and has 2nd-period
alpha 0.797
With lockup, expected 2nd-period alpha:
0.133 x 39% + 0.797 x 61% = 0.538 %
Annual premium: [0.797 - 0.538] / 2 = 0.13 %
Discussion of
Emanuel Derman
George Constantinides
University of Chicago
Summary
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vs.
Emanuel says...
in equilibrium, the fund with 2-year lockup
should command an annual premium of
~ 90 bps
Nun says...
at most ~ 13 bps
Lockup provisions may or may not impose
other handicaps on fund investors
Discussion of
Emanuel Derman
George Constantinides
University of Chicago