Hedge Funds and Financial

Frontiers

William N. Goetzmann
Yale School of
Management
What Are Hedge Funds?

“Unregulated investment companies.”

– SEC.

“You cannot define us, we all do such
different things.”
– Industry participants.
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.
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”.
Hedge Funds:

1. Define the frontiers of finance.

2. Develop the knowledge to understand markets.
3. Must constantly re-adapt to new frontiers.
4. Will never be entirely transparent.
5. Will never be benchmarked well by factor models -
- “Alpha.”
6. Provide some academics with a constant flow of
research topics -- real anomalies!
Frontiers

New Places

New Assets

Event Horizon

Information Frontier

The Macro-Frontier

The Micro-Frontier
New Places

Russia
– Debt, equity, governance.

Eastern Europe
– Liquidity, transformation.

Asian markets
– Emergence.

Next?

Do hedge funds set prices in these markets?
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.
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.
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.
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.
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.
Pairs Profits Historically
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.
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.
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.
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.
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?
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.
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?
Flexible Benchmark Models

Time-varying factor models

Mamaysky, Spiegel and Zhang (2002)

Skill is persistent once dynamic betas are
estimated.
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.
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.
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1/31/1993 6/15/1994 10/28/1995 3/11/1997 7/24/1998 12/6/1999
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.
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.