1© 2000 William N. Goetzmann and Stephen A. RossHedge Funds: Theory and Performance1William N. Goetzmann, Yale University Stephen A. Ross, Massachusetts Institute of TechnologyOctober 1, 2000IndexI. Introduction ........... Page 1 of 50II. What is a Hedge Fund? . . Page 2 of 50III. A Theory of Hedge Funds.................. Page 4 of 50III.1 Arbitrage Pricing: RiskExposureIII.2 Arbitrage Pricing: an exampleIII.3 Hedge Funds and ArbitragePricingIII.4 The ‘Hedge’ in Hedge FundsIV. Key Issues ........... Page 11 of 50IV.1 Relative ValuationIV. 2 Market NeutralityIV. 3 Imperfect MarketsIV.4 Strategic ConsiderationsV. Hedge Fund Risk ...... Page 15 of 50V.1 Model RiskV.2 Convergence RiskV.4 Fund of FundsVI. Hedge Fund Styles .... Page 19 of 50VI.1 Relative Value StrategiesVI.1.i EquitiesVI.1.ii Fixed-IncomeVI.1.iii DerivativesVI.2 Event-Driven StrategiesVI.2.i Risk ArbitrageVI.2.iii Special SituationsVI.3 Tactical StrategiesVI.3.i Global MacroVI.3.ii Market Trend/TimingVI.3.iii Directional VII. Hedge Fund Performance................. Page 27 of 50VII.1 Data Issues - Survivorship BiasVII.2 Skill MetricsVII.3 Sharpe RatioVII.4 Manager AlphaVII.5 Information RatioVIII. Historical Performance................. Page 32 of 50VIII.1 Industry Trends VIII.2 Return CalculationsVIII.3 Mean returnsVIII.4 Sharpe RatioVIII.5 Alpha and Information RatioVIII.6 StrategiesVIII.7 StylesIX. Hedge Funds as Portfolio Assets................. Page 42 of 50X. Conclusion ........... Page 43 of 50 Table 1: Hedge Fund Industry Trends................. Page 45 of 50Table 2: Hedge Fund Performance 2/1977 -12/1988 .......... Page 46 of 50Table 3: Hedge Fund Performance January,1989 - January, 1993................. Page 47 of 50Table 4: Hedge Fund Performance January,1994 - May, 2000 . . . Page 48 of 50Table 5: Correlation of Self-Reported FundStyles and Asset Classes................. Page 49 of 50Table 6: Multi-factor Risk Exposure of HedgeFund Aggregates and Styles................. Page 50 of 50Page 1 of 48© 2000 William N. Goetzmann and Stephen A. RossI. IntroductionHedge funds are a class of investment products which have developed to make optimal useof manager skill. The last decade has experienced dramatic growth in the hedge fund industry dueto a number of factors. These include historically high risk-adjusted returns relative to otherinvestments, the relaxation of regulatory constraints on hedge-fund investment and the growth ofglobal markets and opportunities for skill-based investing. This primer is an introduction to hedgefunds and their role in an investment portfolio. We provide a theoretical background for the valueproposition of hedge fund management, a discussion of the risks peculiar to hedge funds, a reviewof the different fund styles and evidence on their historical performance. Finally, we address thepotential role of hedge funds in a diversified portfolio with long-term performance goals.As we show, the theory of hedge funds is closely related to the theory of asset pricing itself.In fact, hedge funds can be viewed as playing an essential role in the daily process of price discoveryin the global capital markets. Asset pricing theory provides a useful foundation for assessing theskill of the manager and the role of the fund in an investment portfolio. Despite the variety ofdifferent styles pursued by hedge fund managers, we argue that all hedge fund managers essentiallyshare a common value proposition. All seek to exploit temporary mispricings in the value ofmarketable securities. This quest takes hedge fund managers to the frontiers of asset markets,where the valuation of securities is not well understood by all participants. Successful hedge fundmanagers specialize in markets for which they have a comparative informational or technicaladvantage. Hedge funds pursue strategies that we will term “arbitrage in expectations,” orexpectational arbitrage. That is, they seek to provide a positive expected return on capital with aminimal exposure to systematic sources of risk by “hedging away” exposure to traditional assetPage 2 of 48© 2000 William N. Goetzmann and Stephen A. Rossclasses typically held in the investment portfolio. This is significantly different from the behaviorof the traditional asset manager, and it has important implications for return and risk measurement,as well as the evaluation of the role of the hedge fund in the investment portfolio.In the next section we provide some useful background on hedge funds. In section 3 wedevelop a theory of hedge fund management drawn from the theory of asset pricing. Section 4discusses key issues that distinguish hedge funds. Section 5 focuses on the risks distinctive tohedge funds. Section 6 examines the variety of hedge fund styles, the potential of each for addingvalue to the portfolio and the types of risks they represent. In section 7 we discuss the metrics usedto evaluate hedge fund performance. In section 8 we examine the historical performance of hedgefunds over the past decade with an eye to what history reveals about their future potential. Section9 discusses the role of hedge funds in the investment portfolio. Section 10 briefly concludes theprimer and points out important areas for future discussion.II. What is a Hedge Fund?For our purposes, hedge funds are investment companies that actively trade in marketablesecurities. What makes their legal structure unusual for U.S. investors is that they are not regulatedby the United States Investment Company Act of 1940 which established the modern structure ofmutual funds. Because of this, they have much broader flexibility than mutual funds. Mutualfunds have restrictions on the types of securities they can hold, the degree to which their portfoliosmay be concentrated in a single security, the percentage they may hold of any one firm and theamount of leverage they may take. Mutual funds are not allowed to hold shares of other mutualfunds, or to offer managers asymmetric performance contracts and they are required to offer dailypricing and liquidity to investors and to publically report their security holdings on a quarterly basis.Page 3 of 48© 2000 William N. Goetzmann and Stephen A. RossWhile all of these restrictions have some merit, they significantly restrict manager strategies. Byelecting not to qualify as regulated investment companies, hedge funds have