1. Discussion of Emanuel Derman George Constantinides University of Chicago 1 The Premium for Hedge Fund Lockups Emanuel Derman

2. Discussion of Emanuel Derman George Constantinides University of Chicago 2 Overview of Derman 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

3. Discussion of Emanuel Derman George Constantinides University of Chicago 3 Equilibrium Implications Derman calibrates a model of correlated hedge fund returns He compares two funds with 1-year and 2- year lockups Claim: in equilibrium, the fund with 2-year lockup should command an annual premium of ~ 90 bps

4. Discussion of Emanuel Derman George Constantinides University of Chicago 4 Nun Lectures Hedge-Fund Managers on Sex Education (and Alphas) Are annual returns predictable? What annual premium, if any, should the fund with 2-year lockup command?

5. Discussion of Emanuel Derman George Constantinides University of Chicago 5 Methodological issues 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

6. Discussion of Emanuel Derman George Constantinides University of Chicago 6 Methodological issues continued... 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

7. Discussion of Emanuel Derman George Constantinides University of Chicago 7 Empirical Evidence—1 Brown, Goetzmann, Ibbotson (1999) 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

8. Discussion of Emanuel Derman George Constantinides University of Chicago 8 Empirical Evidence—2 Agarwal and Naik (2000) 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

9. Discussion of Emanuel Derman George Constantinides University of Chicago 9 Empirical Evidence—3 Baquero, ter Horst, Verbeek (2005) 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

10. Discussion of Emanuel Derman George Constantinides University of Chicago 10 Why Do We Observe High- Frequency 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 unexploitable by investors

11. Discussion of Emanuel Derman George Constantinides University of Chicago 11 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

12. Discussion of Emanuel Derman George Constantinides University of Chicago 12 Empirical Evidence—4 Jagannathan, Malakhov, Novikov (2006) 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

13. Discussion of Emanuel Derman George Constantinides University of Chicago 13 Jagannathan et. al. Results

14. Discussion of Emanuel Derman George Constantinides University of Chicago 14 Implied Probability of Fund Transition from Superior to Neutral 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 %

15. Discussion of Emanuel Derman George Constantinides University of Chicago 15 Annual Premium on Fund with 2-year Lockup 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 %

16. Discussion of Emanuel Derman George Constantinides University of Chicago 16 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 Summary vs.