Hedge Funds

Hedge Funds: An Analytic Perspective (Revised and Expanded Edition)

Copyright Date: 2010
Edition: STU - Student edition
Pages: 416
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  • Book Info
    Hedge Funds
    Book Description:

    The hedge fund industry has grown dramatically over the last two decades, with more than eight thousand funds now controlling close to two trillion dollars. Originally intended for the wealthy, these private investments have now attracted a much broader following that includes pension funds and retail investors. Because hedge funds are largely unregulated and shrouded in secrecy, they have developed a mystique and allure that can beguile even the most experienced investor. InHedge Funds, Andrew Lo--one of the world's most respected financial economists--addresses the pressing need for a systematic framework for managing hedge fund investments.

    Arguing that hedge funds have very different risk and return characteristics than traditional investments, Lo constructs new tools for analyzing their dynamics, including measures of illiquidity exposure and performance smoothing, linear and nonlinear risk models that capture alternative betas, econometric models of hedge fund failure rates, and integrated investment processes for alternative investments. In a new chapter, he looks at how the strategies for and regulation of hedge funds have changed in the aftermath of the financial crisis.

    eISBN: 978-1-4008-3581-2
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-x)
  3. List of Tables
    (pp. xi-xvi)
  4. List of Figures
    (pp. xvii-xx)
  5. List of Color Plates
    (pp. xxi-xxii)
  6. Acknowledgments
    (pp. xxiii-xxvi)
  7. 1 Introduction
    (pp. 1-33)

    One of the fastest growing sectors of the financial services industry is thehedge fund or alternative-investmentssector, currently estimated at more than $1 trillion in assets worldwide. One of the main reasons for such interest is the performance characteristics of hedge funds—often known as “high-octane” investments: Many hedge funds have yielded double-digit returns for their investors and, in many cases, in a fashion that seems uncorrelated with general market swings and with relatively low volatility. Most hedge funds accomplish this by maintaining both long and short positions in securities—hence the term “hedge” fund—which, in principle, gives...

  8. 2 Basic Properties of Hedge Fund Returns
    (pp. 34-63)

    It is clear from Chapter 1 that hedge funds exhibit unique and dynamic characteristics that bear further study. Fortunately, the returns of many individual hedge funds are now available through a number of commercial databases such as Altvest, CISDM, HedgeFund.net, HFR, and Lipper TASS. For the empirical analysis in this book, we use two main sources: (1) a set of aggregate hedge fund–index returns from CS/Tremont, and (2) the Lipper TASS database of hedge funds, which consists of monthly returns and accompanying information for 7,924 individual hedge funds (as of September 2007) from February 1977 to August 2007.¹


  9. 3 Serial Correlation, Smoothed Returns, and Illiquidity
    (pp. 64-96)

    It is apparent from the basic empirical properties outlined in Chapter 2 that one of the most significant characteristics of hedge fund returns is serial correlation. This is somewhat surprising because serial correlation is often (though incorrectly) associated with market inefficiencies, implying a violation of the Random Walk Hypothesis and the presence of predictability in returns. This seems inconsistent with the popular belief that the hedge fund industry attracts the best and the brightest fund managers in the financial services sector. In particular, if a fund manager’s returns are predictable, the implication is that the manager’s investment policy is not...

  10. 4 Optimal Liquidity
    (pp. 97-120)

    It should be apparent from Chapter 3 that liquidity is an important risk factor for hedge funds. Many studies—in both academic journals and more applied forums—have made considerable progress in defining liquidity, measuring the cost of immediacy and price impact, deriving optimal portfolio rules in the presence of transaction costs, investigating the relationship between liquidity and arbitrage, and estimating liquidity risk premia in the context of various partial and general equilibrium asset-pricing models.¹ However, relatively little attention has been paid to the more practical problem of integrating liquidity directly into the portfolio construction process.²

    In this chapter, we...

  11. 5 Hedge Fund Beta Replication
    (pp. 121-167)

    As institutional investors take a more active interest in alternative investments, a significant gap has emerged between the culture and expectations of these investors and hedge fund managers. Pension plan sponsors typically require transparency from their managers and impose a number of restrictions in their investment mandates because of regulatory requirements such as ERISA rules; hedge fund managers rarely provide position-level transparency and bristle at any restrictions on their investment process because restrictions often hurt performance. Plan sponsors require a certain degree of liquidity in their assets to meet their pension obligations and also desire significant capacity because of their...

  12. 6 A New Measure of Active Investment Management
    (pp. 168-197)

    With the growing popularity of hedge funds and other absolute-return investment strategies, there is a widening gap between the performance metrics of traditional investment management and alternatives. While alpha, beta, volatility, tracking error, the Sharpe ratio, and the information ratio have become the standard tools for gauging the value-added of long-only portfolio managers, they have not had as much impact among investors of absolute-return strategies. Part of this gap is no doubt cultural in origin; the growth of the mutual fund industry was accelerated by the broad acceptance of portfolio theory and the benefits of diversification. This in turn led...

  13. 7 Hedge Funds and Systemic Risk
    (pp. 198-216)

    The term “systemic risk” is commonly used to describe the possibility of a series of correlated defaults among financial institutions—typically banks—that occurs over a short period of time and is often caused by a single major event. A classic example is a banking panic in which large groups of depositors decide to withdraw their funds simultaneously, creating a run on bank assets that can ultimately lead to multiple bank failures. Banking panics were not uncommon in the United States during the nineteenth and early twentieth centuries, culminating in the 1930–1933 period with an average of 2,000 bank...

  14. 8 An Integrated Hedge Fund Investment Process
    (pp. 217-236)

    Despite the growing number of studies proposing quantitative approaches to alternative investments,¹ hedge fund investors have yet to embrace any single analytic framework for formulating their investment policies. There are several reasons for this state of affairs. One reason may lie in the cultural history of the hedge fund investor community, which was forged by high-net-worth individuals, family offices, foundations, and endowments. These early patrons of hedge funds, CTAs, and private equity placed more emphasis on the specific characteristics of individual managers and entrepreneurs than on detailed portfolio construction algorithms. It was in this milieu that the financial “gunslinger” was...

  15. 9 Practical Considerations
    (pp. 237-254)

    In addition to the new analytics proposed in this monograph, there are several practical considerations that should be kept in mind when evaluating alternative investments. The first is that despite the emphasis on alpha among hedge fund managers and investors, risk management can be a significant source of alpha in and of itself, as we illustrate through a simple example in Section 9.1. Of course, the ultimate determination of how much risk is appropriate for a hedge fund involves risk preferences—of both investors and managers—and this is discussed in Section 9.2. And finally, one of the most controversial...

  16. 10 What Happened to the Quants in August 2007?
    (pp. 255-302)

    The months leading up to August 2007 were a tumultuous period for global financial markets, with events in the U.S. subprime mortgage market casting long shadows over many parts of the financial industry. The blow-up of two Bear Stearns credit strategies funds in June, the sale of Sowood Capital Management’s portfolio to Citadel after losses exceeding 50% in July, and mounting problems at Countrywide Financial—the nation’s largest home lender—throughout the second and third quarters of 2007 set the stage for further turmoil in fixed income and credit markets during the month of August.

    But during the week of...

  17. 11 Jumping the Gates
    (pp. 303-322)

    The financial crisis of 2007–2008 has created enormous stress in the hedge fund industry, with wholesale liquidations at firesale prices causing hedge fund managers to impose gates on investor redemptions. In many cases, such measures may well be justified because the unwinding of illiquid positions under duress can lead to extreme losses for both exiting and remaining investors. By instituting a gate, managers can unwind positions in a more orderly manner, preserving value for all investors. However, if unwinding positions in a more orderly manner takes months or, in some extreme cases, years, gated investors may be forced to...

  18. Appendix
    (pp. 323-340)
  19. References
    (pp. 341-354)
  20. Index
    (pp. 355-361)