Hedge Funds

by Lo, Andrew W.

• ISBN13: 9780691145983
• ISBN10: 0691145989
• Edition: Revised
• Format: Paperback
• Copyright: 2010-07-01
• Publisher: Princeton Univ Pr

Summary

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. He concludes with a case study of quantitative equity strategies in August 2007, and presents a sobering outlook regarding the systemic risks posed by this industry.

Author Biography

Andrew W. Lo is the Harris Harris Group Professor at the MIT Sloan School of Management, and director of the MIT Laboratory for Financial Engineering. He is the coauthor of A Non-Random Walk Down Wall Street and The Econometrics of Financial Markets (both Princeton).

Table of Contents

List of Tables	p. xi
List of Figures	p. xvii
List of Color Plates	p. xxi
Acknowledgments	p. xxiii
Introduction	p. 1
Tail Risk	p. 7
Nonlinear Risks	p. 13
Illiquidity and Serial Correlation	p. 25
Literature Review	p. 30
Basic Properties of Hedge Fund Returns	p. 34
CS/Tremont Indexes	p. 37
Lipper TASS Data	p. 40
Attrition Rates	p. 43
Serial Correlation, Smoothed Returns, and Illiquidity	p. 64
An Econometric Model of Smoothed Returns	p. 66
Implications for Performance Statistics	p. 70
Estimation of Smoothing Profiles	p. 75
Smoothing-Adjusted Sharpe Ratios	p. 79
Empirical Analysis of Smoothing and Illiquidity	p. 83
Optimal Liquidity	p. 97
Liquidity Metrics	p. 98
Liquidity-Optimized Portfolios	p. 105
Empirical Examples	p. 107
Summary and Extensions	p. 117
Hedge Fund Beta Replication	p. 121
Literature Review	p. 123
Two Examples	p. 124
Linear Regression Analysis	p. 126
Linear Clones	p. 138
Summary and Extensions	p. 164
A New Measure of Active Investment Management	p. 168
Literature Review	p. 170
The AP Decomposition	p. 172
Some Analytical Examples	p. 181
Implementing the AP Decomposition	p. 186
An Empirical Application	p. 193
Summary and Extensions	p. 197
Hedge Funds and Systemic Risk	p. 198
Measuring Illiquidity Risk	p. 200
Hedge Fund Liquidations	p. 203
Regime-Switching Models	p. 211
The Current Outlook	p. 215
An Integrated Hedge Fund Investment Process	p. 217
Define Asset Classes by Strategy	p. 221
Set Portfolio Target Expected Returns	p. 222
Set Asset-Class Target Expected Returns and Risks	p. 222
Estimate Asset-Class Covariance Matrix	p. 223
Compute Minimum-Variance Asset Allocations	p. 224
Determine Manager Allocations within Each Asset Class	p. 225
Monitor Performance and Risk Budgets	p. 227
The Final Specification	p. 227
Risk Limits and Risk Capital	p. 229
Summary and Extensions	p. 235
Practical Considerations	p. 237
Risk Management as a Source of Alpha	p. 237
Risk Preferences	p. 239
Hedge Funds and the Efficient Markets Hypothesis	p. 242
Regulating Hedge Funds	p. 250
What Happened to the Quants in August 2007?	p. 255
Terminology	p. 260
Anatomy of a Long/Short Equity Strategy	p. 261
What Happened in August 2007?	p. 269
Comparing August 2007 with August 1998	p. 273
Total Assets, Expected Returns, and Leverage	p. 276
The Unwind Hypothesis	p. 281
Illiquidity Exposure	p. 284
A Network View of the Hedge Fund Industry	p. 286
Did Quant Fail?	p. 292
Qualifications and Extensions	p. 298
The Current Outlook	p. 300
Jumping the Gates	p. 303
Linear Risk Models	p. 305
Beta Overlays	p. 308
Hedging Long/Short Equity Managers	p. 310
Dynamic Implementations of Beta Overlays	p. 317
Conclusion	p. 319
Appendix	p. 323
Lipper TASS Category Definitions	p. 323
CS/Tremont Category Definitions	p. 325
Matlab Loeb Function tloeb	p. 328
GMM Estimators for the AP Decomposition	p. 330
Constrained Optimization	p. 332
A Contrarian Trading Strategy	p. 333
Statistical Significance of Aggregate Autocorrelations	p. 334
Beta-Blocker and Beta-Repositioning Strategies	p. 335
Tracking Error	p. 339
References	p. 341
Index	p. 355
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