Hedgefunds: An Analytic Perspective

Hedgefunds: An Analytic Perspective

Hedgefunds: An Analytic Perspective

Hedgefunds: An Analytic Perspective

Synopsis

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. In Hedge 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.

Excerpt

One of the fastest growing sectors of the financial services industry is the hedge fund or alternative-investments sector, 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 investors an opportunity to profit from both positive and negative information while at the same time providing some degree of “market neutrality” because of the simultaneous long and short positions. Long the province of foundations, family offices, and high-net-worth investors, alternative investments are now attracting major institutional investors such as large state and corporate pension funds, insurance companies, and university endowments, and efforts are underway to make hedge fund investments available to individual investors through more traditional mutual fund investment vehicles.

However, many institutional investors are not yet convinced that alternative investments comprise a distinct asset class, i.e., a collection of investments with a reasonably homogeneous set of characteristics that are stable over time. Unlike equities, fixed income instruments, and real estate—asset classes each defined by a common set of legal, institutional, and statistical properties—alternative investments is a mongrel categorization that includes private equity, risk arbitrage, commodity futures, convertible bond arbitrage, emerging-market equities, statistical arbitrage, foreign currency speculation, and many other strategies, securities, and styles. Therefore, the need for a set of portfolio analytics and risk management protocols specifically designed for alternative investments has never been more pressing.

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