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.
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List of Tables xi
List of Figures xvii
List of Color Plates xxi
Acknowledgments xxiii
Chapter 1: Introduction 1
1.1 Tail Risk 7
1.2 Nonlinear Risks 13
1.3 Illiquidity and Serial Correlation 25
1.4 Literature Review 30
Chapter 2: Basic Properties of Hedge Fund Returns 34
2.1 CS/Tremont Indexes 37
2.2 Lipper TASS Data 40
2.3 Attrition Rates 43
Chapter 3: Serial Correlation, Smoothed Returns, and Illiquidity 64
3.1 An Econometric Model of Smoothed Returns 66
3.2 Implications for Performance Statistics 70
3.3 Estimation of Smoothing Profiles 75
3.4 Smoothing-Adjusted Sharpe Ratios 79
3.5 Empirical Analysis of Smoothing and Illiquidity 83
Chapter 4: Optimal Liquidity 97
4.1 Liquidity Metrics 98
4.2 Liquidity-Optimized Portfolios 105
4.3 Empirical Examples 107
4.4 Summary and Extensions 117
Chapter 5: Hedge Fund Beta Replication 121
5.1 Literature Review 123
5.2 Two Examples 124
5.3 Linear Regression Analysis 126
5.4 Linear Clones 138
5.5 Summary and Extensions 164
Chapter 6: A New Measure of Active Investment Management 168
6.1 Literature Review 170
6.2 The AP Decomposition 172
6.3 Some Analytical Examples 180
6.4 Implementing the AP Decomposition 187
6.5 An Empirical Application 191
6.6 Summary and Extensions 196
Chapter 7: Hedge Funds and Systemic Risk 198
7.1 Measuring Illiquidity Risk 200
7.2 Hedge Fund Liquidations 203
7.3 Regime-Switching Models 211
7.4 The Current Outlook 215
Chapter 8: An Integrated Hedge Fund Investment Process 217
8.1 Define Asset Classes by Strategy 221
8.2 Set Portfolio Target Expected Returns 222
8.3 Set Asset-Class Target Expected Returns and Risks 222
8.4 Estimate Asset-Class Covariance Matrix 223
8.5 Compute Minimum-Variance Asset Allocations 224
8.6 Determine Manager Allocations within Each Asset Class 225
8.7 Monitor Performance and Risk Budgets 227
8.8 The Final Specification 227
8.9 Risk Limits and Risk Capital 229
8.10 Summary and Extensions 235
Chapter 9: Practical Considerations 237
9.1 Risk Management as a Source of Alpha 237
9.2 Risk Preferences 239
9.3 Hedge Funds and the Efficient Markets Hypothesis 242
9.4 Regulating Hedge Funds 250
Chapter 10: What Happened to the Quants in August 2007? 255
10.1 Terminology 260
10.2 Anatomy of a Long/Short Equity Strategy 261
10.3 What Happened in August 2007 269
10.4 Comparing August 2007 with August 1998 273
10.5 Total Assets, Expected Returns, and Leverage 276
10.6 The Unwind Hypothesis 281
10.7 Illiquidity Exposure 284
10.8 A Network View of the Hedge Fund Industry 286
10.9 Did Quant Fail? 292
10.10 Qualifications and Extensions 298
10.11 The Current Outlook 300
Appendix 303
A.1 Lipper TASS Category Definitions 303
A.2 CS/Tremont Category Definitions 305
A.3 Matlab Loeb Function tloeb 308
A.4 GMM Estimators for the AP Decomposition 310
A.5 Constrained Optimization 312
A.6 A Contrarian Trading Strategy 313
A.7 Statistical Significance of Aggregate Autocorrelations 314
References 317
Index 331
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