Hedge Funds: An Analytic Perspective by Andrew W. Lo

Hedge Funds: An Analytic Perspective by Andrew W. Lo

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Introduction

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, statis-

tical 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.

Part of the gap between institutional investors and hedge fund managers is due
to differences in investment mandate, regulatory oversight, and business culture
between the two groups, yielding very different perspectives on what a good
investment process should look like. For example, a typical hedge fund manager’s
perspective can be characterized by the following statements:
• The manager is the best judge of the appropriate risk/reward trade-off of
the portfolio and should be given broad discretion in making investment
decisions.
• Trading strategies are highly proprietary and therefore must be jealously
guarded lest they be reverse-engineered and copied by others.
• Return is the ultimate and, in most cases, the only objective.
• Risk management is not central to the success of a hedge fund.
• Regulatory constraints and compliance issues are generally a drag on
performance; the whole point of a hedge fund is to avoid these issues.
• There is little intellectual property involved in the fund; the general partner
is the fund.
Contrast these statements with the following characterization of a typical institutional investor:
• As fiduciaries, institutions need to understand the investment process
before committing to it.
• Institutions must fully understand the risk exposures of each manager and,
on occasion, may have to circumscribe the manager’s strategies to be
consistent with the institution’s overall investment objectives and
constraints.
• Performance is not measured solely by return but also includes other
factors such as risk adjustments, tracking error relative to a benchmark,
and peer group comparisons.
• Risk management and risk transparency are essential.
• Institutions operate in a highly regulated environment and must comply
with a number of federal and state laws governing the rights,
responsibilities, and liabilities of pension plan sponsors and other
fiduciaries.
• Institutions desire structure, stability, and consistency in a well-defined
investment process that is institutionalized—not dependent on any single
individual.

Hedge Funds: An Analytic Perspective by Andrew W. Lo