Hedge Funds: An Analytic Perspective - Updated Edition by Andrew W. LoHedge Funds: An Analytic Perspective - Updated Edition by Andrew W. Lo

Hedge Funds: An Analytic Perspective - Updated Edition

byAndrew W. Lo

Paperback | July 21, 2010

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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.

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).
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Title:Hedge Funds: An Analytic Perspective - Updated EditionFormat:PaperbackDimensions:400 pagesPublished:July 21, 2010Publisher:Princeton University PressLanguage:English

The following ISBNs are associated with this title:

ISBN - 10:0691145989

ISBN - 13:9780691145983

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Table of Contents

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 181

6.4 Implementing the AP Decomposition 186

6.5 An Empirical Application 193

6.6 Summary and Extensions 197





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





Chapter 11: Jumping the Gates 303

11.1 Linear Risk Models 305

11.2 Beta Overlays 308

11.3 Hedging Long/Short Equity Managers 310

11.4 Dynamic Implementations of Beta Overlays 317

11.5 Conclusion 319





Appendix 323

A.1 Lipper TASS Category Definitions 323

A.2 CS/Tremont Category Definitions 325

A.3 Matlab Loeb Function tloeb 328

A.4 GMM Estimators for the AP Decomposition 330

A.5 Constrained Optimization 332

A.6 A Contrarian Trading Strategy 333

A.7 Statistical Significance of Aggregate Autocorrelations 334

A.8 Beta-Blocker and Beta-Repositioning Strategies 335

A.9 Tracking Error 339

References 341

Index 355


Editorial Reviews

"This book provides a useful and very timely overview of key aspects of the hedge fund industry. It summarizes the basic properties of hedge fund returns, discusses why traditional performance measures may be misleading when analyzing hedge fund performance, and highlights important issues such as serial correlation, return smoothing, and illiquidity."-Markus K. Brunnermeier, Princeton University