The Financial Times
The Financial Times
In this opinion piece, MIT Sloan Prof. Andrew Lo writes, “The world has become more complex over the past 20 years, and we need to update our investment paradigm to incorporate these new complexities... To achieve true diversification, investors must now have a broader set of asset classes and risk exposures, long and short, in their portfolios.”
The New York Times, Freakonomics Blog
The recent proposal by the Fed to regulate bankers’ compensation practices is understandable given the events of the past two years, but setting caps on salaries and bonuses misses the fundamental problem of compensation on Wall Street. Despite the public resentment surrounding finance-industry payouts, the fact is that no one objects to paying for performance. We just want to make sure we’re not getting fleeced or paying for pure dumb luck, and this is where the problem lies.
with A. Healy, Journal of Investment Management 7 (2009), 1–20.
In response to the current financial crisis, a number of hedge funds have implemented "gates" on their funds that restrict withdrawals when the sum of redemption requests exceeds a certain percentage of the fund's total assets. To reduce the investor's risk exposures during these periods, we propose a futures overlay strategy designed to hedge out or control the common factor exposures of gated assets. By taking countervailing positions in stock, bond, currency, and commodity exposures, an investor can greatly reduce the systematic risks of their gated assets while still enjoying the benefits of manager-specific alpha. Such overlay strategies can also be used to reposition the betas of an investor's entire portfolio, effectively rebalancing asset-class exposures without having to trade the less liquid underlying assets during periods of market dislocation. To illustrate the costs and benefits of such overlay, we simulate the impact of a simple beta-hedging strategy applied to long/short equity hedge funds in the TASS database.
Journal of Financial Economic Policy 1 (2009), 4-43
Financial crises are unavoidable when hardwired human behavior—fear and greed, or 'animal spirits—is combined with free enterprise, and cannot be legislated or regulated away. Like hurricanes and other forces of nature, market bubbles and crashes cannot be entirely eliminated, but their most destructive consequences can be greatly mitigated with proper preparation. In fact, the most damaging effects of financial crisis come not from loss of wealth, but rather from those who are unprepared for such losses and panic in response. This perspective has several implications for the types of regulatory reform needed in the wake of the Financial Crisis of 2007-2008, all centered around the need for greater transparency, improved measures of systemic risk, more adaptive regulations including counter-cyclical leverage constraints, and more emphasis on financial literacy starting in high school, including certifications for expertise in financial engineering for the senior management and directors of all financial institutions.
This document is the written testimony submitted to the House Oversight Committee for its hearing on hedge funds and the financial crisis, held November 13, 2008, and is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned—this paper is not research but is instead a summary of the policy implications that I have drawn from my interpretation of that research
I begin with a proposal to measure systemic risk and argue that this is the natural starting point for regulatory reform since it is impossible to manage something that cannot be measured. Then I review the relation between systemic risk and hedge funds, and show that early warning signs of the current crisis did exist in the hedge-fund industry as far back as 2004. However, I argue that financial crises may be an unavoidable aspect of human behavior, and the best we can do is acknowledge this tendency and be properly prepared. This behavioral pattern, as well as traditional economic motives for regulation—public goods, externalities, and incomplete markets—are relevant for systemic risk or its converse, 'systemic safety', and I suggest applying these concepts to the functions of the financial system to yield a rational process for regulatory reform. Also, I propose the formation of a new investigative office patterned after the National Transportation Safety Board (NTSB) to provide the kind of information aggregation and transparency that is called for in the previous sections. Another aspect of transparency involves fair-value accounting, and I review some of the recent arguments for its suspension and propose developing a new branch of accounting focusing exclusively on risk. I conclude with a discussion of the role of financial technology and education in the current crisis, and argue that more finance training is needed, not less.
Journal of Investment Management 6 (2008), 1–29.
The value of active investment management is traditionally measured by alpha, beta, tracking error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager's investment process. In this paper, I propose a new measure of the value of active investment management that captures both static and dynamic contributions of a portfolio manager's decisions. The measure is based on a decomposition of a portfolio's expected return into two distinct components: a static weighted-average of the individual securities' expected returns, and the sum of covariances between returns and portfolio weights. The former component measures the portion of the manager's expected return due to static investments in the underlying securities, while the latter component captures the forecast power implicit in the manager's dynamic investment choices. This measure can be computed for long-only investments, long/short portfolios, and asset allocation rules, and is particularly relevant for hedge-fund strategies where both components are significant contributors to their expected returns, but only one should garner the high fees that hedge funds typically charge. Several analytical and empirical examples are provided to illustrate the practical relevance of these new measures.
with Pankaj Patel, Journal of Portfolio Management 34 (2008), 12-38.
Long-only portfolio managers and investors have acknowledged that the long-only constraint is a potentially costly drag on performance, and loosening this constraint can add value. However, the magnitude of the performance drag is difficult to measure without a proper benchmark for a 130/30 portfolio. In this paper, we provide a passive but dynamic benchmark consisting of a 'plain-vanilla' 130/30 strategy using simple factors to rank stocks and standard methods for constructing portfolios based on these rankings. Based on this strategy, we produce two types of indexes: investable and 'look ahead' indexes, in which the former uses only prior information and the latter uses realized returns to produce an upper bound on performance. We provide historical simulations of our 130/30 benchmarks that illustrate their advantages and disadvantages under various market conditions.
with Nicholas Chan, Mila Getmansky, Shane M. Haas, The Risks of Financial Institutions and the Financial Sector, edited by M. Carey and R. Stulz, 2007. Chicago, IL: University of Chicago Press.
In this article, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.
The New Palgrave: A Dictionary of Economics, edited by L. Blume and S. Durlauf, Second Edition, 2007. New York: Palgrave McMillan.
The Efficient Markets Hypothesis (EMH) refers to the notion that market prices fully reflects all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960's, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioral economists who argue that the EMH is based on counterfactual assumptions regarding human behavior, i.e., rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioral anomalies.