Radical Reform of Executive Pay2009
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.
Jumping the Gates: Using Beta-Overlay Strategies to Hedge Liquidity Constraints2009
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.
Regulatory Reform in the Wake of the Financial Crisis of 2007-20082009
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.
MIT Roundtable on Corporate Risk Management2008
Our topic is corporate risk management, with perhaps a look at the implications for the current financial crisis. And I’d like to start by saying a few things that might help set the stage for our four panelists, who are all very interesting and accomplished people. When we think about risk and risk management, everybody says it’s very important. When a firm or an institution goes down, a lot of people lose their jobs, assets change hands, and a lot of franchise value can be destroyed in the process. So risk management is important in the sense of protecting on the downside. But there’s also a common perception that risk management has very little to do with creating growth and value—that you’ll never get to the Fortune 100 just by having good risk management. And I think that’s a serious misunderstanding of what risk management is really all about.
Efficient Markets Hypothesis2008
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.
Where Do Alphas Come From?: A New Measure of the Value of Active Investment Management2008
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.
130/30: The New Long-Only2008
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.
International Library of Financial Econometrics, Volumes I – V2007
This major collection presents a careful selection of the most important published articles in the field of financial econometrics. Starting with a review of the philosophical background, the collection covers such topics as the random walk hypothesis, long-memory processes, asset pricing, arbitrage pricing theory, variance bounds tests, term structure models, market microstructure, Bayesian methods and other statistical tools.
Read Andrew Lo's Introduction to the International Library of Financial Econometrics
Systemic Risk and Hedge Funds2007
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.
Can Hedge-Fund Returns Be Replicated?: The Linear Case2007
In contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield additional and complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or "clones" using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we find that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.
What Happened To The Quants In August 2007?2007
During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid "unwind" of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector—in a completely unrelated set of markets and instruments—suggesting that systemic risk in the hedge-fund industry may have increased in recent years.
The Derivatives Sourcebook2006
The Derivatives Sourcebook is a citation study and classification system that organizes the many strands of the derivatives literature and assigns each citation to a category. Over 1800 research articles are collected and organized into a simple web-based searchable database. We have also included the 1997 Nobel lectures of Robert Merton and Myron Scholes as a backdrop to this literature.
Attack of the Clones2006
Hedge funds are considered by many investors to be an attractive investment, thanks in large part to their diversification benefits and distinctive risk profiles. The major drawbacks are their high fees and lack of transparency. Research by Jasmina Hasanhodzic and Andrew W. Lo of the Massachusetts Institute of Technology raises the possibility of creating passive portfolios that provide similar risk exposures to those of hedge funds at lower costs and with greater transparency. Hasanhodzic and Lo find that for certain hedge fund strategies, these hedge fund “clones” perform well enough to warrant serious consideration.
Survival of the Richest2006
In financial markets, as in many human endeavors, there’s a battle between reason and madness. On one side are the disciples of the efficient-markets hypothesis: the notion that markets fully, accurately, and instantaneously incorporate all relevant information into prices. These adherents assume that market participants are rational, always acting in their own interest and making mathematically optimal decisions. On the other side are the champions of behavioral economics: a younger discipline that points to bubbles, crashes, panics, manias, and other distinctly unreasonable phenomena as evidence of irrationality.
It’s hard to deny that investors act irrationally from time to time, yet behavioralists have so far failed to offer an alternative to supplant the efficient-markets hypothesis, which does brilliantly explain many economic occurrences and has had an enormous impact on modern financial theory and practice. Both approaches seem to have compelling explanatory power in their own right, yet they have opposing premises: rationality versus human psychology. How can the efficient-markets hypothesis and behavioral economics ever be reconciled? Perhaps by looking to Charles Darwin instead of Adam Smith.
Do Hedge Funds Increase Systemic Risks?2006
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. This is a redacted version of our paper "Systemic Risk and Hedge Funds".