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. 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.

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 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