Tuesday, September 06, 2005

Hedge fund risks high

Andrew Lo is a finance professor at MIT/Sloan, and runs the hedge fund AlphaSimplex. In a recent paper (also discussed in the Times) he argues that risks for a hedge fund meltdown are high.

Lo et al. posit that the smoothness of returns is a proxy of illiquidity. That is, if positions are marked to market using theoretical models (rather than actual trading values), the resulting valuations will be unnaturally smooth. Based on this notion, they propose the serial auto-correlation of hedge fund returns as a proxy for illiquidity and find that this is at a 20 year high. I find this analysis convincing as a method of tracking illiquidity. It is also plausible that illiquidity is an important contributor to systemic risk - under adverse market conditions we may see a lot of funds scrambling to get out of their positions.
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2 comments:

Mr. Naybob said...

Steve,

Since they are all modeled the same, they will all behave the same.

And you know that 1000 fat guys can't all fit through the turnstile at once. Ouch!!

11:53 AM
Mr. Naybob said...

Steve,

Thanks for pointing to Andrew Lo's work, it validates something I have suspected for a long time.

I call it the lull before the storm, just when you think everything is Jake, wham!! it hits you upside the head and hard.

A lack of volatility indicates complaceny in the form of willingness to accept less return for higher risk; and a lack of liquidity in the marketplace.

It kind of works like Ex-Lax, once inertia takes over, it all runs downhill.

12:31 PM

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