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.