The hedge fund industry has grown dramatically over the years. Originally intended for the wealthy, these private investments have attracted a much broader following that includes pension funds and retail investors. This book addresses the pressing need for a systematic framework for managing hedge fund investments.

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 4: Optimal Liquidity 97 4.1 Liquidity Metrics 98 4.2 Liquidity-Optimized Portfolios 105 4.3 Empirical Examples 107 4.4 Summary and Extensions 117 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 181 6.4 Implementing the AP Decomposition 186 6.5 An Empirical Application 193 6.6 Summary and Extensions 197 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 Chapter 11: Jumping the Gates 303 11.1 Linear Risk Models 305 11.2 Beta Overlays 308 11.3 Hedging Long/Short Equity Managers 310 11.4 Dynamic Implementations of Beta Overlays 317 11.5 Conclusion 319 Appendix 323 A.1 Lipper TASS Category Definitions 323 A.2 CS/Tremont Category Definitions 325 A.3 Matlab Loeb Function tloeb 328 A.4 GMM Estimators for the AP Decomposition 330 A.5 Constrained Optimization 332 A.6 A Contrarian Trading Strategy 333 A.7 Statistical Significance of Aggregate Autocorrelations 334 A.8 Beta-Blocker and Beta-Repositioning Strategies 335 A.9 Tracking Error 339 References 341 Index 355

"Andrew Lo's Hedge Funds is likely to be the high-water mark in the analysis of hedge funds for years to come. Focusing on hedge fund returns and trading strategies, risk characteristics, and potential for illiquidity, Lo brings to bear his always fresh and insightful thinking."—Richard Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

"Lo offers a truly unique perspective. He examines the properties of returns and illiquidity in great detail and introduces an innovative concept of mean-variance-liquidity optimization, something that no other book on hedge funds has addressed."—Narayan Y. Naik, London Business School

"This book provides a useful and very timely overview of key aspects of the hedge fund industry. It summarizes the basic properties of hedge fund returns, discusses why traditional performance measures may be misleading when analyzing hedge fund performance, and highlights important issues such as serial correlation, return smoothing, and illiquidity."—Markus K. Brunnermeier, Princeton University

Andrew Lo's Hedge Funds is likely to be the high-water mark in the analysis of hedge funds for years to come. Focusing on hedge fund returns and trading strategies, risk characteristics, and potential for illiquidity, Lo brings to bear his always fresh and insightful thinking. -- Richard Bookstaber, author of "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" Lo offers a truly unique perspective. He examines the properties of returns and illiquidity in great detail and introduces an innovative concept of mean-variance-liquidity optimization, something that no other book on hedge funds has addressed. -- Narayan Y. Naik, London Business School This book provides a useful and very timely overview of key aspects of the hedge fund industry. It summarizes the basic properties of hedge fund returns, discusses why traditional performance measures may be misleading when analyzing hedge fund performance, and highlights important issues such as serial correlation, return smoothing, and illiquidity. -- Markus K. Brunnermeier, Princeton University