The Lo down

Date: Friday, June 13, 2008
Author: Economist.com

THE basic idea behind efficient market theory is that it seems implausible that there are $20 notes lying on pavements waiting to be picked up. It is thus tough for investors to beat the stockmarket average. But the billion-dollar fortunes accumulated by hedge-fund managers (and the outsized fees they charge) imply that not just $20 notes but bulging wallets can be grabbed by those that are smart enough.

The belief that hedge-fund managers have the magic touch has prompted the industry to grow from just $39 billion of assets in 1990 to around $2 trillion today. But it has also prompted academics to examine exactly how hedge-fund managers are making their money, to question whether clients are getting the short end of the stick and to assess the impact of hedge-fund actions on the stability of financial markets as a whole.

Andrew Lo, a professor at the Massachusetts Institute of Technology, has been at the forefront of that process. His latest book, packed as it is with statistical tables and equations, will appear daunting to the casual reader. Nevertheless, anyone who is considering investing in hedge funds, or is involved in regulating the financial-services industry, should give it a go.

All those tables and equations are required because hedge-fund strategies are highly complex and, in the jargon, “non-linear”. In other words, all may appear to be going well, but then suddenly goes horribly wrong. The problem for investors is that strategies dubbed “picking up nickels in front of steamrollers” may deliver fat fees for the manager, only for the clients to pick up the bill when disaster hits.

This pattern of returns occurs because hedge-fund managers often invest in illiquid (hard-to-trade) assets. Since the prices of such assets rarely change, that can produce the illusion of smooth returns and make hedge-fund portfolios look less risky than they are. Mr Lo duly suggests a number of ways of assessing those dangers.

He also examines the market turmoil of August 2007, when some of the best- known hedge funds experienced unprecedented losses in the course of a couple of days. He says this provided the first piece of evidence that problems in one corner of the markets—in this case, subprime mortgages—can spill over into a completely unrelated area. Regulators should take note. Specifically, Mr Lo argues that the American watchdog, the Securities and Exchange Commission, should get more data on hedge-fund positions and should undertake an “air safety review” when individual funds go bust.

What about the thought that hedge funds undermine the idea of efficient markets? Instead, Mr Lo suggests an alternative concept: adaptive market theory. Under that system, he says, spare $20 notes do exist, maybe not on the high street, but in remote culs-de-sac. Hedge funds may be the first to spot them, but eventually a crowd gathers and the chance disappears.

This implies that a hedge-fund manager can build up a brilliant track record—but with no guarantee that he can keep it up. And that may explain why so many hedge-fund managers get rich, and why their clients are much less likely to do so.