Derivatives Event Fallout II
From the NY Times:
Economists have thought that big up-and-down fluctuations in returns indicated risky investments, so many hedge fund investors have hoped to see a pattern of smooth and even returns.
In a paper to be published by the University of Chicago, Mr. Andrew Lo, working with his graduate students, has come to a disturbing conclusion: that smooth returns, far from proving that hedge funds are safe, may be a warning sign for the industry.
Mr. Lo shows in his paper, measuring the smoothness of returns gives economists a good way to estimate the level of relatively illiquid investments in the hedge fund world.
By Mr. Lo's measures, hedge fund investments are less liquid now than they have been in 20 years. His work shows that the same pattern of investing preceded the 1998 global hedge fund meltdown and the 1987 stock market crash.
In his paper, he shows that the catastrophic losses of 1998 were preceded by a noticeable series of months of mediocre performance. Mr. Lo argues that while a hedge fund crisis appears to be sudden and to be caused by unforeseen events, the breakdown is only the late stage of the problem.
His research indicates that the industry may have already entered a period of lower returns that signal a prelude to crisis. He points to a downturn in April that hit virtually every category of hedge fund pursuing every kind of strategy.
"The concern that I and others have is that we're approaching the perfect financial storm where all the arrows line up in one direction," Mr. Lo said. The more money that is invested in hedge funds, he said, "the bigger the storm will be."
Possible triggers? An oil-price increase to $100 a barrel, a level predicted by one Goldman Sachs analyst, could do it. Or , he said, a tightening of lending rules at Fannie Mae, the mortgage giant, could set off a "humongous unwinding" in credit markets.
Is a Hedge Fund Shakeout Coming Soon? This Insider Thinks So
Andrew Lo's Research Paper
Economists have thought that big up-and-down fluctuations in returns indicated risky investments, so many hedge fund investors have hoped to see a pattern of smooth and even returns.
In a paper to be published by the University of Chicago, Mr. Andrew Lo, working with his graduate students, has come to a disturbing conclusion: that smooth returns, far from proving that hedge funds are safe, may be a warning sign for the industry.
Mr. Lo shows in his paper, measuring the smoothness of returns gives economists a good way to estimate the level of relatively illiquid investments in the hedge fund world.
By Mr. Lo's measures, hedge fund investments are less liquid now than they have been in 20 years. His work shows that the same pattern of investing preceded the 1998 global hedge fund meltdown and the 1987 stock market crash.
In his paper, he shows that the catastrophic losses of 1998 were preceded by a noticeable series of months of mediocre performance. Mr. Lo argues that while a hedge fund crisis appears to be sudden and to be caused by unforeseen events, the breakdown is only the late stage of the problem.
His research indicates that the industry may have already entered a period of lower returns that signal a prelude to crisis. He points to a downturn in April that hit virtually every category of hedge fund pursuing every kind of strategy.
"The concern that I and others have is that we're approaching the perfect financial storm where all the arrows line up in one direction," Mr. Lo said. The more money that is invested in hedge funds, he said, "the bigger the storm will be."
Possible triggers? An oil-price increase to $100 a barrel, a level predicted by one Goldman Sachs analyst, could do it. Or , he said, a tightening of lending rules at Fannie Mae, the mortgage giant, could set off a "humongous unwinding" in credit markets.
Is a Hedge Fund Shakeout Coming Soon? This Insider Thinks So
Andrew Lo's Research Paper
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