Economic View: Is a Hedge Fund Shakeout Coming Soon> This Insider Thinks So
The New York Times

OF all the sectors of the financial universe, the hedge fund world is probably the most secretive and almost certainly the most alluring. Open only to institutions and the wealthy, hedge funds offer sophisticated models of risk, access to the best financial minds and the chance for outsized returns. According to Van Hedge Advisors, hedge fund assets have topped a trillion dollars.

The downside, unfortunately, is that occasionally the industry may be subject to catastrophic and unexpected losses. In 1998, many top hedge fund managers lost their shirts. Long Term Capital Management came close to collapse. Just last month, investors were reminded of exactly this kind of possibility with the apparent failure of a $400 million Connecticut hedge fund managed by the Bayou Group.

Andrew W. Lo, a finance professor at the Sloan School of Management at the Massachusetts Institute of Technology, has been studying hedge fund failures and risks, and he says that another hedge fund industry shakeout is likely in the near future. Mr. Lo runs a company, AlphaSimplex, that manages a $400 million hedge fund - so he is not looking for a reason to say hedge funds are in trouble. But that is exactly what he's saying, backing it up with powerful data and a couple of unexpected theories.

Mr. Lo has been working on the economics of hedge funds since the mid-1990's, but he started thinking seriously about how to measure risk across the industry in 1999, when he was first approached by backers to start his own hedge fund; it opened in 2003. He knew that sophisticated investors would want lots of data about his fund's returns and about the risk level he would assume, so he started looking carefully at the return data provided by other funds.

Traditionally, 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. But Mr. Lo quickly saw that lots of hedge funds were posting returns that were just too smooth to be realistic. Digging deeper, he found that funds with hard-to-appraise, illiquid investments - like real estate or esoteric interest rate swaps - showed returns that were particularly even. In those cases, he concluded, managers had no way to measure their fluctuations, and simply assumed that their value was going up steadily. The problem, unfortunately, is that those are exactly the kinds of investments that can be subject to big losses in a crisis. In 1998, investors retreated en masse from such investments.

Now, in a paper to be published by the University of Chicago, Mr. 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. (The paper is at http://web.mit.edu/alo/www/Papers/systemic2.pdf.)

That doesn't necessarily hold true for every individual fund, but as 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. The approach lets economists measure industrywide liquidity risks without knowing the details of the investments - information that hedge funds just don't give out.

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.

But that's not the only reason for worry. He says that crises like that of 1998 may be more predictable than was previously thought - and that another crisis is likely.

The 1998 panic is generally thought to have been set off by the Russian government's default on its debt. But Mr. Lo points out that only a minuscule proportion of the world's hedge fund investments were in Russian government bonds.

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. As more hedge funds compete for the same slice of the pie, he says, their managers feel that they have no choice but to "leverage up," juicing their returns by borrowing more money to make bigger investments.