The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Wednesday, November 01, 2006

Hedge Funds & Minding One's Pennies

There is an old adage that basically goes like this: 'Mind your pennies, and your dollars will mind themselves.' ('Pounds' instead of 'dollars' if you're in the UK.) Investors in hedge funds would do well to keep that maxim in mind. After all, even if hedge funds can deliver the stellar returns they trumpet (despite the mounting empirical evidence that the belief in hedge fund out-performance tends to be exaggerated), the high costs associated with investing in hedge funds should provide investors with incentives to look for cheaper alternatives.

According to the Buttonwood column in The Economist, Send in the clones: A cheap alternative to hedge funds (Oct. 26, 2006), finance scholars have come up with ways to create cheaper, 'knock-off' copies of more expensive hedge funds. For example, MIT's Andrew Lo and Jasmina Hasanhodzic have written a research paper, Can Hedge-Fund Returns Be Replicated?: The Linear Case, that "raises the possibility of creating passive replicating portfolios or clones using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency." They do so by using econometric techniques to identify six factors that are closely associated with hedge funds' expected returns and volatility, and using those findings to create back-tested portfolios that 'clone' hedge funds.

Besides the theoretically lower costs of these hedge fund 'clones,' an additional benefit is that they use off-the-shelf financial instruments and assets instead of the less accessible tactics and products that hedge funds often use. Therefore, in theory, average investors would have easier access to these more liquid exchange-traded assets and that could make it easier to clone hedge funds without having to rely on more exotic instruments.

I have to admit, however, that I'm a bit skeptical of the promises of hedge fund 'cloning' (I don't even like that term since it's a bad analogy to biology since these cheaper alternatives would not be exact 'genetic' copies of the originals). Sure, I like the theoretical possibilites of having cheaper investment vehicles that utilize more accessible financial assets and strategies. The problem is that I'm not sure whether theory will be translated properly into practice. The kind of techniques that Prof. Lo and others who are cited in the Buttonwood column use to 'clone' hedge funds require algorithms and skill sets that are at least as -- and, probably, more -- sophisticated than the methods utilized by hedge funds themselves. That alone would likely mean that, rather than run-of-the-mill punters, sophisticated and deep-pocketed investors -- such as institutional investors and investment firms (including hedge funds themselves) -- would be able to utilize these strategies. So if the heavy hitters are best positioned to use these 'cloning' techniques, why would the costs go down when they have little incentives to lower the costs and the techniques themselves entail high human capital costs?

On a lighter note, I noticed a blog post on the New York Times' DealBook, Amaranth's Other Casualty: The Cabbies, that details how a taxi company's business was hurt by the blow up of a hedge fund. This is reminiscent of my last blog post on Daylight Savings Time and network effects. Apparently, the hedge fund world also has coordination or network effects (or externalities) on other parts of society and the economy. Relatively speaking, the billions of dollars of trades that hedge funds like Amaranth were dealing in make the fat fares of Connecticut cabbies look like pennies compared to dollars. In this case, a hedge fund not minding their 'dollars,' caused cabbies to lose out on 'pennies.'

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