Hedge Funds are something to be very wary of. 
If you invest in one read this post. If you have friends who invest in one have a look.
I spent part of Saturday reading on the beach with my wife. One of the more gripping reads was Systemic Risk and Hedge Funds by Nicholas Chan, Mila Getmansky, Shane M. Haas and the esteemed Andrew W. Lo.
One of the more interesting papers I have come across in finance for some time. A copy of it is available Download systemic2.pdf .
Wow what can I say but great work. Some fascinating insites into the style and performance aspects of funds. Some highlights that most people already know. Funds under management are now $1 trillion they were only, $200 billion in 1997. Some more interesting research is strong indications that the average hedge fund has a half-life (survival) of 30 months.
The analysis of highest risk and lowest risk fund types is fascinating. Hint: managed futures are dangerous.
Lo does a great job of explaining the dangers of selling options (volatility) that many funds use. Lo constructs what many managers and investors would consider a model portfolio Sharpe Ratio over 1.90 with returns double the S&P 500 over 7 years. The approach is simple and explained. The approach yields a 2,300% return over the period The approach is also statistically pointed to ruin.
Attention: Volatility is mean reverting and at historic lows. When Volatility comes back it will be short, sharp and Cruel to many funds!
Hedge funds are famously opaque. This paper does one of the best jobs of showing the hidden flaws and approaches of many funds. For every George Soros, there are literally hundreds of train wrecks for investors. I am speaking as one who once designed and put together a set of still born quantitative offshore funds. Ouch! Lesson learned when I was a green 27-28 living in London.
The hedge fund business still lives by the 2% and 20% performance payment. As more than one participant has stated, "hedge funds are more about being a compensation class than a true asset class."
The crux of the paper mentioned above is that hedge funds have in built risks that are not just limited to themselves but the banking system as a whole, systemic risk. This is an area, I have studied for years. I am impressed with the approaches for assessing proxies for systemic risk using a chain of logical analysis involving auto-correlations among fund performance and cross correlations among style and asset classes. The approach is not rock solid, but by far one of the more interesting ways of statistically teasing out the hidden games and trading profiles of hedge funds. Unfortunately the potential for systemic risk due to hedge fund phase locking is real, but un measurable.
I won't go into further details about the paper, only to say that it is worth the read. The authors should be commended as producing a tour de force. I would be interested in the authors comments on systemic risk and phase locking in regards to Basel 2 risk capital accords. If you think Phase locking and regime change (in the financial sense) is scary with $1 trillion in hedge funds, consider the implications for the entire global banking system.
Should any people out there be curious or want to speak about Hedge funds and systemic risk, feel free to ping me.
