Blog: Our Views on Risk Management and Portfolio Construction

Quantitative Perspectives on Alternative Investments - Why Conventional Approaches Fail

We are not going to delve into endless discussions of how Bernie Madoff has successfully managed to defraud hundreds of investors for years. We will not talk about the reasons of the SEC’s dereliction, when the latter was supposed to examine the Madoff’s books since 2006. All these aspects are largely irrelevant for us.

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Typical mistakes in hedge fund valuation and risk assessment arise from neglecting their unique properties: non-normal return distributions, low transparency, bizzarre hedge fund indices, inapplicability of the mean-variance methodology, numerous data biases etc. The distinct hedge fund valuation and risk management problems can be outlined as follows...

The unique hedge fund risk assessment problems arising from numerous causes like non-normality of their distributions of returns, bizarre hedge fund indices and data biases are not new. One may easily find hundreds of articles and deep researches on the subject as well as a few proven investment frameworks offering feasible solutions by enhancing the commonly used risk metrics.

There are two distinct trends in finance software applications: tools designed to provide a deep insight into the matter and products aimed to make impressions. The latter dominate the industry, thus opening an apparently naive question - why do investors need analytical tools and applications at all?

Low transparency of hedge funds is often viewed as a key risk factor of alternative investments, while the term transparency is referred to fund asset allocations. Such a standpoint ignores the fact that the degree of investment risks depends on the way of structuring assets in the portfolio, rather than on assets themselves.

The hardest aspect about hedge fund properties is to understand that they present an entirely distinct category of financial instruments, therefore, deploying a traditional methodology commonly used for stocks and bonds, will lead to the unexpected and most questionable results.

Biases in fund databases present another serious problem originated from the following reasons. First, databases include only a part of the whole hedge find population that varies from 30 percent to 50 percent. Second, some biases are derived from the peculiar terms of counting hedge funds and their respective returns.

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