INNOVATION: RESEARCH

Although hedge funds have been in existence for the past 50 years, the industry has experienced explosive growth over the past decade. Despite their popularity, many investors remain uninformed regarding some of the basic aspects of these complex investment vehicles. This paper is designed to assist investors in understanding hedge funds and the issues that all potential investors should be aware of before investing in such vehicles.

If the growth in the number and variety of published indices is any indication, there is no shortage of disagreement on the proper way to construct and apply a market benchmark. Competition in the index marketplace is to be expected as it is far from a purely academic pursuit. Indexes are big business, and getting bigger every year. Trillions of dollars are either measured against or invested in published equity indexes and that means substantial revenue for index providers who license their products and peddle supporting data and services. Sales hype from the various index publishers touts different construction methodologies as superior for one reason or another. In some cases their claims are valid, but all too often approaches that seem rational and theoretically appealing have undesirable consequences when applied in the real world.

The last two decades have seen the rise and fall of enthusiasm of US investors for the stocks of foreign owned companies. With few exceptions international equity performance of the past several years as measured by the MSCI EAFE index has been disappointing at best. At the same time measures of correlation with US equity indices appear to have reached a historically high plateau, causing many investors to question whether international stocks should still be considered the diversifiers that they once were touted to be. For US investors who are rethinking their allocation to this important asset class, the issues involved are not as clear-cut as they might first appear.

The stock market bubble of 1999 and the three year bear market that followed in its wake has caused many investors to question their rationale for investing in stocks. Were the large portions of investors' portfolios dedicated to this asset class in the past a colossal mistake, or the logical result of years of investment wisdom. With returns on high-quality bonds for the past 20 years at over 10% per year, it is easy to see why some are asking if stocks are worth the risk. Examining the historical behavior of stock and bond market returns, however, reveals that the rewards of long-term stock investing have been well worth the risk and that the best days for bonds may already be over.

Peer group comparisons in performance measurement and manager selection are so widespread that they have attained an almost unspoken air of legitimacy. This comes in spite of a significant body of research detailing the serious flaws inherent in the construction of manager universes and their application. This paper surveys the existing literature on the inadequacies of peer group analytics and why they should be rejected as serious benchmarks of active manager performance.

Among institutional investors, the past decade has seen equity style evolve from a subjective generalization of investment philosophy to a crowded bazaar of rigid quantitative classification systems for stocks and portfolios. These modern style methodologies have enjoyed wide acceptance from the institutional investment community under a presumption that their application benefits both portfolio construction and performance measurement. Are these ostensibly scientific systems for parsing stocks and measuring their performance actually helpful to the investment process, or do they handicap effective portfolio management?

Since the early 1970's passive investing, or "indexing" has grown from an intriguing academic concept to an investment strategy boasting over $500 billion in retail investment market value. The impact on institutional investment portfolios has been just as dramatic with the firm Greenwich Associates estimating that approximately 30% of institutional assets are passively invested. Traditional methods of manager selection have produced disappointing results and have reinforced the perception that markets are efficient and active management is incapable of beating buy-and-hold strategies. But the field of Behavioral Finance continues to mount evidence against efficient market theories and recent research indicates that managers with the skill to beat passive indices can be successfully identified.

The past 15 years have seen Markowitz Mean-Variance Optimization grow from an obscure academic argument for diversification to a ubiquitous elixir to cure what ails the portfolio of every individual investor. This study tests how using Mean-Variance Optimization to reposition a three-asset portfolio on an annual basis would have faired against various fixed allocations with equivalent expected risk. Optimizations were performed using six different methods to derive inputs and over three different look-back periods. Results indicate that most input derivation methods cause the "optimized" portfolios to underperform their fixed allocation counterparts.