Seeking to compensate for the stock market’s lackluster returns over the past five years, institutional investors are putting more and more money into hedge funds, while maintaining core portfolio allocations in bonds and stock index funds. As a result, hedge funds are now the fastest-growing sector of the asset management industry. As endowment and pension fund managers explore this largely uncharted territory, how can they understand and manage the risk associated with hedge funds?
Building on a decade of research in dynamic portfolio theory, Sid Browne developed a model that helps endowments and pension funds use hedge fund investments to securely meet their long-term financial obligations. His earlier research was based on the idea that endowments and pension funds are less interested in maximizing utility — the classic framework for economic analysis — than in maximizing survival. That is, given a fixed spending rule, what investment strategy will keep the organization alive for the next 100 years? In his work at Columbia Business School, Browne developed goal-based portfolio models that enable institutional investors to create such a strategy.
“My research,” he explains, “took trading-based objectives and put them into a rigorous investment framework — meaning, forget about expected utility and consider instead objectives like minimizing the expected time until I double my money, subject to a constraint that I don’t lose more than 10 percent along the way. That’s the way endowment and pension fund managers think.”
During a three-year stint at Goldman Sachs Asset Management from 1998 to 2001, Browne shifted his attention from investment risk to trading risk, developing a factor model that breaks down the risk of option volatilities. In 2004, he took another leave of absence from the classroom and returned to Goldman, where his responsibilities include helping endowment and pension fund managers understand how to use hedge fund investments within a long-term asset-allocation framework.
Applying insights from his previous models, Browne developed a factor model that decomposes the risk of hedge funds’ dynamic trading strategies. It focuses on the wings — for example the top and bottom quartiles — of the distribution of hedge fund returns. “When you’re investing over a long horizon, you can’t trade around volatility,” he says, “so it’s not volatility that you want to have a factor model for — it’s more the wings, or tails.” Because hedge funds use sophisticated strategies to control risk, their returns have a statistical behavior that endowments and pension funds can use to match their liability streams.
While Browne’s work combines portfolio management and risk management, he notes that these two approaches are based on seemingly conflicting philosophies. “Risk management is concerned with putting in the correct stops,” he says. “One part of risk management, the trading rule, tells you once you’ve lost a certain amount of your portfolio, quickly close those positions and sell. This appears to be fundamentally different than the basic trading rule of standard academic portfolio theory, which says to buy on the dips and take profits on the upside. But in portfolio theory you know the underlying model, and the trading rule tells you to have confidence in your model and buy on losses. The risk management rule of selling on losses comes into effect when it appears that your model may be wrong.”
In his work at Goldman, Browne has been surprised by how well the intuition of academic models applies to reality, in spite of the models’ inherent lack of precision. “At the end of the day, in many instances you have to have a model and you have to bet on it,” he says. “You have to say, I believe the model, and unless the data prove me wrong, I stick to it, because from a model you can gain insight. I was surprised by how much this resonates with pension fund and endowment managers. They understand this, and they actually live by it.”
In the wake of the mutual fund scandals of 2001–02, the opacity of hedge funds has raised concerns among some investors and regulators, prompting the SEC last fall to step up hedge fund regulation. But Browne thinks much of the doomsday fear about the systemic risk of hedge funds is somewhat overblown, noting that General Motors’s credit downgrade in May caused only a minor ripple in the hedge fund world.
“For years people were saying that the big danger in hedge fund land was that hedge funds were the main traders of credit derivatives and that in the event of a crisis, hedge funds could bring down the economy,” Browne says. “Well, in May we had an event that the press called a crisis. And the aftereffect was that a few funds went out of business and the rest of the world stayed standing. People should see this as more evidence that hedge funds are just the natural evolution of the asset management industry.”
Sid Browne is professor of decision, risk and operations at Columbia Business School. He is currently head of quantitative analysis, risk and research for alternative investments at Goldman Sachs Asset Management.