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Andrea Eisfeldt, Hanno Lustig and Lei Zhang: To Grab Expected Excess Return, the Hard Part is Designing Just the Right Tracking Portfolio

Summary:
Andrea Eisfeldt finds that hedge funds with infrastructure to execute sophisticated arbitrage crowd out less-expert investors An asset that consistently provides a compelling risk-adjusted return would seemingly attract a new crowd of investors, the increased demand quickly driving down returns. Yet that’s not always the case. More complex assets, such as mortgage-backed securities, which persistently generate outsized risk-adjusted returns when run through effective arbitrage strategies, tend not to be overrun by the capitalistic herd mentality. A missed opportunity for the investing masses? Not exactly. UCLA Anderson’s Andrea Eisfeldt, Stanford’s Hanno Lustig and the University of Hong Kong’s Lei Zhang find that the complexity of the asset — more specifically, the

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Andrea Eisfeldt finds that hedge funds with infrastructure to execute sophisticated arbitrage crowd out less-expert investors

An asset that consistently provides a compelling risk-adjusted return would seemingly attract a new crowd of investors, the increased demand quickly driving down returns.

Yet that’s not always the case. More complex assets, such as mortgage-backed securities, which persistently generate outsized risk-adjusted returns when run through effective arbitrage strategies, tend not to be overrun by the capitalistic herd mentality.

A missed opportunity for the investing masses? Not exactly. UCLA Anderson’s Andrea Eisfeldt, Stanford’s Hanno Lustig and the University of Hong Kong’s Lei Zhang find that the complexity of the asset — more specifically, the need for an effective arbitrage strategy that grabs the excess return (alpha) without excess risk — creates a high barrier to entry.

The researchers developed a model using data from the Hedge Fund Research database. The structure of hedge funds lends itself to the world of complex assets, where extracting value works best with a two-step strategy: a long position in the asset that is focused on grabbing the potential alpha, along with a tracking portfolio run to hedge. It’s the latter that keeps demand lower. “Because each investor has their own model and strategy implementation, tracking portfolios introduce investor-specific shocks,” said Eisfeldt. That is, you’re only as good as your execution on the hedging side.

Miles Kimball
Miles Kimball is Professor of Economics and Survey Research at the University of Michigan. Politically, Miles is an independent who grew up in an apolitical family. He holds many strong opinions—open to revision in response to cogent arguments—that do not line up neatly with either the Republican or Democratic Party.

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