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Volatility vs Liquidity

Traditionally, economists have thought that big up-and-down
fluctuations in returns indicated risky investments, so many hedge
fund investors have hoped to see a pattern of smooth and even returns.

Andrew Lo quickly saw that lots of hedge funds were posting returns
that were just too smooth to be realistic. Digging deeper, he found
that funds with hard-to-appraise, illiquid investments - like real
estate or esoteric interest rate swaps - showed returns that were
particularly even. In those cases, he concluded, managers had no way
to measure their fluctuations, and simply assumed that their value was
going up steadily. The problem, unfortunately, is that those are
exactly the kinds of investments that can be subject to big losses in
a crisis. In 1998, investors retreated en masse from such investments.

Mr. Lo came to a disturbing conclusion: that smooth returns,
far from proving that hedge funds are safe, may be a warning
sign for the industry.


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