To outsiders, the hedge fund industry often looks like the Wild West. For these lightly regulated and secretive investment pools, restricted to institutions and the wealthy, anything goes: exotic "black box" strategies, bets on portfolios packed with seemingly unrelated holdings, heavy borrowing to magnify results....
But hedge funds aren't betting the farm on a roll of the dice. In fact, many hedge fund managers spend considerable time and money trying to insure that the potential gains from any investment strategy will be worth the risks.
How well does risk management work? Because hedge funds are so secretive, that hasn't always been easy to figure out. "It's very hard to understand empirically what the benefit of risk management is," says Wharton accounting professor Gavin Cassar. "Most of the time you cannot observe what an organization's risk practice is."
And although a layman may assume risk management is a good thing, that's not a given, either. Hedging and other strategies can be expensive, and too much caution can stunt profits. "It's not obvious that by having better risk management, you are going to be a better-performing fund," Cassar notes...
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Random portfolios select a sample of portfolios that obey a given set of constraints.
They have many uses -- measuring performance is one of the most important.
Performance can be measured much more accurately with random portfolios than
with other methods. The measurement can be on hypothetical strategies in backtests
as well as traditional performance measurement.