GREENWICH, Conn. -- Andrew W. Lo, finance professor on leave from the Massachusetts Institute of Technology, will manage a hedge fund for Paloma Partners Management Co.,
Mr. Lo and a team he assembled as AlphaSimplex Group LLC have been building a quantitative trading model for a strategy known as statistical arbitrage for the past year for Paloma. He said he expects to begin managing money by early next year, awaiting the completion of the development of the investment strategy.
S. Donald Sussman, chairman, chief executive officer and owner of Paloma, said Mr. Lo will be assigned a small amount of money initially to manage to test the strategy and keep the risk of loss for client portfolios low; then, if successful, "whatever it can take."
How long will Paloma give Mr. Lo and his team to perform? "I'm a very patient man," Mr. Sussman said.
Because of the addition of Mr. Lo and the pending addition of two other managers, Paloma, which has been virtually closed to new clients since 1993, soon will reopen. Mr. Sussman said he expects Paloma soon will have capacity to take $400 million to $500 million in money from new clients.
Paloma, based in Greenwich, Conn., has $1.6 billion under management, including about $240 million from pension funds and $720 million from endowments, foundations and insurance companies. It specializes in market-neutral strategies.
Mr. Sussman said Mr. Lo "is the real intellectual driving force" behind statistical arbitrage, laying groundwork for the strategy in academic papers going back to the 1980s, which gave rise to its use by other money managers.
"The strategy is the use of advanced mathematics to generate a large basket of securities that have a high probability of trading in a predictable manner," Mr. Sussman said.
Jane Buchan, principal at Pacific Alternative Asset Management Co. LLC, Irvine, Calif., a fund of hedge funds, spoke in general about statistical arbitrage. She said it seeks to exploit shorter-term trading patterns of stocks. One phenomenon might be the short-term reversal, where there is a tendency for a stock after it surges for two or three days to backtrack a little, or for a stock that has weakened for a few days to rebound a little. She said the strategy in general is characterized by a high degree of turnover trying to take advantage of tiny, short-term statistical anomalies in the way a stock trades.
"Statistical arbitrage is a name I'm not that fond of," said Mr. Lo, adding AlphaSimplex uses lots of economic and fundamental data. "That's an industry term. It didn't come out of academia.
"Quantitative models based on trading are lumped together with black boxes," he said. "I'm a firm opponent of black box trading. If you don't know what is in the model, you shouldn't trade it."
Mr. Lo said the AlphaSimplex model "uses lots of fundamental variables, like accounting data, but we do so in a computationally complex way."
Building a trading model
Mr. Lo said he and his team are developing a trading model that uses underlying economic and financial theories. The factors he said the strategy will use include accounting variables, earnings surprises, and dividend yields. In addition, he said, "Behavioral and psychological aspects will be relevant to what we are doing."
He said the investment process is taking a long time to develop because "we are building a substantial infrastructure of computers, data, and algorithms."
"We want to create a platform by which new strategies can be developed," he said, to ensure longevity of the process. "Strategies can quickly lose value as they become known in the market." As other investors seek to replicate the strategy, the anomalies the investors are chasing tend to go away, Mr. Lo added.
Mr. Lo said the approach will be equal-weighted long-short. "We don't plan to use leverage aside from the shorting," he added.
The strategy will be benchmarked against 90-day Treasury bills. He expects returns of 15-20 percentage points above the benchmark a year.
Mr. Lo in July began a one-year leave from MIT, Cambridge, Mass., to devote more time to developing the strategy. He said he plans to remain on the faculty.
"I believe having a strong research base is the goose that lays the golden egg," he added.
Paloma, which provided the capital for Mr. Lo to set up his Cambridge-based firm, has an exclusive agreement with him for managing money. The venture is the first time Mr. Lo, who has "done a fair bit of consulting to money managers," will manage money, he said.
Mr. Lo set up AlphaSimplex in October 1999. Mr. Lo, its chief scientific officer, is one of 14 partners of the firm. Others on the AlphaSimplex team include A. Craig MacKinlay, professor of finance at the Wharton School, University of Pennsylvania, who also has consulted to some money management firms.
In a separate effort, AlphaSimplex has a joint development project under way on global asset allocation with Deutsche Asset Management Inc., New York. Mr. Lo said Paloma has right of first refusal on AlphaSimplex's work and wasn't interested in the project.