The Japanese attack on Pearl Harbor might have had a very different outcome had the United States made better use of a new and unique tool in its possession. The tool called radar could identify, track and anticipate the movements of specific targets using only position data and special filtering algorithms. Unfortunately, the technique was so new its users could not trust the results to avoid disaster. Radar eventually became a trusted cornerstone of civilian aviation and air defense, with advances like sophisticated filtering techniques, which helped to guide the descent of the Apollo 11 lunar module to the moon, among other key uses. In light of the Madoff scandal, in addition to other recent hedge fund fraud cases, it seems appropriate to ask why we cant develop tools to warn us of these kinds of financial threats as well.
As it happens, such "financial radar" is available to investment professionals. However, it has only been with recent advances in technology and modeling that the approach has been able to address the needs of hedge fund analysts and gain their trust. The disciplined use of such tools, along with skeptical qualitative analysis, can help the industry better identify and avoid its next threats.
In his groundbreaking work on returns-based style analysis in 1992, Nobel laureate William F. Sharpe demonstrated that one doesn't have to know the historical holdings of a portfolio to understand its investment style and anticipate its performance and risk; rather all one needed was a stream of monthly or quarterly portfolio returns and a generic quadratic optimization technique. The adoption of returns-based style analysis tools over the past 17 years has made the industry more transparent, secure and efficient. The applications ranged from manager searches, due diligence and monitoring, to risk management and competitive intelligence.
Institutional investors, among the first to embrace returns-based style analysis, found that they no longer had to rely solely on a consultant's or manager's assessment of strategy and skill they could easily vet both with the click of a button. Today, recent advances in returns-based style analysis have incorporated some of the techniques used in actual radar and hold much promise in improving hedge fund risk analysis.