FAST TRACK: Money management? It’s academic

Academia meets money management.

Andrew W. Lo, a finance professor on leave from the Massachusetts Institute of Technology, will manage a hedge fund for Paloma Partners Management Co. in Greenwich, Conn.

Mr. Lo and a team he assembled, AlphaSimplex Group LLC, during the past year have been building for Paloma a quantitative trading model for a strategy called statistical arbitrage. He says 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, says Mr. Lo initially will be assigned a small amount of money to manage. He will use it to test the strategy and keep the risk of loss for client portfolios low. Then, if Mr. Lo is successful, he will be entrusted with “whatever it can take,” says Mr. Sussman.

How long will Paloma give Mr. Lo and his team to perform? “I’m a very patient man,” Mr. Sussman says.

Because of the addition of Mr. Lo and two other managers, Paloma, which has been virtually closed to new clients since 1993, will soon reopen. Mr. Sussman says he expects Paloma will have the capacity to take $400 million to $500 million in money from new clients.

Market-neutral specialist

Paloma 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. Lo in July began a one-year leave from MIT in Cambridge, Mass., to devote more time to developing the strategy. He says he plans to remain on the faculty.

“I believe having a strong research base is the goose that lays the golden egg,” he adds.

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 says.

Mr. Sussman says Mr. Lo “is the real intellectual driving force” behind statistical arbitrage strategy.

“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 says.

Jane Buchan, a principal at Irvine, Calif.-based Pacific Alternative Asset Management Co. LLC, a fund of hedge funds, says statistical arbitrage 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 that has surged for two or three days to backtrack a little, or for a stock that has weakened for a few days to rebound.

She says 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.

Mr. Lo says he and his team are developing a trading model that uses underlying economic and financial theories. He says the factors the strategy will use include accounting variables, earnings surprises and dividend yields. In addition, he says, “behavioral and psychological aspects will be relevant to what we are doing.”

Mr. Lo says the approach will be equal-weighted long-short. “We don’t plan to use leverage aside from the shorting,” he adds.

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 set up AlphaSimplex in October 1999. Mr. Lo, its chief scientific officer, is one of 14 partners of the firm. The AlphaSimplex team also includes A. Craig MacKinlay, professor of finance at the Wharton School of the University of Pennsylvania, who also has consulted to some money management firms.