Markov Processes’ reverse engineering of hedge fund portfolios with.....

Opalesque New York: Opalesque recently had the chance to speak with Michael Markov, CEO and Director of Research at the U.S. offices of Markov Processes International (MPI) about the firm�s reverse engineering approach to hedge fund analysis as well as their thoughts on hedge fund replication strategies and some of the new ways they are using their data capabilities to increase transparency to clients within the industry.

One of the tests which elite US Navy SEALs must take to be considered expert marksmen requires them to disassemble and reassemble a variety of weapons. In addition to the physical ability to take apart and put together the tools of their profession, they must name each part as they go, while an instructor times them and asks them various probing questions about each part of the weapon and about its function as a whole.

It is perhaps an apt comparison to the requirements of the team at MPI (a team that includes a former lead software engineer with a specialty in robotics and technical cybernetics who designed robots for Russian military and space programs) which disassemble and reassemble portfolios as part of their analysis of a fund�s return streams. In fact, the team is capable of reverse engineering a portfolio to provide in-depth analysis of a fund even when given less than a year of returns to work with and only the most basic information on a fund�s focus of investing.

MPI launched in 1992 with a focus on mutual funds and institutional products. Using the ideas that Nobel Laureate William Sharpe (creator of Sharpe ratio) published, Markov and Mik Kvitchko, MPI Chairman and Chief Technology Officer, wrote the first commercial application to analyze mutual fund products. The program itself received an endorsement from Sharpe . �It is harder to apply the same methodology to hedge funds because they have fewer restrictions, trade frequently, have derivatives, can turn their portfolio on a whim, and do various things which traditional managers cannot do,� Markov explained. However, the collapse of Long Term Capital in 1998 proved to be too intriguing a case study for the team and soon MPI set their sights on the hedge fund industry.

�The key to the analysis is dynamic modeling,� explains Markov. �Most analysis is static and the problem with that is betas are changing all of the time�There are techniques in other sciences, especially in the defense industry where they track moving targets. They are very delicate methodologies.�

Using an international team of mathematicians MPI was able to write a program which could regress a hedge fund from performance backwards to reveal the portfolio�s possible investments.

With only 8 or 9 months of performance numbers they reverse engineered the Long Term Capital portfolio and released a white paper detailing the fund�s collapse. The program itself received several recommendations for the firm�s first hedge fund clients.

More recently, Markov has used the......................

Source:
http://www.opalesque.com/AMB2008/47811Markov_reverse_engineering_of_hedge.html