This story appears in the December 29, 2014 issue of Forbes.
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Ivory-tower money managers have been viewed suspiciously since the spectacular 1998 collapse of Long-Term Capital Management,
with two Nobel Prize economics winners, Robert Merton and Myron
Scholes, involved. But don’t write the eggheads off. After all, Yale’s
Robert Shiller warned about the housing bubble long before it burst.
Here are four academics whose insights could help you get rich or at
least protect the wealth you have.
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Andrew W. Lo, 54
MIT Sloan School of Management
Finance professor and director, Laboratory for Financial Engineering
Artificial Stupidity
“It’s unrealistic to say buy and hold. It’s like telling teenagers to abstain from sex,” quips Lo.
The Hong Kong-born and Yale-and Harvard-educated Lo is hardly the first to observe that many investors hold on too long when markets are going down, finally panic and sell, and then wait way too long to get back in. What’s novel is the way he mixes behavioral economics and artificial intelligence to design programs that allow for human emotions while minimizing their wealth-destroying impact, an approach he dubs “artificial stupidity.”
Simple example: There’s a threshold of pain–say, a 25% dive in the stock market–beyond which most normal humans can’t resist dumping stocks and going to cash. Fine. At that point the computer puts you in cash so you can sleep at night. But when market volatility subsides, as reflected, for example, by a decline in the Chicago Board of Options Exchange VIX Index, the computer starts buying again, long before most people would have the stomach to get back in. Truth is, buying and selling according to the VIX isn’t so stupid. “When the VIX spikes,” Lo says, “equities are almost never your friend.”
Formulas for success: From left, Andrew Low
of MIT, Robert Whitelaw of NYU, Stockholm’s Lasse Pedersen, and Jeffrey
Brown of U. Ill. (Photo credit: Jason Grow, David Yellen and Jeff
Sciortino For Forbes)
Don’t want to pony up the fund’s 1.33% annual expense and up to 5.75% sales load?
Lo offers this free advice: Accept you are a mortal who can panic, and adjust your portfolio to the risk in the marketplace, moving to bonds and cash when volatility goes up and moving back to equities when it subsides. The case for this approach is stronger since the increased tendency of different asset classes to move downward together in a crisis has weakened the power of diversification as a sleep-at-night prescription. “We all live in a world of diversification-deficit disorder,” says Lo.
Robert Whitelaw, 51
NYU Stern School of Business
Professor and chairman, Department of Finance
Hedge Funds on the Cheap
The British-born and MIT- and Stanford-educated Whitelaw is an avid skier who has hiked the Alps, completing the popular 105-mile Tour du Mont Blanc trail through France, Italy and Switzerland with his family. So perhaps it’s fitting that he aims to conquer the hedge fund heights–for the average investor.
As chief investment strategist of $1.5 billion (assets) IndexIQ (which New York Life Insurance Co. just agreed to buy) Whitelaw is attempting to replicate hedge fund strategies on the cheap with combinations of ETFs. Underlying this effort is his belief that there’s a good reason to own hedge funds: Their performance isn’t correlated with the ups and downs of the rest of your portfolio because they invest in alternative markets (or strategies) most retail investors don’t have access to.
But, he says, you can’t know in advance which managers will actually generate alpha–that is, which will outperform the market return (or beta) of those alternatives–particularly after their voracious fees (typically 2% of assets and 20% of profits) are taken into account.
Want exposure to commodities? Instead of paying a manager to trade corn futures on the Chicago Mercantile Exchange, you could buy a portfolio of stocks whose earnings are driven mostly by commodity prices, then short the whole stock market to strip out market beta. What’s left is a synthetic commodities portfolio, minus the 2-and-20. IndexIQ’s Global Resources ETF uses this strategy. Total expense ratio: 0.76% of assets.
What about replicating the performance of global macro hedge funds? Whitelaw has identified half a dozen substrategies, including fixed-income arbitrage and emerging markets equities, that he thinks explain most of their returns. He and IndexIQ programmers have devised “optimizers” that shift money from strategy to strategy.
He admits there’s one style of hedge fund he can’t match: that of activist managers like Daniel Loeb, who make concentrated bets no computer could predict.
Lasse Pedersen, 42
NYU Stern and Copenhagen Business School
Finance professor
Momentum and Value Do Mix
Momentum investing is nothing new–instead of fighting the tape, you buy stocks that are going up and dump (or short) those going down.
But what makes Pedersen’s work intriguing is his finding that all sorts of individual securities in different countries display a sort of momentum effect, where they tend to keep going in the direction they’ve been going for, say, a year. From stocks to commodities to currencies, it doesn’t matter what you’re trading, just the direction it’s been going lately.
Pedersen gets to apply his theories with real money these days as a principal with AQR, which manages $115 billion, and he admits it’s been an education. Trading strategies that look good on paper can fall apart when the humans who actually buy and sell securities panic and liquidity evaporates, he notes–the very sequence of events that took down Long-Term Capital. But wait. If you’re more of a Warren Buffett value investor than a day trader, the prolific Denmark native also has work that suggests an answer to the mystery of why boring value stocks return more than their flashy growth counterparts.
Some academics say it’s because boring companies are actually more risky, since they tend to be in older industries that could fade away. Pedersen sees something else going on: Most investors can’t or won’t use leverage to goose their returns (as some academics predict they should), yet they still want to get rich quick. So they pay too much for stocks that offer the promise of Google-type returns, just as people pay too much for lottery tickets.
For those with an eclectic investing approach, Pedersen has found that you can combine a diversified portfolio of momentum investments with low-priced value stocks to get nicely balanced returns. “If you take value and momentum, they almost sound like they are opposites,” he admits. “The fact that they’ve both worked together historically is quite remarkable.”
Jeffrey Brown, 46
University of Illinois
Finance professor and director, Center for Business & Public Policy
Longevity Play
Brown doesn’t manage any investment funds. But he just might have a bigger impact on your retirement than the other profs. With a Ph.D. in economics from MIT and a master’s in public policy from Harvard, Brown was a Social Security advisor to President George W. Bush, and his research is now influencing tweaks being made in Washington to 401(k)s.
His work tries to figure out why people don’t buy retirement annuities as often as economists think they should–an issue that has new urgency now that 401(k)s are replacing fixed pensions, leaving more retirees at risk of outliving their money. He went through likely reasons: Too expensive? No inflation protection? Wanting to leave an inheritance for the kids? “Each explained a little bit, but nothing explained the preponderance,” he says.
Brown’s research, including surveying thousands of investors, suggests that part of the explanation is in the way an annuity purchase is “framed.” If folks are asked how much they need for basic expenses in retirement and then shown how annuitizing part of their nest egg leaves the rest of their money to be invested how they see fit, they respond better than if they are asked to hand over their life savings to an insurance company, he says.
Plus, the very nature of 401(k)s–in which you focus on building up an account–creates a psychological barrier to annuities. “If you spend your career focused on measuring how much money you have in your account, it’s hard handing that money over for an exchange of income,” observes Brown, a paid trustee for TIAA-CREF.
Brown’s findings suggest that, with some modest nudges, folks will buy more annuities. In July the Obama Treasury changed tax rules to make it easier for longevity annuities, which begin paying a fixed benefit when a retiree is very old–say, 80–to be purchased and held within IRAs and 401(k)s. The change: Up to $125,000 can be spent on such an annuity without its principal counting in calculating the annual required minimum distributions folks over 70 must take from their pretax retirement accounts.
In October the Treasury approved annuities as a holding for the target-date funds that fill a growing number of workers’ 401(k)s. “There’s been a huge wall preventing plan sponsors from providing annuities,” Brown says, and that change has opened a crack. “It will take a few more swings of the ax, and hopefully this barrier will come down.”
