Investing for the Future: Academics predict more complexity

“A theory should be as simple as possible, but no simpler.” If one applies Albert Einstein’s words to a colorful basket of theses from leading US academics about the future of investing, it could look like this:

Andrew Lo of MIT’s Sloan School of Management provides the foundation of the theory. For one of America’s current academic superstars, it is pretty clear how the future must look: “We need to solve investors’ biggest problem – uncertain outcomes of risks and returns.

So far, so simple. However, beyond this basic plot, it gets complicated.

The consequence of Mr. Lo’s intuitive statement could prove vexing for those, like academics such as Harvard’s Robert Pozen, who advocate the need for simplicity and a so-called “back-to-basics” approach. Ironically, they could soon find themselves in a complex world where financial engineering celebrates a massive comeback, rather than in a simplistic universe of current accounts, plain vanilla products and massive regulation.

We can explore some details of this world by asking some simple questions.

Will we be fully certain about our risks and rewards?

No, but we are getting closer as financial engineering is set to shift its focus from delivering more return to providing more stability. For example, according to Mr. Lo, in less than five years an investor will be able to buy an equity linked product, guaranteeing him a volatility of, say 15 per cent. However, financial engineers are still far away from understanding why markets change so quickly without necessarily being efficient – solving this big puzzle will take another 50 years.

Will we still think in asset classes?

Yes, but there will be many more, as more investors pick up hedge fund type strategies and as technology allows them to move away from market cap-weighted, long-only indexes to employ more sophisticated, yet investable benchmarks.
Harvard professor Luis Viceira goes further, suggesting investors would benefit from allocating money to products that directly expose them to performance drivers like equity risk, real interest rate risk and inflation risk, instead of investing in pools of risks like asset classes, where risks are not clearly separated.

Will we use indexes more ?

Yes. Since there are many more asset classes, there are as many new indexes and betas (market or asset class returns) to choose from. Prominent examples are carry trade betas (the strategy of borrowing in low interest currencies to invest in high interest ones), credit trade betas, volatility betas, liquidity betas and alternative betas, which replicate the performance of hedge fund strategies.

Will we still strive for more than just average?

Yes. Mr Lo, along with academics at Harvard Business School such as Robert Pozen, Kenneth Froot, Malcolm Baker and Luis Viceira, still regards alpha, outperformance based on unique insights, as the ultimate goal of intelligent investing.
This judgment comes as a surprise at a time when passive investments are seriously challenging the business models of traditional long-only managers and trustees are asking whether a pension fund needs alpha at all.

Will we perceive risk differently?

Yes, mainly because of two risks no one cared about much: illiquidity and inflation. According to Mr. Froot, “investors will demand higher risk premiums as a consequence of the illiquidity and intransparency of the bond market”. US investors such as university endowments should have learned their lesson with illiquidity, adds behavioral finance expert Malcolm Baker: “They had to realize their investment horizon is much shorter than they thought.„

Inflation, on the other side, catches Mr Viceira’s attention. That is why he advocates inflation-linked investments as the most likely new risk-free asset class, not cash or money market deposits. Endowments have taken up Mr Viceira’s idea, as has APG investments, the asset management arm of Dutch pension fund ABP, where Mr Viceira sits on the board.

Will we still benefit from diversification?

Yes, but it could disillusion investors even more than before. The excessive liquidity provided by the central banks is a big concern for the academics. They expect asset price bubbles, primarily in bonds, but also in emerging markets.

Will hedge funds disappear?

No. For Mr Lo, hedge funds are “the Galapagos islands of the financial services industry”, as they will adapt fastest to new opportunities, giving them a competitive advantage and remain the choice for the sophisticated successful investor.

Will the US capital markets become less attractive?

No, says Andrei Shleifer of Harvard’s economic department. The Russian-born academic expects the US to remain the financial superpower. Hence, with the largest and most liquid capital markets in the world, it will still attract the bulk of investors’ assets.