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Interview With Andrew Lo: Masters in Business (Audio) · Masters in Business

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Speaker 1: s I PC. This is Masters in Business with very
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Speaker 1: Ridholtz on Boomberg Radio. This week on the show, I
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Speaker 1: have an extra special guest, Professor Andrew Lowe of m
0:29
Speaker 1: I T. I first heard Professor Lowe speak at a
0:33
Speaker 1: conference about a decade ago, and I was I was
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Speaker 1: quite fascinated by his willingness to I don't want to
0:43
Speaker 1: say attack, but take on the efficient market hypothesis and
0:48
Speaker 1: adapt it uh to what he sees as some obvious
0:53
Speaker 1: modern changes in how people in technology are interacting with markets,
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Speaker 1: be they more efficient or less efficient. It's pretty clear
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Speaker 1: that the strong efficient market hypothesis, which essentially states markets
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Speaker 1: reflect the all information about stock prices in any given
1:13
Speaker 1: instant's a little bit of an overstatement. You have to
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Speaker 1: work in the actual human side, the emotions and and
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Speaker 1: as well as the adaptive side, how markets are consisting
1:26
Speaker 1: of organic participants and they themselves become organic and adapt
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Speaker 1: to changes fairly rapidly. UM. I think Professor Lowe's read
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Speaker 1: on the efficient efficient market hypothesis predated the Nobel Committee
1:41
Speaker 1: giving Bob Shiller of Yell and Gene Fama of chicag
1:45
Speaker 1: University of Chicago uh CO Nobel prizes, one for m
1:50
Speaker 1: H and the other for behavioral economics the same year.
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Speaker 1: It's not a coincidence, and and he very much was
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Speaker 1: clued into that before the Nobel Committee was. Anyway, if
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Speaker 1: you are at all interested in how markets operate, how
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Speaker 1: they adapt, what investors do that's right and wrong, and
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Speaker 1: as well as the significance of hedge funds within the
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Speaker 1: universe of market participants, I think you'll find this to
2:16
Speaker 1: be a fascinating conversation. So, with no further ado, my
2:19
Speaker 1: conversation with Professor Andrew low of m I T. This
2:25
Speaker 1: is Masters in Business with Barry Ridholts on Bloomberg Radio.
2:32
Speaker 1: My special guest today is Professor Andrew Lowe of the
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Speaker 1: m I T. Sloan School of Management. He has been
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Speaker 1: the director of m I T. S Laboratory for Financial Engineering,
2:43
Speaker 1: since he comes to US with a PhD in economics
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Speaker 1: from Harvard. He briefly taught at Wharton before going to
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Speaker 1: m I T and is the author of numerous books
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Speaker 1: about finance, including A non random Walk Down Wall Street,
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Speaker 1: Analytic Perspective on hedge Funds, The Evolution of Technical Analysis,
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Speaker 1: most recently Adaptive Markets, Financial Evolution at the Speed of Thought.
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Speaker 1: Professor Andrew Low, Welcome to Bloomberg. Thanks for having me.
3:12
Speaker 1: I'm thrilled you here. I've been a fan of your
3:14
Speaker 1: work for a long time. Let's jump into your background
3:18
Speaker 1: a little bit before we get to some of the
3:20
Speaker 1: heavy financial engineering work. Ironically, you right that you weren't
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Speaker 1: an especially good math students as a kid, and yet
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Speaker 1: you end up in a field that is dominated by
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Speaker 1: heavy mathematics. How did that come about? Well, you know,
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Speaker 1: I didn't know this at the time, but when I
3:38
Speaker 1: was going through elementary school and middle school, UM, I
3:41
Speaker 1: had a learning issue, which was I guess the mathematical
3:45
Speaker 1: equivalent of dyslexia. I think it's called DS calculia really,
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Speaker 1: and uh, I had a terrible time memorizing the multiplication
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Speaker 1: tables and were you transposing exactly? And uh, some of
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Speaker 1: my teachers told my mother that they thought I was
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Speaker 1: mentally retarded. That was the term of art in those
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Speaker 1: days and um, but it was a third grade teacher,
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Speaker 1: Mrs Barbara pick Laura that saw something in me and
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Speaker 1: encouraged me and appointed me to this position of class scientists,
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Speaker 1: where I was able to do experiments and demonstrate the
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Speaker 1: various kinds of knowledge that I had gotten over the
4:18
Speaker 1: course of several periods during the school and that really
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Speaker 1: boosted my self confidence. I still struggle with math until
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Speaker 1: high school, where the new math came about, and which
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Speaker 1: is essentially when we talk about new math, we're talking
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Speaker 1: about what well replacing algebra, trigonometry, and geometry with things
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Speaker 1: like group theory, ring theory and abstract algebra. And it
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Speaker 1: was an incredibly important moment for me because I went
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Speaker 1: from a C student in math to an A student
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Speaker 1: pretty much overnight. And it was because I could handle
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Speaker 1: abstract concepts much better than being able to do multiplication,
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Speaker 1: and so it was a really wonderful thing. I know
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Speaker 1: that new math is viewed is a failure in New
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Speaker 1: York City back in the nineteen seventies, but for me
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Speaker 1: it was a godsend. So now let's let's jump forward
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Speaker 1: a little bit and and bring the idea of abstract
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Speaker 1: concepts to markets. What's more important to markets supply and
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Speaker 1: demands or fear and greed? Well, you know the answer
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Speaker 1: is both. And that's really the interesting thing that I
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Speaker 1: discovered about human nature. We have two aspects to our
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Speaker 1: cognitive functions. Were incredibly good at logical deliberation and being
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Speaker 1: able to balance supply and demand using various fancy mathematical
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Speaker 1: and statistical tools. But at the same time, every once
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Speaker 1: in a while, we freak out. And when we freak out,
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Speaker 1: emotion rules today, and fear and greed then take over.
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Speaker 1: And it's this jackal and hide aspect of human decision
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Speaker 1: making that I think we're missing in economics being able
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Speaker 1: to integrate those two. So behavioral economics has become a
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Speaker 1: huge field between Professor Schiller, Professor sailor Danny Kahneman. Go
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Speaker 1: down the list of all the folks um who have
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Speaker 1: who have worked in this area. What does this say
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Speaker 1: about the efficient market hypothesis? Is it wrong or is
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Speaker 1: it simply incomplete? Yeah, it's definitely not wrong. There's some
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Speaker 1: very important elements of efficient markets hypothesis that actually can
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Speaker 1: protect us from making some pretty bad investment mistakes. But
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Speaker 1: it is incomplete in the sense that it doesn't capture
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Speaker 1: the fear and greed aspect of it. And I think
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Speaker 1: it's trying to integrate the two that really got me
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Speaker 1: to start thinking down the road towards adaptive markets. So
6:29
Speaker 1: let's talk about another duality. Rational rationality and irrationality coexist
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Speaker 1: even within the same person. How does that manifest itself
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Speaker 1: in in investment. Well, you know, it really comes from
6:44
Speaker 1: the neuroscientific aspect of decision making. So neuroscientists like Antonio
6:49
Speaker 1: Dimazio have come up with a really interesting notion of
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Speaker 1: what rationality means. And what he developed was this idea
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Speaker 1: that rationality actually requires a certain degree of emotion. In
7:02
Speaker 1: other words, when you take a look at patients that
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Speaker 1: have had brain surgeries that have removed the emotional part
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Speaker 1: of the brain, they end up acting in a very
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Speaker 1: irrational way because they have no way of balancing the
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Speaker 1: various different demands on their time. You know, when we
7:16
Speaker 1: think about showing up to work on time or meeting
7:19
Speaker 1: a deadline, emotion actually plays an important role in those
7:22
Speaker 1: kinds of behaviors. So with the proper balance of emotion
7:26
Speaker 1: and logical deliberation, we end up seeming quite rational. But
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Speaker 1: when that balance goes askew, when we have too much
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Speaker 1: or too little emotion, we end up making mistakes. And
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Speaker 1: that's very much along the same lines of how investors
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Speaker 1: actually behave. So when we talk about fear and greed,
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Speaker 1: we're really talking about the moments when the irrational side
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Speaker 1: of the brain takes over and the logic steps back,
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Speaker 1: and no one says to themselves, g I'm gonna be
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Speaker 1: able to time my in and out perfectly. I'm going
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Speaker 1: to be able to jump back in despite having the
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Speaker 1: being in a terrible crash. We just tend to panic exactly.
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Speaker 1: And you know, panic is actually a very important evolutionary adaptation.
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Speaker 1: Fear and greed are a lot older than the ability
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Speaker 1: to solve differential equations, and so when we start becoming threatened,
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Speaker 1: we will react emotionally and and for physical threats that's
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Speaker 1: actually a great response, but for financial threats it doesn't
8:23
Speaker 1: work out nearly as well. I'm Barry Hults. You're listening
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Speaker 1: to Masters in Business on Bloomberg Radio. My special guest
8:30
Speaker 1: today is Professor Andrew Low of m I. T. Sloan School,
8:34
Speaker 1: of management. Let's talk a little bit about economists, and
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Speaker 1: especially financial economists. I've long been a fan of the
8:42
Speaker 1: phrase that economists suffer from physics envy, and there's a
8:47
Speaker 1: quote of years that I have to share. Physicists can
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Speaker 1: explain of all observable physical phenomena using Newton's three laws
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Speaker 1: of motion. Economists probably have laws that explain three percent
9:03
Speaker 1: of all economic behavior. Explain that, well, you know, economics
9:09
Speaker 1: is about a much more complicated subject in physics, and
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Speaker 1: I think that's the first point that we have to
9:14
Speaker 1: grapple with. I think it was the physicist Richard Feynman
9:18
Speaker 1: who speaking at a Caltic graduation said, imagine how much
9:22
Speaker 1: harder physics would be if electrons had feelings, And I
9:25
Speaker 1: think that really captures it. We're dealing with people that
9:28
Speaker 1: have feelings, and they react emotionally, sometimes as opposed to
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Speaker 1: logically and rationally, and so the laws of physics don't
9:35
Speaker 1: really apply to human interactions in the same way that
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Speaker 1: they apply to particles in a gravitational field. And it's
9:41
Speaker 1: very tempting for us to use the mathematics and the
9:43
Speaker 1: mantle of physicists, but the fact is that we're dealing
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Speaker 1: with a very different object to say the very least.
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Speaker 1: So let's talk about the criticism of the profession. Do
9:55
Speaker 1: you think, first, do you think economists get unfairly criticized
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Speaker 1: and if so, what four? I think they do get
10:02
Speaker 1: unfairly criticized for certain things. Uh. It was once said
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Speaker 1: that economists predict five out of the last three recessions.
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Speaker 1: And uh, of course, you know, we don't have a
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Speaker 1: perfect track record or prediction, but neither do weather forecasters.
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Speaker 1: The nature of the task is much more challenging, and
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Speaker 1: so I think that people have to understand the difficulty
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Speaker 1: in making these kinds of economic predictions. We're getting better
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Speaker 1: all the time, but it's still not purely predictive science.
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Speaker 1: We need to actually take into account the art of
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Speaker 1: economic forecasts. So let me push back on that a
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Speaker 1: little bit. Yeah, that whether people are not perfect, but
10:37
Speaker 1: they could usually tell you a day or so before
10:40
Speaker 1: if it's going to rain, or if there's a possibility
10:42
Speaker 1: of rain, bring your umbrella. It's always always couched in
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Speaker 1: probabilistic terms, which if you say there's a ten percent
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Speaker 1: chance of rain and it rains, hey, the one intent
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Speaker 1: chance came in. But the big criticism about economists, especially
10:57
Speaker 1: in the past decade, has was how did you guys
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Speaker 1: miss the single biggest financial crisis since the Great Depression?
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Speaker 1: If you can't see that coming, how, how why should
11:09
Speaker 1: people rely on you? And I know that's a loaded question,
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Speaker 1: but defend the entire profession for missing the financial crisis, Well,
11:19
Speaker 1: you know, I'm not sure we did miss it. For example,
11:22
Speaker 1: in two thousand and five, Bob Schiller, ragu Rajan, and myself,
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Speaker 1: all three of us wrote papers that described stress fractures
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Speaker 1: in the financial system. Bob Shiller talked a bit about
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Speaker 1: the real estate market and how that was going to
11:37
Speaker 1: be another kind of irrational exuberance UH bubble that was
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Speaker 1: about to burst. In two thousand and five, ragu Rajan
11:44
Speaker 1: talked about the banking system becoming over extended and developing
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Speaker 1: these kinds of UH risks of financial crisis. And some
11:53
Speaker 1: of my students and I wrote about the fact that
11:55
Speaker 1: the hedge fund industry was also heading for another debacle,
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Speaker 1: very much along the line NDS of what happened in
12:02
Speaker 1: and so there was evidence in the data, and all
12:04
Speaker 1: three of us wrote papers and gave talks about it.
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Speaker 1: But the fact is that unless you've got a very
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Speaker 1: strong notion from the entire financial profession that we're headed
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Speaker 1: to a crisis. It's very difficult to engage in policies
12:17
Speaker 1: to try to do anything about it. And certainly the U. S.
12:20
Speaker 1: Treasury and the FED were not in a position to
12:23
Speaker 1: make very strong changes in policy because there was no
12:26
Speaker 1: official word like the National Weather Service to tell you
12:29
Speaker 1: that a hurricane was coming. We need to have something
12:31
Speaker 1: like a national weather service for financial crisis. Isn't that
12:35
Speaker 1: supposed to be part of the role of the Federal Reserve.
12:38
Speaker 1: Shouldn't they be looking at the sustainability of the system
12:41
Speaker 1: and looking for those hurricanes coming. Well, you know, that's
12:45
Speaker 1: part of their responsibility. But their focus is on the
12:48
Speaker 1: banking system, and as we know from the financial crisis,
12:50
Speaker 1: it was the shadow banking system that actually grew very
12:53
Speaker 1: very quickly, and that they don't actually have jurisdiction. But
12:56
Speaker 1: the other thing is that the FED has a dual responsibility.
12:59
Speaker 1: They're actually all is supposed to be encouraging economic growth
13:02
Speaker 1: with their monetary policies, and so it's very difficult when
13:05
Speaker 1: you've got this dual mission to be able to focus
13:08
Speaker 1: single mindedly on preventing financial crises from occurring. See I
13:12
Speaker 1: think that you yourself, um, Professor Schiller, and who was
13:17
Speaker 1: which was Raja? And there were a handful of others
13:21
Speaker 1: who had pointed out, um, the the huge um disquilibria
13:27
Speaker 1: that was existing in the in the system um. Righthart
13:31
Speaker 1: and Rogoff put out a paper in late oh seven
13:33
Speaker 1: early oh eight saying, hey, here's what the prior five
13:36
Speaker 1: financial crisis looked like and if the United States as one,
13:40
Speaker 1: which they were strongly implying, this is what we should expect.
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Speaker 1: Turned out to be fairly prescient. But the run of
13:46
Speaker 1: people of economists who were warning or at least talking
13:49
Speaker 1: about it, UH are notable because they are the exceptions
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Speaker 1: and the by and large most of the profession kind
13:57
Speaker 1: of missed it, Which raises the question how we learned
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Speaker 1: anything from the last crisis, and might the profession be
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Speaker 1: better suited to identify the next hurricane that comes along. Well,
14:07
Speaker 1: there's no doubt that the economics profession has been indelibly
14:11
Speaker 1: altered by the events of the past, chastened, absolutely humbled.
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Speaker 1: We've had many individuals who have stated publicly that they
14:19
Speaker 1: felt economics, particularly macroeconomics, has let down the profession, and
14:25
Speaker 1: I think part of it was a devotion to these
14:27
Speaker 1: extraordinarily complex, rigorous mathematical formulations which were precise but precisely wrong.
14:36
Speaker 1: And uh, someone once said that it's better to be
14:38
Speaker 1: approximately right than precisely wrong. And I think we're sort
14:41
Speaker 1: of taking that now to heart. Do do we? Are
14:44
Speaker 1: we overly enamored with precision and data, specifically for things
14:49
Speaker 1: that as you described, You know, the the old joke
14:53
Speaker 1: is why why do economists um provide data to two
14:57
Speaker 1: decimal points? And the answer is to shoot show they
15:00
Speaker 1: have a sense of humor. Are we overly reliant on
15:03
Speaker 1: the illusion of precision? And is that part of the
15:06
Speaker 1: problem that we run into? Well, that's definitely a problem,
15:09
Speaker 1: and I think that a number of economists have written
15:12
Speaker 1: about it, and I believe that there is some kind
15:14
Speaker 1: of a reaction or a backlash to the mathematization of economics.
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Speaker 1: There's no doubt that rigor has a role to play
15:22
Speaker 1: in our field. But someone once said that along with
15:25
Speaker 1: rigor usually goes mortis. So I think we have to
15:27
Speaker 1: be very careful about how we use mathematics. I'm Barry Ridholts.
15:31
Speaker 1: You're listening to Masters in Business on Bloomberg Radio. My
15:34
Speaker 1: special guest today is Professor Andrew Lowe of the m
15:38
Speaker 1: I T. Sloan School of Management, where he is the
15:41
Speaker 1: director of the m I T Labs for Financial Engineering.
15:45
Speaker 1: He has a PhD from Harvard and is the author
15:48
Speaker 1: of numerous books, including most recently, Adaptive Markets Financial Evolution
15:55
Speaker 1: at the Speed of Thought. Let's talk a little bit
15:57
Speaker 1: about the new book, because I I it's really fascinating
16:00
Speaker 1: and accessible. I don't want to call it a primer,
16:03
Speaker 1: but really a next generation look at how markets have
16:08
Speaker 1: changed over time and how investors should be interacting with them.
16:13
Speaker 1: Let me let me pull a quote right to begin with.
16:16
Speaker 1: The adaptive markets hypothesis is based on the insight than
16:20
Speaker 1: investors and financial markets behave more like biology than physics,
16:26
Speaker 1: comprising a population of living organisms competing to survive, not
16:32
Speaker 1: a collection of inanimate objects subject to the immutable laws
16:36
Speaker 1: of motion. How did you come about this biological organic
16:42
Speaker 1: explanation as opposed to the more traditional mathematical physics explanation. Well,
16:48
Speaker 1: you know I came about it. I guess really being dragged,
16:51
Speaker 1: kicking and screaming through various different disciplines. So the book
16:55
Speaker 1: is really a travelogue of my intellectual journey from a
17:00
Speaker 1: I heard devotee of efficient markets and rational expectations into
17:05
Speaker 1: the realm of first psychology and behavioral finance, and then
17:09
Speaker 1: to neuroscience and how people really make decisions, and then
17:12
Speaker 1: to the evolutionary biology of how our brain evolved, and
17:17
Speaker 1: then ultimately to the ecology of all of the various
17:21
Speaker 1: different dynamics of multiple competing species. So it wasn't that
17:25
Speaker 1: I was looking for these other disciplines, but they ultimately
17:28
Speaker 1: ended up becoming really important for understanding the very simple
17:32
Speaker 1: idea that you've got to explain these facts using as
17:36
Speaker 1: whatever tools you have at your disposal. We were speaking
17:39
Speaker 1: um off air that I had seen you Um give
17:43
Speaker 1: a lecture I think it was right after the financial crisis,
17:47
Speaker 1: trying to explain some of the reasons why markets were
17:50
Speaker 1: less efficient than they appear. How do you end up
17:53
Speaker 1: with a crisis and you end up with these wild
17:55
Speaker 1: highs and these crazy lows. If the markets are truly efficient,
17:58
Speaker 1: it can't be. That can't be the case. And the
18:02
Speaker 1: genesis of this process of the organic way of looking
18:06
Speaker 1: at markets were evident in your lecture. How long have
18:11
Speaker 1: you been playing with this idea? It has to be
18:14
Speaker 1: at least a decade, if not longer. Well, it's actually longer.
18:17
Speaker 1: It really started in when I started looking at the
18:22
Speaker 1: data for the random walk hypothesis. That's a particular version
18:25
Speaker 1: of efficient markets, which says that stock prices follow random walks.
18:29
Speaker 1: You can't predict where you're gonna be tomorrow based upon
18:31
Speaker 1: where you are today. At least that was the theory,
18:34
Speaker 1: And when my co author Craig McKinley and I started
18:37
Speaker 1: looking at the data, no matter which way we sliced it,
18:40
Speaker 1: we couldn't get the random walk to work. In other words,
18:43
Speaker 1: the data are not consistent with the random walk. There
18:46
Speaker 1: are predictability, there's some persistence and some momentum and other factors.
18:50
Speaker 1: In fact, you wrote a book A non random Walk
18:52
Speaker 1: down Wall Street, and you also wrote a book on
18:56
Speaker 1: the Heretics of Finance about technical analysts. How does that
19:00
Speaker 1: play into the biological approach? Well, so it was really
19:03
Speaker 1: looking at the technical analysis literature that got me to
19:06
Speaker 1: start thinking a little bit more broadly. For those of
19:09
Speaker 1: the listeners who don't know, technical analysis is really a
19:14
Speaker 1: somewhat disreputable uh field of study that academics often pooh pooh,
19:19
Speaker 1: but which I think actually has quite a lot of value,
19:23
Speaker 1: and it's the idea that you can use geometric patterns
19:26
Speaker 1: in price data to be able to make forecasts and
19:28
Speaker 1: to try to understand how markets move. The technical analysts
19:32
Speaker 1: from the nineties, forties and fifties really understood that markets
19:37
Speaker 1: were driven not just by supplying demand, but also by
19:40
Speaker 1: the nature of emotion, by fear and greed, and so
19:44
Speaker 1: they would actually come up with patterns, trends, reversals, and
19:48
Speaker 1: other kinds of tools that, for those days where they
19:50
Speaker 1: didn't have computers and fancy technology, actually allowed them to
19:55
Speaker 1: make pretty useful forecasts. And it was reading that literature
19:58
Speaker 1: that got me to start thinking a little bit more
20:00
Speaker 1: oddly that maybe the mathematical equations that we use in
20:02
Speaker 1: modern finance is not the be all, in the end
20:05
Speaker 1: all of how you think about financial markets. And to
20:08
Speaker 1: that point, another quote of yours were more impulsive over
20:12
Speaker 1: the short term and more logical over the long term,
20:15
Speaker 1: very reminiscent of Danny Kahneman's thinking fast and slow. Tell
20:19
Speaker 1: us what you mean by impulsive versus logical. Well, if
20:22
Speaker 1: you take a look at how people make decisions, it
20:25
Speaker 1: turns out that from the neurophysiological perspective, there are multiple
20:29
Speaker 1: competing components of the brain that are at work. For
20:32
Speaker 1: long term decisions where we have the luxury of thinking
20:36
Speaker 1: carefully and deliberating on various different choices, for example, asset
20:40
Speaker 1: allocation or retirement planning. We can make supremely rational, mathematically
20:45
Speaker 1: precise decisions. But then crisis hits, events happen and we react,
20:51
Speaker 1: and in those cases we're reacting emotionally, not necessarily logically.
20:55
Speaker 1: And it's the emotional components of the brain, which are
20:59
Speaker 1: far older than the ability to do mathematics, that kick in,
21:03
Speaker 1: and the way they kick in they really overwhelm us.
21:05
Speaker 1: We are overwhelmed by our emotional centers, and when that happens,
21:10
Speaker 1: the decisions that we make are not particularly good when
21:14
Speaker 1: it comes to for our financial health. I'm Barry rid Halts.
21:18
Speaker 1: You're listening to Masters in Business on Bloomberg Radio. My
21:21
Speaker 1: special guest today is Professor Andrew Lowe of the m I. T.
21:26
Speaker 1: Sloan School of Management. Let's talk a little bit about
21:29
Speaker 1: hedge funds, which you've written about extensively as well as
21:34
Speaker 1: written a book, Hedge Funds and Analytic Perspective. Let's start
21:38
Speaker 1: with a quote of yours. At the start, the general
21:41
Speaker 1: partner brings all the experience and the limited partners bring
21:45
Speaker 1: all the money. At the end, the general partner leaves
21:48
Speaker 1: with all the money and the limited partner leaves with
21:51
Speaker 1: all the experience. I find that to be a hilarious quote.
21:55
Speaker 1: How do you really feel about hedge funds? Well, you know,
21:58
Speaker 1: that was really meant to represent the kind of skepticism
22:00
Speaker 1: that a lot of people have for hedge funds. But
22:02
Speaker 1: I think that hedge funds play an incredibly important role
22:06
Speaker 1: in the financial ecosystem. They're the tip of the spear
22:09
Speaker 1: in terms of taking advantage of profit opportunities as they emerge,
22:12
Speaker 1: but they're also the canary in the coal mine. They
22:14
Speaker 1: get hit first when financial distress starts to develop. Why
22:18
Speaker 1: is that? Why are they so fast to react when
22:21
Speaker 1: an opportunity exists, but sometimes fast to embrace risks that
22:26
Speaker 1: don't pay off in fact have a negative ramification. Well,
22:31
Speaker 1: it's because of their unregulated nature. Hedge funds are allowed
22:35
Speaker 1: to do anything and everything in order to make returns
22:37
Speaker 1: for their investors, and the fact that they are unregulated
22:40
Speaker 1: is actually really important. It's because it allows us to
22:43
Speaker 1: see what all of the various different dynamics are in
22:46
Speaker 1: financial markets unfettered by regulation of any sort. So they're
22:50
Speaker 1: the laboratory. They're the experiment where these different things take place.
22:54
Speaker 1: And while they're three trillion dollars, which sounds like a
22:56
Speaker 1: lot of money in the grand scheme of global and
23:00
Speaker 1: sestable assets, that really is a few percentage of total
23:04
Speaker 1: um money that's out there at work. Well, it seems
23:06
Speaker 1: like a small number compared to say, Vanguard. Vanguard just
23:09
Speaker 1: passed their four trillion two right, So the entire hedge
23:13
Speaker 1: fund industry is only three trillion, But that number is
23:16
Speaker 1: misleading because hedge funds can use leverage, and they can
23:19
Speaker 1: go short, and they can trade at much higher frequencies
23:22
Speaker 1: than say mutual funds, So that three trillion goes a
23:24
Speaker 1: long long way in terms of having market impact. And
23:27
Speaker 1: one of the things that I'm always surprised when people
23:32
Speaker 1: bring up the financial crisis and hedge funds, and somehow
23:36
Speaker 1: I believe hedge funds were responsible. They really survived the crisis.
23:40
Speaker 1: They might have taken a little bit of a beating.
23:42
Speaker 1: I think the numbers were down, but they certainly weren't
23:45
Speaker 1: the cause of the crisis. In any way, shape or
23:47
Speaker 1: form or or Am I overstating it? No, No, you're
23:50
Speaker 1: right that it's really hard to attribute cause to any
23:53
Speaker 1: one player in the system. I think we all contributed
23:56
Speaker 1: to the financial crisis in one form or another. It's
23:59
Speaker 1: really the complex city of the system and the fact
24:01
Speaker 1: that we have these non linearities that people really weren't
24:04
Speaker 1: focusing on that ultimately caused this huge debacle. But really,
24:08
Speaker 1: hedge funds were not a big player in all the
24:11
Speaker 1: spaces that ultimately blew up. They weren't giant in securitization
24:15
Speaker 1: of mortgages, they weren't underwriting uh, subprime credit. They really
24:20
Speaker 1: were doing what they normally do, which is buying and
24:23
Speaker 1: selling stocks, bonds, and even some derivatives exactly. But the
24:26
Speaker 1: hedge fund industry showed some very important stress fractures that
24:30
Speaker 1: had we been listening, had we really spent time watching
24:33
Speaker 1: what was going on in the hedge fund world, we
24:35
Speaker 1: would have seen all sorts of early warning signs, And
24:38
Speaker 1: in fact, a number of us did write about them
24:40
Speaker 1: back in two thousand and five and six. And I
24:42
Speaker 1: think that's one of the reasons why the hedge fund
24:44
Speaker 1: industry is such an important part of the financial ecosystem.
24:47
Speaker 1: Has your thinking about hedge funds evolved over the years,
24:50
Speaker 1: or or how has your perspectives? How might your perspectives
24:54
Speaker 1: have changed? Well, you know, I'm now more convinced than
24:56
Speaker 1: ever that hedge funds play an important role and that
24:59
Speaker 1: we can learn a lot by monitoring the industry. But
25:02
Speaker 1: I think that the hedge fund industry itself is undergoing
25:05
Speaker 1: some pretty dramatic changes, both because hedge funds have become
25:09
Speaker 1: more sophisticated technologically, but also because competition has actually winnowed
25:13
Speaker 1: the field. A lot of hedge funds disappointed in their
25:16
Speaker 1: returns over the last five to ten years, and so
25:18
Speaker 1: the hedge fund industry has seen a lot of consolidation.
25:21
Speaker 1: So the industry today is very different than what it
25:23
Speaker 1: was a decade ago. Any theories as to why the
25:26
Speaker 1: performance of hedge funds over the last decade has been
25:30
Speaker 1: not only below with their traditional returns have been, they've
25:33
Speaker 1: been below just a straight up sixty forty portfolio, Yeah,
25:36
Speaker 1: you know, there are three factors that are going on
25:38
Speaker 1: in the hedge fund industry that have really challenged its performance.
25:41
Speaker 1: The first is that the risk free rate is actually
25:45
Speaker 1: much lower now than before, and so hedge fund industries
25:48
Speaker 1: relied to some degree on the risk free rate in
25:50
Speaker 1: order to be able to add to its expected wouldn't
25:54
Speaker 1: that make their borrowing costs that much cheaper and allow
25:56
Speaker 1: their leverage to be more effective? Or am I oversimple
25:59
Speaker 1: You would think so. But that's the second factor that's
26:01
Speaker 1: actually hurting hedge fund returns. It's that leverage is way down.
26:05
Speaker 1: Even though risk free rate is lower, the amount of
26:08
Speaker 1: leverage that hedge funds are afforded is much lower now
26:11
Speaker 1: because people are less risk seeking. And that we know
26:14
Speaker 1: that policies like the FEDS changes in leverage restrictions among
26:18
Speaker 1: banks have made it more difficult for hedge funds to
26:20
Speaker 1: get the same kind of leverage that they did in
26:22
Speaker 1: the early two thousands. And what's the third reason. And
26:25
Speaker 1: the third reason is that if you look at the
26:28
Speaker 1: volatility of markets, it's lower now than it's been in
26:32
Speaker 1: quite a long time. And hedge funds really make money
26:35
Speaker 1: on volatility. They actually look for high volatility to be
26:38
Speaker 1: able to earn their returns. Well, we saw a lot
26:41
Speaker 1: of volatility in the financial crisis, and a decent amount
26:44
Speaker 1: of volatility in the first couple of years afterwards. They
26:47
Speaker 1: didn't do too great that period as well. Well, you know,
26:50
Speaker 1: there was actually a lot of diversity. There are some
26:51
Speaker 1: hedge funds that did spectacularly well crisis, and but you're
26:56
Speaker 1: right that overall hedge funds were challenged, and I think
26:59
Speaker 1: it's because the relationships that they were trading on. Those
27:02
Speaker 1: relationships changed when we had this huge shock called the
27:05
Speaker 1: financial crisis, and over time they're gonna learn how to
27:08
Speaker 1: adapt to that. But it's gonna take time and not surprisingly,
27:11
Speaker 1: just like when we lost the dinosaurs, when that meteorite
27:14
Speaker 1: hit the planet, kicked up a cloud of dust, killed
27:16
Speaker 1: the trees, you know, sixty five million years ago, that
27:19
Speaker 1: same kind of extinction event occurred in two thousand and eight,
27:23
Speaker 1: two thousand and nine. So Michael Mobison of Colombia and
27:27
Speaker 1: Credit Swiss talks about the paradox of of skill. Um
27:32
Speaker 1: Jim Chenos of Kindicost Partners, who's been running a hedge
27:35
Speaker 1: fund for about thirty years, said, in the early days,
27:38
Speaker 1: there were a hundred hedge funds generating alpha, and now
27:41
Speaker 1: there's eleven thousand, but it's the same hundred. How much
27:45
Speaker 1: does that paradox of of skilled tremendous number of really sharp,
27:50
Speaker 1: really smart guys, and it's mostly guys. Uh, not exclusively,
27:54
Speaker 1: but but almost um primarily. How much does that wave
27:59
Speaker 1: of new hedge funds reduce the amount of alpha that's
28:04
Speaker 1: there to go around. Well, you know, there's no doubt
28:07
Speaker 1: that you're going to have much more competition in any time.
28:11
Speaker 1: You have an industry that does well for a period
28:13
Speaker 1: of time because it draws people from all walks of
28:16
Speaker 1: life to start applying their trade in the hedge fund industry.
28:20
Speaker 1: And by the way, you're right that the hedge fund
28:21
Speaker 1: industry seems to be dominated by men, but I want
28:24
Speaker 1: to mention there is an organization called one Women in
28:26
Speaker 1: Hedge Funds, So I think we are drawing women into
28:29
Speaker 1: the field as well. Over time, you're going to see
28:32
Speaker 1: that competition create these kinds of periods of consolidation. But
28:36
Speaker 1: then when you have large events like the financial crisis,
28:39
Speaker 1: that's also an opportunity for lots of new hedge funds
28:41
Speaker 1: to spring up, like new species that come into existence
28:44
Speaker 1: after an extinction event. So it's not surprising that, say,
28:48
Speaker 1: the hedge high frequency trading funds popped up over the
28:52
Speaker 1: course of the last ten years, whereas they didn't play
28:54
Speaker 1: nearly as big a role the previous decade. And I
28:57
Speaker 1: know I've seen studies about women as trade leaders generally
29:01
Speaker 1: outperformed men. They're less emotional, they're less attached to bad decisions,
29:05
Speaker 1: They're quicker to cut their losses. I'm surprised we haven't
29:09
Speaker 1: seen more women hedge fund managers, given given some of
29:12
Speaker 1: the academic data. I think that there's going to be
29:15
Speaker 1: more women coming into the industry over time. And I
29:17
Speaker 1: think I welcome that because you're right that women tend
29:20
Speaker 1: to have a very different trading profile, and some of
29:22
Speaker 1: our experiments we've seen that women do tend to perform better,
29:25
Speaker 1: not just on an absolute basis, but on a risk
29:28
Speaker 1: adjusted basis. They tend to be much more careful about
29:30
Speaker 1: managing their risk. Let's let's talk about one of those
29:33
Speaker 1: hedge funds that are in the few hundreds that generate alpha.
29:36
Speaker 1: You you spoke with the David Shaw of d Shaw
29:41
Speaker 1: and UM, which also spawns some guy named Jeff Bezos
29:45
Speaker 1: and and Amazon UM. He said, anomalies that had previously
29:50
Speaker 1: generated significant profits stopped making money, and you were forced
29:55
Speaker 1: to discover other more complex effects that people had not
29:59
Speaker 1: yet found. The market is never completely efficient, but it
30:04
Speaker 1: certainly has a tendency to become more efficient over time.
30:08
Speaker 1: Does that help to explain why we've seen hedge fund
30:12
Speaker 1: performance sort of flatten out over the last decade. Absolutely.
30:15
Speaker 1: I think what David was talking about is exactly this
30:18
Speaker 1: process of adaptation, innovation, competition, and over time, the evolution
30:24
Speaker 1: of financial markets with one trading strategy at a time.
30:28
Speaker 1: And you know, he's a real pioneer in the in
30:30
Speaker 1: the field and having developed some of the earliest trading
30:33
Speaker 1: strategies for statistical arbitrage, and that's an area that's really
30:38
Speaker 1: evolved quite a bit over the last decade. So our
30:41
Speaker 1: markets now adapting too fast to all these changes in
30:45
Speaker 1: all these new strategies. It used to be you would
30:49
Speaker 1: come up with an idea before anybody else, you could
30:52
Speaker 1: work on it for a while and it would be
30:54
Speaker 1: profitable for a couple of years. It seems that these
30:57
Speaker 1: ideas are either smaller and rower, or the markets adapting
31:02
Speaker 1: that much faster and whatever edge exists goes away pretty quickly. Yeah.
31:07
Speaker 1: You know, technology plays a much bigger role today than
31:09
Speaker 1: it did ever before, and it's kind of a financial
31:12
Speaker 1: arms race where if you've got a good idea you
31:15
Speaker 1: can implement it now faster than you can even think
31:17
Speaker 1: about it. Uh. It's what I call the confluence of
31:21
Speaker 1: Moore's law meets Murphy's law. And I think that's the challenge.
31:24
Speaker 1: It's that we now have technologies that are so powerful
31:27
Speaker 1: it allows us to do things that we really never imagined,
31:31
Speaker 1: and there are going to be unintended consequences. We have
31:34
Speaker 1: been speaking with Professor Andrew low of m I T.
31:38
Speaker 1: S Sloan School of Management. If you enjoy this conversation,
31:41
Speaker 1: be sure and check out our podcast extras where we
31:45
Speaker 1: keep the tape rolling and continue to talk about all
31:47
Speaker 1: things financial engineering. You can find that on SoundCloud, iTunes
31:52
Speaker 1: and Bloomberg dot com. You can find all the Professor
31:56
Speaker 1: lows uh written work either at the m I T.
31:59
Speaker 1: Website or at any bookstore Barnes, Noble or Amazon dot com.
32:05
Speaker 1: Be sure and check out my daily column on Bloomberg
32:08
Speaker 1: View dot com or follow me on Twitter at Rit Halts.
32:12
Speaker 1: I'm Barry Rit Halts. You're listening to Masters in Business
32:15
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Speaker 1: Bank of America. Mary Lynch makes available pducts and services
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Speaker 1: offered by Merrill Lynch. Pierce, Feder and Smith Incorporated, a
32:30
Speaker 1: registered broker dealer. Remember s I PC. Welcome to the podcast.
32:33
Speaker 1: Thank you Professor Lowe for doing this and being so
32:36
Speaker 1: generous with your time. I had I had mentioned um earlier,
32:40
Speaker 1: I had seen you speak it's got to be a
32:42
Speaker 1: decade ago. It was right after the financial crisis, and
32:47
Speaker 1: I had discussed with you how how the high efficient
32:51
Speaker 1: market hypothesis could really exist in its strong form When
32:55
Speaker 1: we see how can I how can I market be
32:57
Speaker 1: worth X on day one and Y on day too,
33:00
Speaker 1: it doesn't really seem to make a whole lot of sense.
33:03
Speaker 1: And I thought you're marriage of of the biological to
33:11
Speaker 1: to the markets is really fascinating, and because it brings
33:13
Speaker 1: in not only behavioral economics, but it brings in some
33:17
Speaker 1: of the neuroscience that's out there, that that's pretty fascinating.
33:20
Speaker 1: You do some interesting experiments at M I t looking
33:25
Speaker 1: at this sort of stuff. Um. The one that stood out,
33:28
Speaker 1: I think it was this book the study where you
33:31
Speaker 1: took twenty eight students and had them go through a
33:35
Speaker 1: simulated market, and you ended up with fairly efficient um
33:40
Speaker 1: decision making with just participants. Am I? Am I misstating that?
33:46
Speaker 1: Or no, that's right, So so explain explain that lab
33:49
Speaker 1: a little bit and and what you're looking to accomplish
33:52
Speaker 1: with it and what that experiment showed. Sure, well, you know,
33:55
Speaker 1: it was an interesting collaboration between myself and a neuroscience
34:00
Speaker 1: as Tommy Poggio, and a marketing expert Elita Han, and
34:04
Speaker 1: a couple of our students Nicolas Chan and Adler Kim.
34:07
Speaker 1: What we were trying to do there was to understand
34:10
Speaker 1: how the standard consumer marketing surveys could be replaced with
34:15
Speaker 1: a simple market simulation. And we did the experiment where
34:19
Speaker 1: we compared a situation where you were trying to get
34:22
Speaker 1: consumers to express their preferences about different kinds of bicycle pumps.
34:27
Speaker 1: And so typically a consumer survey would involve a long
34:32
Speaker 1: series of studies where you ask a bunch of customers
34:35
Speaker 1: features about particular bicycle pump that they may or may
34:37
Speaker 1: not like, and these surveys generally take many hundreds of
34:41
Speaker 1: thousands of dollars and weeks and weeks to conduct. We
34:44
Speaker 1: decided to run a simulation where we created synthetic securities
34:49
Speaker 1: representing each of these different bicycle pumps, and we allowed
34:52
Speaker 1: students to trade them over the course of thirty minute
34:56
Speaker 1: interval in a kind of a mock trading session in
34:59
Speaker 1: our trading lab. And what we found at the end
35:01
Speaker 1: of that thirty minutes is that the relative prices of
35:05
Speaker 1: these synthetic securities actually corresponded precisely to the marketing surveys
35:11
Speaker 1: that took weeks and weeks to conduct. In other words,
35:14
Speaker 1: by using the market, you could actually collect the wisdom
35:17
Speaker 1: of crowds much more quickly than if you've just done
35:20
Speaker 1: the surveys individual by individual. Even a simulated market with
35:24
Speaker 1: a small number of participants exactly so instead of having
35:28
Speaker 1: to use hundreds or thousands of consumers, just a small
35:31
Speaker 1: number over a short period of time can actually give
35:34
Speaker 1: you much the same results. How do you set that
35:36
Speaker 1: up where you're incentivizing the participants to actually put the
35:40
Speaker 1: time and energy into it to to do it so
35:43
Speaker 1: it's functional and efficient. Well, that's the beauty of markets.
35:46
Speaker 1: People are already incentivized to try to beat the market,
35:49
Speaker 1: that to try to come up with the winning picks.
35:52
Speaker 1: And it's that process, that kind of competitive spirit that
35:55
Speaker 1: financial markets bring out in people that allow us to
35:58
Speaker 1: extract information in a much more efficient manner. So let me, UM,
36:02
Speaker 1: I'm gonna pull something from UM one of the efficient
36:08
Speaker 1: market issues that had come up that has always it
36:11
Speaker 1: has always annoyed me, and it had to do with
36:14
Speaker 1: the This is why I never print on two page,
36:18
Speaker 1: two sided. UM. It always had had to do with
36:21
Speaker 1: the Challenger explosion and the reaction. And I always thought, Um,
36:26
Speaker 1: the wisdom of crowds got it wrong, and a few
36:28
Speaker 1: other things got it wrong. But I'm curious as to
36:30
Speaker 1: your perspective. Here, here's something we pulled from the book.
36:35
Speaker 1: The day the Challenger exploded provided evidence that prices rapidly
36:40
Speaker 1: reflect all available information. So I'm gonna stop there. Morton
36:45
Speaker 1: Theicole was halted for training thirteen minutes after the Challenger exploded,
36:49
Speaker 1: even though it was one of four potential culprits had
36:52
Speaker 1: closed the day down twelve no evidence of insider trading.
36:57
Speaker 1: The other three didn't sell off. And I want to
36:58
Speaker 1: say the other three were wing Um. It might have
37:03
Speaker 1: been Northbrook, Brumen. I don't know if they were separate
37:05
Speaker 1: companies back then and one other. Um what took the
37:09
Speaker 1: smartest minds five months to figure out, the stock market
37:13
Speaker 1: figured out in hours. I've always hated that argument because
37:18
Speaker 1: Morton theicle essentially had a soul. Their business was providing
37:24
Speaker 1: the sort of stuff too the government, these sort of
37:27
Speaker 1: contracts for aerospace and aviation. All the other companies had massive,
37:32
Speaker 1: unrelated businesses to the Challenger. So it wasn't so much
37:36
Speaker 1: that the market figured out who made the OH ring
37:41
Speaker 1: and we knew and the market figured out the O
37:43
Speaker 1: ring was. It was essentially a bet. Hey, if it
37:46
Speaker 1: was Grumman or north Rope or Boeing, the business has
37:50
Speaker 1: nothing to do with this, it's not gonna have a
37:52
Speaker 1: big impact. But if it's Morton theical, hey, this is
37:54
Speaker 1: really potentially problematic. It wasn't. It's always presented as Oh,
38:00
Speaker 1: the market figured out that Morton the cole knew that
38:02
Speaker 1: they were responsible for the Challenger disaster. In reality, their
38:08
Speaker 1: business was so tied to it that it mattered more
38:10
Speaker 1: to them than everybody else. That does that criticism hold
38:14
Speaker 1: water well? I think it does hold water to some degree,
38:17
Speaker 1: but it's very difficult for us to separate out the
38:19
Speaker 1: two effects, because you know, Morton Thiacle was responsible for
38:23
Speaker 1: creating the booster rocket that ultimately exploded, whereas Rockwell International,
38:28
Speaker 1: Martin Marietta, and Lockheed were involved in other parts of
38:31
Speaker 1: the Space Shuttle mission. And you're quite right that they're
38:33
Speaker 1: bigger companies that were involved in different aspects. But the
38:36
Speaker 1: fact that within minutes of this event, Martin thy Call
38:40
Speaker 1: was singled out does suggest that, for whatever reason, there
38:43
Speaker 1: was wisdom in the crowds in saying that that company
38:45
Speaker 1: was going to be more effective. But you're absolutely right
38:48
Speaker 1: that we had no idea about the o ring and
38:50
Speaker 1: that really required the five and a half month investigation
38:53
Speaker 1: that the Roger's Commission conducted. Yeah, I've always looked at
38:56
Speaker 1: as as hey, if any of these other companies are
38:59
Speaker 1: found responsible, this is a small part of their business.
39:02
Speaker 1: But for Morton Thoicle, this this is really problematic, and
39:05
Speaker 1: it's always always seems to be um misdescribed, or at
39:10
Speaker 1: least that's that's how I've looked at it. We talked
39:12
Speaker 1: about hedge funds before. What we didn't get to two
39:15
Speaker 1: questions that I thought were really important. One was hedge
39:19
Speaker 1: funds and an e T F rapper. Good idea, terrible idea.
39:23
Speaker 1: What do we think about this? Well, I think it's
39:25
Speaker 1: a mixed idea. And the reason is that for many
39:29
Speaker 1: kinds of hedge fund strategies, retail investors should and want
39:34
Speaker 1: to get access to them. But the problem is that
39:37
Speaker 1: certain kinds of hedge funds strategies carry with them very
39:40
Speaker 1: subtle risks that retail investors are not in a position
39:44
Speaker 1: to be able to evaluate. So a good example is
39:47
Speaker 1: tail risk, for example, catastrophe reinsurance. UH, that kind of
39:52
Speaker 1: risk is very subtle in the sense that it generally
39:55
Speaker 1: doesn't happen the time, and so most to the time
40:00
Speaker 1: you're earning pretty decent returns at relatively the low risk.
40:03
Speaker 1: It sounds like a great deal. But every once in
40:06
Speaker 1: a while, in the parlance of Wall Street, you get
40:08
Speaker 1: your face ripped off. And that's the thing that retail
40:11
Speaker 1: investors don't fully appreciate, don't understand, and aren't really prepared for.
40:16
Speaker 1: So the hedge fund strategies that have those kinds of
40:18
Speaker 1: risks are going to be very difficult for investors to
40:21
Speaker 1: tolerate in an E t F format, and that that's
40:24
Speaker 1: the concern that I have about these kinds of strategies.
40:27
Speaker 1: The criticism that i've I've seen about the E t
40:32
Speaker 1: F hedge funds, some people have described them as muppets.
40:35
Speaker 1: Famous quote from one of the earlier Goldman sachs Um
40:40
Speaker 1: litigations that was pulled out of context, but salespeople describing
40:45
Speaker 1: their clients as muppets. But what it means in this
40:48
Speaker 1: context is, Hey, the really good hedge funds are filled up.
40:52
Speaker 1: They have institutions that can swing billions of dollars around.
40:57
Speaker 1: By the time you get to the hedge funds that
40:58
Speaker 1: are put into an e t F rapper, lesser managers,
41:02
Speaker 1: lesser track records, not as strong a model, or at
41:06
Speaker 1: least a perspective model looking forward, So you're left with
41:10
Speaker 1: second tier hedge funds in an E t F rapper
41:12
Speaker 1: for them uppets, fair criticism or again overstating it. I
41:16
Speaker 1: think that's a bit of an overstatement, and I think
41:18
Speaker 1: it misses the point that there's actually a spectrum of
41:22
Speaker 1: risk reward opportunities that investors are really looking for. At
41:27
Speaker 1: the one extreme of that spectrum are investors that are
41:29
Speaker 1: looking for absolute return, high octane investments. They don't care
41:33
Speaker 1: if you lose in a year as long as there's
41:36
Speaker 1: a chance of making in a year. And that's perfectly
41:39
Speaker 1: fine for that group of investors. But for typical retail
41:43
Speaker 1: investors that are saving money for their four oh one
41:45
Speaker 1: K plan, they don't want that to turn into a
41:47
Speaker 1: tool one K plan. They want to make sure that
41:50
Speaker 1: the downside is not going to be completely devastating, and
41:54
Speaker 1: so you've got to put in various kinds of protections
41:57
Speaker 1: and risk management tools that will definitely reduce the upside,
42:01
Speaker 1: but it will also reduce the downside. There's no free lunch,
42:03
Speaker 1: as the old adage goes, and so you've got to
42:05
Speaker 1: take the good with the bad. And I think there's
42:07
Speaker 1: a role for those kinds of vehicles, and that's really
42:09
Speaker 1: what the hedge fund industry is transforming into when they
42:13
Speaker 1: develop mutual fund products. It reminds me of yet another
42:16
Speaker 1: quote of yours. Traditional market cap weighted static index funds
42:21
Speaker 1: still work very well for the average investor, but some
42:24
Speaker 1: investors continue to look for an edge, hoping to find
42:28
Speaker 1: alpha in an ocean of beta. That raises two questions.
42:32
Speaker 1: One is is it really just a drop of alpha
42:35
Speaker 1: in an ocean of data? How much alpha exists for
42:39
Speaker 1: the hedge fund industry to to go after. Well, you know,
42:43
Speaker 1: the way I think about alpha is that really represents
42:46
Speaker 1: sort of the the creative opportunities that active competitive investors
42:52
Speaker 1: are trying to come up with. And so by definition,
42:55
Speaker 1: all of these kinds of creative opportunities are going to
42:57
Speaker 1: be limited. The more compare editive a market is, the
43:01
Speaker 1: more difficult it is to be coming up with genuine alpha.
43:04
Speaker 1: You know, the famed investor Marty Lebowitz wrote an article
43:07
Speaker 1: once UH that called uh, these particular objects alpha hunters
43:13
Speaker 1: versus beta grazers, And I think that really captures the spirit,
43:17
Speaker 1: that's the dynamic between alpha and beta, alpha hunters and
43:20
Speaker 1: beta grazers. I like the way, I like the way
43:24
Speaker 1: that UM sounds. Let's let's talk a little bit about
43:28
Speaker 1: something that is UM somewhat related. So, over time, we've
43:34
Speaker 1: seen the drag that high fees put on returns. We
43:38
Speaker 1: talked earlier about Vanguard at four point to trillion. They've
43:42
Speaker 1: been notorious for driving fees down. It's even called the
43:45
Speaker 1: Vanguard effect. What are we given what we know about
43:49
Speaker 1: the drag of high fees and the effect of compounding
43:53
Speaker 1: over time, are we likely to see a substantial change
43:57
Speaker 1: in hedge fund fees anytime soon. Well, there's no doubt
44:01
Speaker 1: that it's going to be pressure on hedge fund fees
44:03
Speaker 1: because of all of the very different lower cost vehicles. Uh.
44:07
Speaker 1: In fact, you know Jack Bogel's principle, the cost matter hypothesis,
44:12
Speaker 1: I think really summarizes at all. Uh. Well, I think
44:16
Speaker 1: we have to be careful about that trend. But at
44:18
Speaker 1: the same time, investors are also looking for new investment opportunities,
44:22
Speaker 1: and to the degree that they can come up with
44:25
Speaker 1: great returns beyond fees, they're going to actually be able
44:28
Speaker 1: to command whatever it is that the market will bear. So,
44:31
Speaker 1: speaking about Jack Bogel, the rise of indexing has really
44:35
Speaker 1: taken off again since the uh this is a story
44:39
Speaker 1: that's fifty years in the making. One was Bogel's famous paper.
44:44
Speaker 1: He launched Vanguard, and I think seventy two or seventy
44:46
Speaker 1: four something like that didn't do too well for the
44:49
Speaker 1: first five years. Really, since the financial crisis, they've exploded.
44:54
Speaker 1: I want to say they were about a trillion dollars
44:57
Speaker 1: before the financial crisis. Now they're over fourt brilliant. That
45:01
Speaker 1: raises an interesting question, does the rise of indexing distort
45:05
Speaker 1: markets and at what point does indexing become too big?
45:11
Speaker 1: Estimates are all over the place. It's five percent, it's
45:14
Speaker 1: fift it's of global investable assets um. Even Vanguard is
45:19
Speaker 1: a third active management there over a trillion dollars an
45:22
Speaker 1: active low cost funds. How big is too big for indexing?
45:28
Speaker 1: That's a great question, and it's funny because that's a
45:30
Speaker 1: question that I would have expected people would have asked
45:33
Speaker 1: long time ago, just the same way that people ask
45:36
Speaker 1: how much capacity does a hedgeman have. It's only recently
45:39
Speaker 1: that people who started asking the question about index funds. So,
45:43
Speaker 1: first of all, index funds are an unqualified success. It's
45:47
Speaker 1: clearly that they really benefit investors in the long run
45:50
Speaker 1: by reducing costs and giving them diversification. However, there is
45:54
Speaker 1: one aspect that we have to think about, and that's
45:57
Speaker 1: something that the adaptive markets hypothesis points to, which is
46:00
Speaker 1: that when everybody starts investing in the same vehicle, that
46:04
Speaker 1: means that there's gonna be a hardwired correlation that we
46:09
Speaker 1: create among various different investors experiences. Because now, if we've
46:14
Speaker 1: got lots of people investing in the same index fund,
46:17
Speaker 1: if and when that index fund declines we're all going
46:21
Speaker 1: to be facing those declines at the same time, and
46:24
Speaker 1: if those declines are severe enough to trigger our emotional reaction,
46:28
Speaker 1: we're all going to be freaking out at the same time.
46:31
Speaker 1: So inadvertently, these kinds of index fund holdings could actually
46:35
Speaker 1: create more systematic risk in the financial system. It's not
46:39
Speaker 1: to say that they don't add value. Absolutely they do,
46:42
Speaker 1: and they're an incredible part, important part of the financial ecosystem.
46:46
Speaker 1: But because they're so big, they can actually create these
46:49
Speaker 1: kinds of ripple effects that were only now seeing. So
46:52
Speaker 1: let me tell this back to your earlier UM study
46:56
Speaker 1: where you had the limited number of students replacing the
46:59
Speaker 1: giant UM public survey. How many people does it take
47:05
Speaker 1: to make markets efficient enough? For asked differently, what percentage
47:10
Speaker 1: of investors have to be active traders in order for
47:15
Speaker 1: price discovery to work its magic. Well, it looks like
47:19
Speaker 1: from the experiments that we conducted, if you've got very
47:22
Speaker 1: well funded traders, only a few percentage points of markets
47:27
Speaker 1: need to be informed trading in order to make them
47:30
Speaker 1: very efficially. So we could have making up numbers of
47:35
Speaker 1: the investing public indexing as long as ten percent as
47:39
Speaker 1: active management. You'll still get price discovery, you'll still get
47:42
Speaker 1: markets working efficiently, will still actually be equivalent to as
47:47
Speaker 1: if everybody was was actively trading. Well, in fact, I
47:51
Speaker 1: think that it might work even better if everybody weren't
47:54
Speaker 1: actively trading, because when you have everybody competing to make
47:59
Speaker 1: a slight margin, than any small bump in the road
48:02
Speaker 1: can quickly escalate into a financial crisis. You want to
48:05
Speaker 1: have a majority of the market participants focusing on passive,
48:10
Speaker 1: long term investments in order to maintain market stability. So
48:13
Speaker 1: indexing lowers volatility in the long haul, It certainly can
48:18
Speaker 1: as the potential right that that that's quite fascinating. One
48:21
Speaker 1: of the complaints I've heard from the active community about
48:25
Speaker 1: indexing is, well, there goes price discovery, the markets will
48:29
Speaker 1: no longer be efficient, and how can you identify the
48:32
Speaker 1: true value of a company when you have these big
48:35
Speaker 1: indexers just buying everything. You're saying, that's not necessarily a
48:38
Speaker 1: fair criticism, not at all, because I think that if
48:41
Speaker 1: you take a look at the size of hedge funds
48:44
Speaker 1: and the ability for them to trade and take advantage
48:47
Speaker 1: of market opportunities, despite the fact that they don't have
48:50
Speaker 1: nearly the size of assets as the passive index funds,
48:53
Speaker 1: they can move markets much more rapidly and in greater
48:56
Speaker 1: depth on any given occasion. Alright, So so it gives
49:00
Speaker 1: rise to another quote of yours, which I really want
49:03
Speaker 1: you to explain, because, um, I kept coming back to
49:06
Speaker 1: it within the book. I was having a hard time,
49:10
Speaker 1: UM grasping part of it. It takes a theory to
49:13
Speaker 1: beat a theory. Explain what you mean by that. In academia,
49:17
Speaker 1: it's not good enough to just throw stones at an idea.
49:21
Speaker 1: You've got to come up with a better one. You
49:22
Speaker 1: have to replace the bad idea with a good idea exactly.
49:26
Speaker 1: Or the way I would put it is that there
49:28
Speaker 1: really aren't any bad ideas. We really have approximations to reality,
49:33
Speaker 1: and we try to improve on those approximations one after
49:36
Speaker 1: the other. So version one point oh is a starting point,
49:39
Speaker 1: but then you've got to get to one point one
49:41
Speaker 1: and then eventually two point oh. So we're trying to
49:43
Speaker 1: come up with theories that can actually beat existing theories
49:46
Speaker 1: in order to move of these ideas forward. So I'm
49:50
Speaker 1: I'm gonna mangle a quote and I don't remember if
49:52
Speaker 1: it was physics or economics that I think it was
49:55
Speaker 1: physics originally, Um, and the quote and it'll come to
49:59
Speaker 1: me later who said it, physics advances one funeral at
50:03
Speaker 1: a time, meaning you have these theories that let's call
50:06
Speaker 1: him the one point oh theories, and there's a whole
50:09
Speaker 1: generation of grad students and subsequent scientists trained on it,
50:13
Speaker 1: and it takes a long time before these theories are
50:16
Speaker 1: finally put to rest and the newer, faster, smarter, better
50:20
Speaker 1: theories replace them. How much inertia is there in academia
50:24
Speaker 1: and how much inertia is in the world of financial
50:27
Speaker 1: modeling and theorism. I think it was Max Planck who
50:30
Speaker 1: originally said that, and then Paul Samuelson paraphrase that to
50:34
Speaker 1: said they to say that science progresses funeral by funeral,
50:38
Speaker 1: and uh, you know, that's a particularly morbid kind of
50:41
Speaker 1: an average. Um. But I think there's a truth. There's
50:43
Speaker 1: a certain element of truth to it, and it has
50:46
Speaker 1: to do with the fact that, you know, academics become
50:49
Speaker 1: very attached to their ideas, and so at some point,
50:52
Speaker 1: in order to challenge an existing theory, you really need
50:55
Speaker 1: to develop a competing alternative that really provides some compelling actions. UM.
51:01
Speaker 1: Cliff Astness tells the story. When he was uh doing
51:05
Speaker 1: his doctoral work, his his financial advice, his academic advisor
51:10
Speaker 1: was Eugene Fama, and he had the bright idea of
51:14
Speaker 1: writing his PhD thesis on why momentum actually worked and
51:18
Speaker 1: the markets weren't really all that efficient. And to Fama's credit,
51:22
Speaker 1: he approved the idea and ultimately that was asthnes is
51:26
Speaker 1: of a q rs um thesis. So there are some
51:30
Speaker 1: I don't want to paint with tubro to brush. There
51:31
Speaker 1: are some academics who clearly display and intellectual flexibility. I
51:37
Speaker 1: give huge credit to Fama for saying, sure, poke hole
51:40
Speaker 1: in the thesis and if it works, well, we'll start
51:43
Speaker 1: calling you doctor. I think that's a but, but that
51:46
Speaker 1: isn't necessarily true. Um. Everywhere you you do end up
51:50
Speaker 1: with certain theories that have I mean, look how long
51:53
Speaker 1: it took for behavioral economics to really catch on, And
51:57
Speaker 1: it was so clear that Homo economists was a fabricated
52:02
Speaker 1: um description of human behavior. But it took you know,
52:08
Speaker 1: almost two generations before these ideas. So so why what
52:13
Speaker 1: is it about human nature that we marry even bad
52:17
Speaker 1: ideas and we're so slow to change? And again, how
52:20
Speaker 1: does that manifest itself in markets. Well, you know, now
52:23
Speaker 1: we're veering into a topic on the sociology of science,
52:26
Speaker 1: and I'm not sure I'm an expert hunt, but there
52:29
Speaker 1: is a definite cultural element to our field. We do.
52:31
Speaker 1: We get attached to certain ideas and theories and we
52:34
Speaker 1: start thinking along these lines. You know, I call that narrative.
52:37
Speaker 1: You know, we all have our own narrative of what's
52:40
Speaker 1: going on. And the fact is that unless we take
52:43
Speaker 1: our narrative and try to match them to the data,
52:46
Speaker 1: will always be caught up in our own hypotheses and theories.
52:51
Speaker 1: But when you start confronting these theories with data and
52:54
Speaker 1: you see that they don't fit, then at some point
52:56
Speaker 1: you're gonna actually have to develop better theories. And that's
52:59
Speaker 1: really what I experienced over time. I have to bring
53:02
Speaker 1: up an anecdote, which is what led me to these
53:05
Speaker 1: previous questions. The first time you gave a presentation at
53:10
Speaker 1: the National Bureau of Economic Research, you got called out
53:14
Speaker 1: with the accusation, this work is wrong when the numbers
53:17
Speaker 1: don't add up to something off Here, it turns out
53:21
Speaker 1: you were right. Describe that anecdote and explain how this,
53:26
Speaker 1: how this came about. Yeah, that was a very memorable
53:29
Speaker 1: event November. It was the first presentation that I'd given
53:35
Speaker 1: in an academic forum among my peers. I was an
53:38
Speaker 1: assistant professor, just graduated a couple of years ago from
53:41
Speaker 1: graduate school. And Craig McKinley, a colleague of mine at
53:44
Speaker 1: the Wharton School, and I we'd written a paper rejecting
53:47
Speaker 1: the random walk hypothesis, and it's basically saying markets are
53:51
Speaker 1: not quite random. There is there's I'm doing this from memory,
53:55
Speaker 1: but it's persistence and momentum and other factors that said, hey,
53:59
Speaker 1: if I know this information, I have a better than
54:03
Speaker 1: coin flip chance of predicting that. Exactly. We were looking
54:06
Speaker 1: at weekly stock returns and we found short term momentum
54:09
Speaker 1: in the data, and no matter which way we sliced it,
54:13
Speaker 1: we couldn't get rid of this kind of anomaly. And
54:16
Speaker 1: so we presented the results as we found them, and
54:19
Speaker 1: our discussant, who is a very distinguished academic economist, reviewed
54:23
Speaker 1: our results and said, the theory is very interesting, but
54:26
Speaker 1: the numbers have to be wrong because this would imply
54:29
Speaker 1: way too many profits for our Wall Street traders, And
54:33
Speaker 1: so we were really taken aback by that is the
54:35
Speaker 1: first time that we sort of got hit with the
54:37
Speaker 1: route awakening that you could actually get publicly shamed for
54:42
Speaker 1: your research. What was it? This was in a public forum. Ye,
54:45
Speaker 1: and we'll we'll leave the accuser's name out, but essentially, no, no,
54:50
Speaker 1: you have to be wrong. Did did they at least
54:52
Speaker 1: give a basis for saying why you're wrong other than
54:56
Speaker 1: hold the data aside, we just don't like the theory. Well? No,
55:00
Speaker 1: The only basis was that if this were really correct,
55:02
Speaker 1: then this would imply untold profits for traders. But aren't
55:07
Speaker 1: there untold profits? Well, it turned out, unbeknownst to us
55:10
Speaker 1: and this discussant, this was exactly the time when statistical
55:14
Speaker 1: arbitrage came into its own and when David Shaw was
55:18
Speaker 1: engaged in what would then become a multibillion dollar hedge
55:22
Speaker 1: fund and many many billions of dollars of profits for investors.
55:25
Speaker 1: Did you ever get a mia culpa from the person
55:28
Speaker 1: who made the ruling accusation? We did a few months
55:31
Speaker 1: later he wrote back saying that he had apparently checked
55:35
Speaker 1: our results and in fact agreed that the data are
55:39
Speaker 1: definitely inconsistent with the findings and how interesting, So we
55:43
Speaker 1: did come to uh two terms and I think a
55:46
Speaker 1: number of academics went back to their home institutions and
55:49
Speaker 1: replicated our results. How So, in a way, the act
55:53
Speaker 1: public accusation helped validate the research, which is a good
55:57
Speaker 1: thing it did, and in fact, that illustrates the kind
56:00
Speaker 1: of adaptive nature of academics. It's very competitive. You come
56:03
Speaker 1: up with innovations, and if you survive over time, then
56:07
Speaker 1: your theory ultimately takes over. And that was a pretty
56:10
Speaker 1: um pivotal theory. Really early in the process of saying
56:15
Speaker 1: the strong E. Mh thesis isn't the best one, you
56:19
Speaker 1: really want to look at the weaker meaning. Markets are
56:22
Speaker 1: mostly sort of efficient, but at times there are inefficiencies
56:27
Speaker 1: and sometimes they can last a long time. We still
56:29
Speaker 1: have the Fama French five factor model, which would start
56:32
Speaker 1: as three factors but essentially says, well, markets aren't perfectly efficient.
56:38
Speaker 1: And that seems to be the takeaway. UM. I love
56:41
Speaker 1: that story. I think it's fascinating that someone could actually
56:45
Speaker 1: call you out and turn turn out to be um wrong.
56:49
Speaker 1: I'm going through the questions that we missed. There's one
56:53
Speaker 1: or two I want to get to. Here's one that
56:55
Speaker 1: I find really interesting. While money again, another quote from UH,
57:00
Speaker 1: the adaptive market. Adaptive markets, financial evolution at the speed
57:05
Speaker 1: of thought. While money is historically ancient, it's a novelty
57:09
Speaker 1: in comparison to the length of time the human species
57:13
Speaker 1: has been on the planet. We're using our old brains
57:16
Speaker 1: to respond to new ideas discuss well, you know, Homo
57:21
Speaker 1: sapiens has been in the current form for about a
57:25
Speaker 1: hundred thousand years, and what that means is that the
57:29
Speaker 1: adaptations that are with us today we're really the kind
57:34
Speaker 1: of features that were most useful for the Neolithic Ice
57:37
Speaker 1: Age and uh, if you take a look at what
57:40
Speaker 1: we're dealing with though in modern society, things like financial
57:43
Speaker 1: markets are much much newer innovation, and so our decision
57:48
Speaker 1: making capabilities are not ideally adapted to that environment. And
57:52
Speaker 1: so it's not surprising that what helps us on the
57:55
Speaker 1: planes of the African savannah don't necessarily help us on
57:58
Speaker 1: the floor of the New York Stock Exchange. We have
58:01
Speaker 1: to develop new capabilities that aren't quite there yet, and
58:04
Speaker 1: so periodically we're going to be left with some very
58:07
Speaker 1: poor reactions to financial market threats. One of the bigger
58:11
Speaker 1: books of the past couple of years has been Sapiens,
58:14
Speaker 1: but the book I always mentioned whenever that comes up.
58:17
Speaker 1: Um is a look at evolutionary biology called last ape standing,
58:23
Speaker 1: and there's some at least according to the fossil record,
58:27
Speaker 1: there are twenty eight different species of hominid that existed
58:32
Speaker 1: or coexisted with humans over the past few hundred thousand
58:35
Speaker 1: years or past a few million years for the immediate ancestors.
58:40
Speaker 1: And it's really a little bit of a little bit
58:43
Speaker 1: of luck involved that we are the last ape standing.
58:46
Speaker 1: Apparently there were a number of places where we were
58:49
Speaker 1: not all that far from being wiped out and got
58:53
Speaker 1: a little bit lucky versus Chro magnum and a couple
58:56
Speaker 1: of other um, a couple of other near human species
59:00
Speaker 1: is which raises the question how poorly adapted are we
59:07
Speaker 1: for making the sort of capital market decisions that you describe. Well,
59:12
Speaker 1: that's exactly right, you know. Ian Tattersall at the American
59:15
Speaker 1: Museum and Natural History has some wonderful writings about how
59:19
Speaker 1: Homo sapiens came to be and how we competed with
59:22
Speaker 1: Neanderthals and other early hominids, and at some point we
59:27
Speaker 1: succeeded beyond all expectation. And the theory is because we
59:31
Speaker 1: developed the ability for abstract thought, and that allowed us
59:34
Speaker 1: to cooperate. We developed language and engaged in all sorts
59:38
Speaker 1: of activities and toolmaking that allowed us to dominate our civilization.
59:44
Speaker 1: The problem is that we haven't yet developed all of
59:46
Speaker 1: the necessary tools to dominate the financial landscape that we
59:50
Speaker 1: live in today. It's no longer the case that we
59:52
Speaker 1: have to live by our wits and survive with physical threats.
59:55
Speaker 1: We have to actually think about surviving financial threats. And
59:58
Speaker 1: so we're still a work in progress, and we have
1:00:01
Speaker 1: to worry about how the various different evolutionary mechanisms will
1:00:04
Speaker 1: interact with modern life. The what made me think of
1:00:08
Speaker 1: last State Standing while speaking with you is that author's key.
1:00:13
Speaker 1: It wasn't just tools, because lots of other species had tools.
1:00:17
Speaker 1: We did have language, but more than anything else we had,
1:00:20
Speaker 1: we were more adaptable than every other species, and we
1:00:24
Speaker 1: could survive in a range of um environments, or range
1:00:29
Speaker 1: of geographies, or range of weather conditions. Uh not everybody
1:00:33
Speaker 1: had that ability. Especially if you're bigger and stronger, well
1:00:37
Speaker 1: then you need a lot of resources. And if you're
1:00:40
Speaker 1: uh like humans, a little somewhat frail or somewhat smaller,
1:00:45
Speaker 1: well you don't need the same range of of calories
1:00:50
Speaker 1: to to survive, and so when the weather changed, it
1:00:53
Speaker 1: was real problem. Well that's what I call the revenge
1:00:56
Speaker 1: of the nerds, to say the least. All Right, so
1:01:00
Speaker 1: I know I only have you for a finite amount
1:01:01
Speaker 1: of time. Let's let's jump into some of our favorite
1:01:05
Speaker 1: questions that we ask all of our guests. Um, so
1:01:10
Speaker 1: have you you pretty much have always been in academia?
1:01:12
Speaker 1: Is that fair statemon? So you come out of Harvard
1:01:15
Speaker 1: with PhD, you go straight to Wharton, Isn't that right?
1:01:18
Speaker 1: And then from Wharton you end up at M I T.
1:01:20
Speaker 1: A Was there a way station? That was it? And
1:01:22
Speaker 1: you've been in M I T now for years? Well,
1:01:25
Speaker 1: I was gonna say almost thirty years. That's that's a
1:01:28
Speaker 1: great run. Um, tell us about some of your early mentors,
1:01:31
Speaker 1: who were the people who inspired you and shepherded your
1:01:35
Speaker 1: career along when you first began. You know, I was
1:01:38
Speaker 1: very lucky in having a whole series of extraordinary teachers. Know,
1:01:43
Speaker 1: I grew up in New York City and benefited from
1:01:46
Speaker 1: the New York City public school system, the best education
1:01:49
Speaker 1: that money didn't have to buy. Um had a great
1:01:51
Speaker 1: third grade teacher Mrs Barbara Pico Laura who really believed
1:01:55
Speaker 1: in me and gave me the runway to develop intellectually.
1:01:58
Speaker 1: Then in high school and went to the Bronx High
1:02:00
Speaker 1: School of Science, the best education that I've gotten even
1:02:03
Speaker 1: to date. I'm just amazed by the quality of the
1:02:05
Speaker 1: faculty there and Mrs Henriette amazing. Mr Milton Copleman fantastic teacher,
1:02:10
Speaker 1: is very supportive and really gave me the thirst of
1:02:13
Speaker 1: knowledge that I still benefit from today. And then in
1:02:17
Speaker 1: college I had very fortunate to be able to have
1:02:20
Speaker 1: us all Leve Moore from my econ one on one class,
1:02:23
Speaker 1: and my advisor Sharon Aster was incredibly inspirational. And then
1:02:27
Speaker 1: in grad school, um Andy Abel my thesis advisor, Jerry
1:02:31
Speaker 1: Housman another thesis advisor, and of course Bob Merton, the
1:02:34
Speaker 1: inspirational finance professor that really got me to start thinking
1:02:37
Speaker 1: about a career in finance. So all of these individuals
1:02:41
Speaker 1: are just extraordinarily important in giving me the boost that
1:02:45
Speaker 1: got me to where I am today. Let's let's talk
1:02:47
Speaker 1: about investing in general. Who what investors and or authors
1:02:53
Speaker 1: influence the way you approach the world of investment. Oh,
1:02:57
Speaker 1: there are whole host of them. Obviously, Jim Simons at
1:03:01
Speaker 1: Renaissance Technologies, David Shaw at d Shaw. These are the
1:03:05
Speaker 1: first quants that really demonstrated that using mathematical models can
1:03:09
Speaker 1: actually add value. But then there's Warren Buffett and George
1:03:12
Speaker 1: Soros who have made their money in very different ways
1:03:15
Speaker 1: using qualitative aspects of the business world. And it demonstrates
1:03:19
Speaker 1: that there's more than one way to skin a cat,
1:03:22
Speaker 1: and it really gave me some some fascinating ideas about
1:03:25
Speaker 1: how to integrate the two worlds. Let's let's talk about books,
1:03:29
Speaker 1: be they fiction or nonfiction, investing related or not. This
1:03:34
Speaker 1: is the single biggest question we get from from listeners.
1:03:38
Speaker 1: Tell us about some of your favorite books. What, what
1:03:40
Speaker 1: do you enjoy, what influenced you? What are you reading currently?
1:03:45
Speaker 1: So you know, I'm a big science fiction fan, and
1:03:47
Speaker 1: in a way, I think that's what really got me
1:03:48
Speaker 1: to start thinking along the lines of economics and finance.
1:03:51
Speaker 1: It was Isaac Asthmas Foundation Trilogy in high school. You
1:03:55
Speaker 1: and Paul Krugman, I'm in great company. There um very
1:04:00
Speaker 1: interesting idea of psycho history, the fictitious branch of mathematics
1:04:05
Speaker 1: that allow you to predict human behavior using the law
1:04:07
Speaker 1: of large numbers in the central limit theorem. But I
1:04:10
Speaker 1: loved Arthur C. Clark and more recently or Sin Scott
1:04:13
Speaker 1: Card and Endo games Enders Game. Yeah, the whole Enders series.
1:04:17
Speaker 1: Speaker for the dad, just fascinating ideas. It really allowed
1:04:20
Speaker 1: you to to let your imagination run wild. How about, um,
1:04:24
Speaker 1: something finance related. Tell us some books that you've enjoyed
1:04:27
Speaker 1: in that space. Well, you know, the first book that
1:04:29
Speaker 1: really got me thinking along the lines of finance and
1:04:32
Speaker 1: economics was Hal Browner's Worldly Philosophers. I loved that book.
1:04:36
Speaker 1: And then after that, of course Burton mal Kills random
1:04:38
Speaker 1: walked down Wall Street. I mean he writes so clearly
1:04:41
Speaker 1: and makes finance come alive that that just got me
1:04:44
Speaker 1: really excited about the stock market and thinking about all
1:04:47
Speaker 1: of these financial issues. Any of the books you wanna
1:04:50
Speaker 1: mention reference? I know you have a giant library of
1:04:53
Speaker 1: stuff that it would take readers a lifetime to plow.
1:04:56
Speaker 1: I do I have. That's my guilty pleasure. I love books. Um. Well,
1:04:59
Speaker 1: you know E. L. Wilson, the famous evolutionary biologist, has
1:05:03
Speaker 1: been a long time hero of mine. Uh, not just
1:05:06
Speaker 1: because of his theories and his impact and sociobiology, but
1:05:09
Speaker 1: because he writes like an angel, it's just extraordinary. Reading
1:05:13
Speaker 1: his work is just such a pleasure. Give us one
1:05:15
Speaker 1: book of Wilson's, his current book, Half Earth, that describes
1:05:20
Speaker 1: a new way of thinking about conservation and environmental impact.
1:05:24
Speaker 1: It's really fascinating. It's a very important book that I'm
1:05:27
Speaker 1: hoping more and more people will read. All Right, anything
1:05:29
Speaker 1: else before we leave books? That that's a good starting run.
1:05:33
Speaker 1: I think that's uh. I think that's it. We'll we'll
1:05:35
Speaker 1: leave it with that. That that's a that's a good
1:05:37
Speaker 1: run of books. Um, So, since you started looking at finance,
1:05:41
Speaker 1: what do you think the most significant changes in the
1:05:44
Speaker 1: industry has been and and are these for the better
1:05:48
Speaker 1: of for the worst. I think one of the most
1:05:51
Speaker 1: significant changes is the much bigger role that technology has
1:05:54
Speaker 1: played in our industry. It's really transformed the financial system,
1:05:58
Speaker 1: and I think it's both bad and good. I think
1:06:01
Speaker 1: that obviously technology has allowed us to engage in all
1:06:04
Speaker 1: sorts of financial transactions and services that we really wouldn't
1:06:08
Speaker 1: have been able to undertake. But at the same time,
1:06:11
Speaker 1: I think it's also created some vulnerabilities that we don't
1:06:14
Speaker 1: fully understand the financial system is a lot more complex
1:06:16
Speaker 1: now than it ever was, And I'm not sure that
1:06:19
Speaker 1: we really think about the system as a system. You know,
1:06:22
Speaker 1: we have regulators that focus on mutual funds and futurest
1:06:25
Speaker 1: markets and banks, but we don't have any regulator focused
1:06:28
Speaker 1: on the stability of the financial system as a whole.
1:06:31
Speaker 1: And I think that's really an accident waiting to happen.
1:06:35
Speaker 1: Wasn't Dodd Frank supposed to introduce all of these systemic
1:06:40
Speaker 1: survivability issues companies that are systemically important financial um? What
1:06:48
Speaker 1: is it? Cities? And uh, the idea that a bank
1:06:53
Speaker 1: needs a living will um and then discussions of now
1:06:59
Speaker 1: that's fascinating the new crew in d C. There seems
1:07:03
Speaker 1: to be a new impetus to bring Backglass Stiegel separate
1:07:09
Speaker 1: depository institutions and with checking accounts and and mortgages from
1:07:15
Speaker 1: financial institutions that are going to engage in trading and
1:07:18
Speaker 1: syndication underwriting. And if you do that goes the argument
1:07:21
Speaker 1: you could get rid of most of these regulations. You
1:07:23
Speaker 1: just need some minimum capital rules. And if one of
1:07:27
Speaker 1: those companies blows up, so what you're not affecting the
1:07:29
Speaker 1: rest of the financial system. What what are your thoughts
1:07:32
Speaker 1: on that well. Financial regulation is also an adaptive process,
1:07:35
Speaker 1: and that was one of the things that I really
1:07:37
Speaker 1: learned from watching the process of Dodd Frank. You know,
1:07:41
Speaker 1: DoD Frank isn't perfect, but it actually has done some
1:07:43
Speaker 1: very important things in changing the way we think about
1:07:46
Speaker 1: financial regulation, for example, creating the Office of Financial Research
1:07:49
Speaker 1: to collect data and to monitor the stability of the
1:07:52
Speaker 1: financial system. So I think that we've gotten a long
1:07:56
Speaker 1: ways away from the old days of the wild wild West.
1:08:00
Speaker 1: But at the same time, I don't think that we're
1:08:02
Speaker 1: focusing on financial regulation from a systemic perspective. You know,
1:08:05
Speaker 1: we do have the Financial Stability Oversight Council, which is
1:08:08
Speaker 1: this college of Financial Regulators and the US Treasury Secretary
1:08:13
Speaker 1: as the head, but that College isn't really a single
1:08:16
Speaker 1: regulatory body focus specifically on financial stability. It doesn't necessarily
1:08:22
Speaker 1: have regulatory authority that cuts across all the different jurisdictions
1:08:26
Speaker 1: of financial regulations. So I think we have to start
1:08:28
Speaker 1: thinking more adaptively about financial regulation. We have to think
1:08:32
Speaker 1: about the system not going from one extreme to the other,
1:08:35
Speaker 1: but rather changing in terms of its regulatory approach as
1:08:40
Speaker 1: markets heat up and as they cool down, so that
1:08:43
Speaker 1: that's pretty straightforward. Um, look at that, let where do
1:08:47
Speaker 1: you see as the next major shifts? And I know
1:08:51
Speaker 1: I famously say no forecasts. However, you're in a unique
1:08:57
Speaker 1: situation where you're looking at trends that are changing and
1:09:01
Speaker 1: you're seeing where those canaries in the coal mines are
1:09:04
Speaker 1: starting to either tweet or not. What is the next
1:09:07
Speaker 1: thing that the financial industry is going to have to
1:09:11
Speaker 1: adapt to? I think the process of convergence between hedge
1:09:16
Speaker 1: funds and mutual funds is one trend that we have
1:09:19
Speaker 1: to watch. Because of a combination of competition and innovation
1:09:23
Speaker 1: and the demand from investors looking for more active strategies
1:09:27
Speaker 1: and higher yield, we're going to see a greater retailization
1:09:31
Speaker 1: of hedge fund strategies. That's both an opportunity as well
1:09:34
Speaker 1: as a potential source of financial instability. Second is the
1:09:39
Speaker 1: role of financial technology, or fintech as we call it.
1:09:42
Speaker 1: The fact that investors are now engaging in robo advising
1:09:46
Speaker 1: services means that they're going to be subject to again
1:09:49
Speaker 1: greater algorithmic shifts as we see more and more sophisticated
1:09:53
Speaker 1: robo advisors. Just like we have driverless cars, at some
1:09:56
Speaker 1: point we may have driverless portfolios. And that's again both
1:10:00
Speaker 1: a good thing and a bad thing because it can
1:10:02
Speaker 1: create unintended consequences. This is another reader question. Tell us
1:10:08
Speaker 1: about a time you tried something and failed. What did
1:10:10
Speaker 1: you learn from the experience. How should investors deal with
1:10:16
Speaker 1: with failure, and how should they adapt to to that experience. Well,
1:10:21
Speaker 1: one form of failure was when Craig McKinley and I
1:10:24
Speaker 1: failed to realize how much of a sacred cow we
1:10:27
Speaker 1: were attacking when we started presenting our work on the
1:10:29
Speaker 1: random walk hypothesis. And I think that's a broader theme,
1:10:33
Speaker 1: which is that one has to be careful about the
1:10:36
Speaker 1: fact that other people have very strong narratives, and whether
1:10:40
Speaker 1: the narrative is passive investments or only active investments. We
1:10:44
Speaker 1: have to understand where investors are coming from. We have
1:10:46
Speaker 1: to understand the lens through which they're looking at the
1:10:49
Speaker 1: financial landscape, and we have to try to be realistic
1:10:52
Speaker 1: and develop products and services that take into account those lenses,
1:10:56
Speaker 1: as opposed to trying to force investors into particular ways
1:11:00
Speaker 1: of thinking that they're simply not equipped to do. I'm
1:11:03
Speaker 1: I'm about to google. I'm trying to remember who said
1:11:07
Speaker 1: sacred cows make the best hamburgers, and I'm trying to
1:11:12
Speaker 1: it comes to my head. But um, it was a book,
1:11:16
Speaker 1: there you go, and it was a book by Robert Kriegel.
1:11:20
Speaker 1: All Right, I knew that I knew the phrase was
1:11:22
Speaker 1: out there, but I didn't know where where it came from. Um,
1:11:26
Speaker 1: what do you do to relax outside of the office? Again?
1:11:28
Speaker 1: Another reader question, listener question, what do you do to
1:11:31
Speaker 1: say mentally and or physically fit well? For? For mental fitness,
1:11:37
Speaker 1: obviously doing research and being challenged by my students, I
1:11:41
Speaker 1: work with a lot of undergraduate and graduate students and
1:11:44
Speaker 1: at M I t these students are extraordinary, so that
1:11:46
Speaker 1: keeps me mentally fit. I would imagine for physical fitness,
1:11:50
Speaker 1: I'm an avid squash fan. I'm not a very good
1:11:53
Speaker 1: squash player, but I'm what I What I lack in
1:11:55
Speaker 1: skill I make up for an enthusiasm. And um, what
1:11:58
Speaker 1: about relaxation? What do you do outside of the office
1:12:01
Speaker 1: to relax well? At this point, my kids are still
1:12:05
Speaker 1: my number one focus. My younger son is in high school,
1:12:08
Speaker 1: my oldest son is just graduated from college, so spending
1:12:11
Speaker 1: time with them has been my best source of relaxation.
1:12:14
Speaker 1: I can imagine um. You work with a lot of
1:12:17
Speaker 1: of college students and and millennials. If one of them
1:12:21
Speaker 1: comes to you and says Professor Loh, I'm thinking about
1:12:24
Speaker 1: a career in finance, what sort of advice would you
1:12:27
Speaker 1: give them? I would say that finance is one of
1:12:29
Speaker 1: the most exciting fields to go into, but to keep
1:12:32
Speaker 1: in mind that finance is really a means to an end,
1:12:35
Speaker 1: not an end unto itself, and I think very often
1:12:38
Speaker 1: we lose sight of that. Even I lose sight of
1:12:40
Speaker 1: that because of the research that I do. But over
1:12:43
Speaker 1: the course of the last few years, I've begun to see,
1:12:45
Speaker 1: number one, how finance can be perverted in ways that
1:12:48
Speaker 1: it was never intended. But at the same time, I
1:12:50
Speaker 1: also see that finance can be used to achieve some
1:12:53
Speaker 1: of the greatest challenges that are facing mankind, including things
1:12:57
Speaker 1: like dealing with cancer, Alzheimer's, energy, all sorts of societal
1:13:02
Speaker 1: challenges that require large amounts of financing. So I think
1:13:06
Speaker 1: that this is a great feel to be in and
1:13:08
Speaker 1: it's an important one to focus on. And our final question,
1:13:12
Speaker 1: what is it that you know about financial engineering today
1:13:17
Speaker 1: that you wish you knew thirty years ago when you
1:13:19
Speaker 1: were first arriving in M I T. I wish I
1:13:23
Speaker 1: understood just how important human emotion is in financial decisions.
1:13:27
Speaker 1: I didn't really appreciate enough that logic was not enough
1:13:31
Speaker 1: in determining how people actually behave that. That is a
1:13:36
Speaker 1: answer that I've heard from a number of of guests,
1:13:39
Speaker 1: the behavioral side. It was overlooked way back when, and
1:13:44
Speaker 1: now it's really risen risen to the four. Professor low
1:13:47
Speaker 1: thank you for being so generous with your time. We
1:13:51
Speaker 1: have been speaking with Professor Andrew Lowe of M I T,
1:13:55
Speaker 1: author most recently of Adaptive Markets, Financial Evolution at the
1:14:00
Speaker 1: Speed of Thought. Book is getting tremendous reviews. We read
1:14:04
Speaker 1: it in our office and everybody seemed to really enjoy it.
1:14:08
Speaker 1: Speaking of enjoyment, if you enjoy this conversation, be sure
1:14:12
Speaker 1: and look up an inch or down an inch on
1:14:15
Speaker 1: Apple iTunes and you could see the other Let's call
1:14:18
Speaker 1: it hundred and forty or so such conversations that we've
1:14:21
Speaker 1: had over the past almost three years. I would be
1:14:25
Speaker 1: remiss if I did not thank my producer, Taylor Riggs,
1:14:30
Speaker 1: my head of research, Michael Batnick, and my recording engineer
1:14:35
Speaker 1: Medina Parwana. I'm Barry Ridholts. You're listening to Masters in
1:14:39
Speaker 1: Business on Bloomberg Radio. Our world is always moving, so
1:14:43
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