Perspectives on Risk
Nobel laureate and industry expert offer their ideas on risk management, financial derivatives and the future of the economyby Tony Cusano
In recent years, it has become clear that the collapse of century old firms, including Lehman Brothers, was caused by a disregard for risk throughout the global financial system. As the dust settles, it is apparent that the events of 2008 to 2009 will likely become a chapter in the history books rather than just a few pages. Accordingly, we found it fitting to interview Harry Markowitz and Ross Valkanov, two Rady professors who have spent the majority of their careers studying market risk.
In 1990, Markowitz shared the Nobel Prize in economics for his work on modern portfolio theory. In it, he distilled over 50 years of financial market experience into a strategy for the average investor and provided key market insight. Valkanov's work on risk management, coupled with his understanding of complex derivatives used in managing risk, has made him a rising star in academia. Both were kind enough to share some thoughts and insights, as well as a few predictions for the remainder of 2010 and beyond.
Can you talk about what has changed and what hasn’t changed since you discovered portfolio theory?
HM: The world is still uncertain and you have to diversify. Equity market probability distributions are still not normally distributed. Through the 1960s asset managers were very focused on a bottom up approach, which is all about picking stocks. Today it's more of a top down approach, which is all about picking asset classes. Academic studies have demonstrated that much of investor returns can be explained by asset class selection and weighting. You have more data today, which allows you to make a more informed decision; however, you can't just rely on historical data. Estimates should be forward looking.
How has risk management changed since the credit crisis began in 2007?
RV: Prior to 2007, risk management professionals were viewed as “alpha1 eaters” because they tried to limit traders from taking what the risk management professionals viewed as too much risk. Given the events that have unfolded over the past two years, the financial industry is now much more focused on risk and risk management is seen as more of a necessity again.
Is the recent shift in risk management temporary or more of a permanent change?
RV: It’s hard to say; in the last six months you have seen an appetite for risk and leverage come back into the global markets, which may indicate a reversion to pre-2007 practices. That said, I believe the longer term trend will be for people who invested through the recent downturn to take risk management much more seriously than before.
Are financial derivatives a good thing for risk management and what, if any, changes should be implemented to decrease the systematic risk derivatives pose to the broader economy?
RV: In general, derivatives are a powerful tool for risk management. However, in recent years some forms of derivatives, most notably credit default swaps, have been used for unregulated speculation. I believe that certain derivatives should have more transparency and be forced to post additional collateral. This would reduce the overall risk to the economy from counterparties not being able to cover their obligations in the event of a default.
Is the efficient market hypothesis still valid today? Are markets really efficient?
HM: Markets would be efficient if you could borrow and lend at the risk free rate and you knew all probability distributions with certainty. Practically speaking, markets are not efficient, but that doesn’t mean they are easily beat. Some active managers can beat the market, but most don't when you adjust for their fees.
How efficient are markets and are less efficient markets more prone to asset bubbles?
RV: Public equity markets are very efficient, particularly in the large capitalization space. On the other hand, the real estate and private equity markets are much less efficient. Private equity is a market where some participants have an information advantage over others. In private equity, this leads to a sizable difference in returns of top quartile managers versus second quartile managers. I believe that excessive leverage creates asset bubbles. However, asset bubbles can occur in both public and private markets alike.
How do you view market efficiency in the context of private equity investing?
HM: I go with the advice of David Swensen, Yale’s chief investment officer — if you don’t have the time, talent and training to evaluate alternatives wisely, stay away from the asset class. As to efficiency, Swensen's track record shows that excess returns are available here, but only to the knowledgeable.
What should the average retail investor do with their money?
HM: For equity positions, individual investors should buy no-load mutual funds2 or ETFs3 with low management expenses. It is still important to have the right mix of fixed income and equity to construct a portfolio that considers your time horizon, risk tolerance, liquidity situation, tax consequences and any other unusual circumstances.
How should the average individual investor think about risk management?
RV: Average investors should stay away from derivatives. It makes more sense for a retail investor to identify the optimal portfolio allocation and hold the market through low cost mutual funds or ETFs. If this crisis has taught investors anything, it’s taught them not to try and time markets. Many investors tried to time the recovery and as a result of being early, experienced sizable losses.
How do you define genius?
HM: Genius is somebody who, more than once, is able to gain insight into a problem that changes the world for the better. Many times you have individuals that come up with a solution to a very complex problem, but are unable to ever develop any of their subsequent insights into anything meaningful.
Is genius related to IQ?
HM: They are not the same. A reasonable IQ is necessary, but not sufficient to being a genius as I define it.
Does academic brilliance translate into real world outperformance?
RV: There are some examples where it has but, in general, I don’t believe it does. There are several reasons for this. First, academics are very risk averse, which can make it challenging for them to execute in a principal investment role. Second, in many cases, academics experience additional pressure from the market perception that they should get it right every time. Academics are like coaches, we have a vision and understand the game very well, but aren't the best players of the game.
Do you have any future predictions for the rest of 2010 and beyond?
RV: Two years from today the prices of Treasury securities will be roughly unchanged. Inflation will remain low for the next several years and Europe will struggle with lower growth than the U.S. as it works through its deleveraging process.
What will be the largest shock (downside surprise) to the market over the next two years?
RV: Commercial real estate needs to refinance a sizable amount of short-term debt over the next three years, which will likely cause prices to trade down over the next year. Commercial real estate has too much leverage and there are not enough lenders to refinance the wall of maturities coming due. This process could have an adverse effect on the broader market.
1Alpha is the excess return that a portfolio makes over and above what the capital asset pricing model estimates.
2A no-load mutual fund is a mutual fund that does not charge shareholders a sales charge or commission.
3An Exchange Traded Fund (“ETF”) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
Tony Cusano (’07) is a member of Siguler Guff’s private equity research team where he focuses on distressed debt and special situations opportunities globally. He is based in New York. Cusano previously worked on the distressed research team at StepStone Group. He also holds a bachelor of science summa cum laude from California Polytechnic State University, San Luis Obispo.