Ivory-tower money managers have been viewed suspiciously since the spectacular 1998 collapse of Long-Term Capital Management, with two Nobel Prize economics winners, Robert Merton and Myron Scholes, involved. But don?t write the eggheads off. After all, Yale?s Robert Shiller warned about the housing bubble long before it burst. Here are four academics whose insights could help you get rich or at least protect the wealth you have.
?It?s unrealistic to say buy and hold. It?s like telling teenagers to abstain from sex,? quips Lo.
The Hong Kong-born and Yale-and Harvard-educated Lo is hardly the first to observe that many investors hold on too long when markets are going down, finally panic and sell, and then wait way too long to get back in. What?s novel is the way he mixes behavioral economics and artificial intelligence to design programs that allow for human emotions while minimizing their wealth-destroying impact, an approach he dubs ?artificial stupidity.?
Simple example: There?s a threshold of pain?say, a 25% dive in the stock market?beyond which most normal humans can?t resist dumping stocks and going to cash. Fine. At that point the computer puts you in cash so you can sleep at night. But when market volatility subsides, as reflected, for example, by a decline in the Chicago Board of Options Exchange VIX Index, the computer starts buying again, long before most people would have the stomach to get back in. Truth is, buying and selling according to the VIX isn?t so stupid. ?When the VIX spikes,? Lo says, ?equities are almost never your friend.?
These days Lo puts some of his theories to work as founder of AlphaSimplex Group, with its $3 billion Natixis ASG Global Alternatives Fund (GAFYX), which invests in a constantly changing menu of securities, including stock-index, currency and commodities futures and forwards, dialing the risk up and down according to the volatility of the underlying markets. Returns have been a mediocre 5.1% a year since the fund was launched in September 2008, just half the S&P 500?s return. But Lo argues the fund did its job in the tumultuous final months of 2008, dropping only 3% compared with an 11% loss for hedge funds with similar strategies and a 23% dive in the S&P.
Don?t want to pony up the fund?s 1.33% annual expense and up to 5.75% sales load?
Lo offers this free advice: Accept you are a mortal who can panic, and adjust your portfolio to the risk in the marketplace, moving to bonds and cash when volatility goes up and moving back to equities when it subsides. The case for this approach is stronger since the increased tendency of different asset classes to move downward together in a crisis has weakened the power of diversification as a sleep-at-night prescription. ?We all live in a world of diversification-deficit disorder,? says Lo.
The British-born and MIT- and Stanford-educated Whitelaw is an avid skier who has hiked the Alps, completing the popular 105-mile Tour du Mont Blanc trail through France, Italy and Switzerland with his family. So perhaps it?s fitting that he aims to conquer the hedge fund heights?for the average investor.
As chief investment strategist of $1.5 billion (assets) IndexIQ (which New York Life Insurance Co. just agreed to buy) Whitelaw is attempting to replicate hedge fund strategies on the cheap with combinations of ETFs. Underlying this effort is his belief that there?s a good reason to own hedge funds: Their performance isn?t correlated with the ups and downs of the rest of your portfolio because they invest in alternative markets (or strategies) most retail investors don?t have access to.
But, he says, you can?t know in advance which managers will actually generate alpha?that is, which will outperform the market return (or beta) of those alternatives?particularly after their voracious fees (typically 2% of assets and 20% of profits) are taken into account.
Want exposure to commodities? Instead of paying a manager to trade corn futures on the Chicago Mercantile Exchange, you could buy a portfolio of stocks whose earnings are driven mostly by commodity prices, then short the whole stock market to strip out market beta. What?s left is a synthetic commodities portfolio, minus the 2-and-20. IndexIQ?s Global Resources ETF uses this strategy. Total expense ratio: 0.76% of assets.
What about replicating the performance of global macro hedge funds? Whitelaw has identified half a dozen substrategies, including fixed-income arbitrage and emerging markets equities, that he thinks explain most of their returns. He and IndexIQ programmers have devised ?optimizers? that shift money from strategy to strategy.
He admits there?s one style of hedge fund he can?t match: that of activist managers like Daniel Loeb, who make concentrated bets no computer could predict.
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