Robert C. Merton: The First Financial Engineer2020
This is an edited version of a talk given at the Robert C. Merton 75th Birthday Celebration Conference held at MIT on August 5 and 6, 2019. A video of the talk is available at https://bit.ly/2nvITM6.
This article is one of a pair of articles published in this volume about Robert C. Merton's contributions to the science of financial economics. The other article in this pair is “Robert C. Merton and the Science of Finance” by Zvi Bodie.
Competition and R&D Financing: Evidence from the Biopharmaceutical Industry2018
What is the interaction between competition, R&D investments, and the financing choices of R&D-intensive firms? Motivated by existing theories, we hypothesize that as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to assets-in-place that support existing products; (2) carry more cash; and (3) maintain less net debt. We provide causal evidence supporting these hypotheses by exploiting differences between the biopharma industry and other industries, as well as heterogeneity within the biopharma industry, in response to an exogenous change in competition. We also explore how these changes affect innovative output, and provide novel evidence that in response to greater competition, companies increasingly “focus” their efforts—there is a relative decline in the total number of innovations, but an increase in the economic value of these innovations.
Return Smoothing, Liquidity Costs, and Investor Flows: Evidence from a Separate Account Platform2017
We use a new dataset of hedge fund returns from a separate account platform to examine (1) how much of hedge fund return smoothing is due to main-fund specific factors, such as managerial reporting discretion (2) the costs of removing hedge fund share restrictions. These accounts trade pari passu with matching hedge funds but feature third-party reporting and permissive share restrictions. We use these properties to estimate that 33% of reported smoothing is due to managerial reporting methods. The platform's fund-level liquidity is associated with costs of 1.7% annually. Investor flows chase monthly past performance on the platform but not in the associated funds.
Q Group Panel Discussion: Looking to the Future2016
Moderator Martin Leibowitz asked a panel of industry experts—Andrew W. Lo, Robert C. Merton, Stephen A. Ross, and Jeremy Siegel—what they saw as the most important issues in finance, especially as those issues relate to practitioners. Drawing on their vast knowledge, these panelists addressed topics such as regulation, technology, and financing society’s challenges; opacity and trust; the social value of finance; and future expected returns.
Imagine if Robo Advisers Could Do Emotions2016
WSJ Wealth Expert Andrew W. Lo of MIT says robo advisers are the rotary phones to today’s iPhone--technology that has great potential but it still immature.
Spectral Portfolio Theory2016
Economic shocks can have diverse effects on financial market dynamics at different time horizons, yet traditional portfolio management tools do not distinguish between short- and long-term components in alpha, beta, and covariance estimators. In this paper, we apply spectral analysis techniques to quantify stock-return dynamics across multiple time horizons.Using the Fourier transform, we decompose asset-return variances, correlations, alphas, and betas into distinct frequency components. These decompositions allow us to identify the relative importance of specific time horizons in determining each of these quantities, as well as to construct mean-variance-frequency optimal portfolios. Our approach can be applied to any portfolio, and is particularly useful for comparing the forecast power of multiple investment strategies. We provide several numerical and empirical examples to illustrate the practical relevance of these techniques.
What Is An Index?2016
Technological advances in telecommunications, securities exchanges, and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes but which depart from traditional market-cap-weighted portfolios. I propose broadening the definition of an index using a functional perspective—any portfolio strategy that satisfies three properties should be considered an index: (1) it is completely transparent; (2) it is investable; and (3) it is systematic, i.e., it is entirely rules-based and contains no judgment or unique investment skill. Portfolios satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes.” This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved. Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.
Pioneered by the Nobel Prize–winning economist Harry Markowitz over half a century ago, portfolio theory is one of the oldest branches of modern financial economics. It addresses the fundamental question faced by an investor: how should money best be allocated across a number of possible investment choices? That is, what collection or portfolio of financial assets should be chosen? In this article, we describe the fundamentals of portfolio theory and methods for its practical implementation. We focus on a fixed time horizon for investment, which we generally take to be a year, but the period may be as short as days or as long as several years. We summarize many important innovations over the past several decades, including techniques for better understanding how financial prices behave, robust methods for estimating input parameters, Bayesian methods, and resampling techniques.
Spectral Analysis of Stock-Return Volatility, Correlation, and Beta2015
We apply spectral techniques to analyze the volatility and correlation of U.S. common-stock returns across multiple time horizons at the aggregate-market and individual-firm level. Using the cross-periodogram to construct frequency bandlimited measures of variance, correlation and beta, we find that volatilities and correlations change not only in magnitude over time, but also in frequency. Factors that may be responsible for these trends are proposed and their implications for portfolio construction are explored.
Reply to “(Im)Possible Frontiers: A Comment”2015
In Brennan and Lo (2010), a mean-variance efficient frontier is defined as “impossible” if every portfolio on that frontier has negative weights, which is incompatible with the Capital Asset Pricing Model (CAPM) requirement that the market portfolio is mean-variance efficient. We prove that as the number of assets n grows, the probability that a randomly chosen frontier is impossible tends to one at a geometric rate, implying that the set of parameters for which the CAPM holds is extremely rare. Levy and Roll (2014) argue that while such “possible”frontiers are rare, they are ubiquitous. In this reply, we show that this is not the case; possible frontiers are not only rare,but they occupy an isolated region of mean-variance parameter space that becomes increasingly remote as n increases. Ingersoll (2014) observes that parameter restrictions can rule out impossible frontiers, but in many cases these restrictions contradict empirical fact and must be questioned rather than blindly imposed.
Hedge Funds: A Dynamic Industry In Transition2015
The hedge-fund industry has grown rapidly over the past two decades, offering investors unique investment opportunities that often reflect more complex risk exposures than those of traditional investments. In this article, we present a selective review of the recent academic literature on hedge funds as well as updated empirical results for this industry. Our review is written from several distinct perspectives: the investor’s, the portfolio manager’s, the regulator’s, and the academic’s. Each of these perspectives offers a different set of insights into the financial system, and the combination provides surprisingly rich implications for the Efficient Markets Hypothesis, investment management, systemic risk, financial regulation, and other aspects of financial theory and practice.
Rethinking the Financial Crisis2012
Some economic events are so major and unsettling that they “change everything.” Such is the case with the financial crisis that started in the summer of 2007 and is still a drag on the world economy. Yet enough time has now elapsed for economists to consider questions that run deeper than the usual focus on the immediate causes and consequences of the crisis. How have these stunning events changed our thinking about the role of the financial system in the economy, about the costs and benefits of financial innovation, about the efficiency of financial markets, and about the role the government should play in regulating finance? In Rethinking the Financial Crisis, some of the nation’s most renowned economists share their assessments of particular aspects of the crisis and reconsider the way we think about the financial system and its role in the economy.
Hedge Funds: An Analytic Perspective2010 Revised Edition
The hedge fund industry has grown dramatically over the last two decades, with more than eight thousand funds now controlling close to two trillion dollars. Originally intended for the wealthy, these private investments have now attracted a much broader following that includes pension funds and retail investors. Because hedge funds are largely unregulated and shrouded in secrecy, they have developed a mystique and allure that can beguile even the most experienced investor. In Hedge Funds, Andrew Lo--one of the world's most respected financial economists--addresses the pressing need for a systematic framework for managing hedge fund investments.
The Heretics of Finance2009
The Heretics of Finance provides extraordinary insight into both the art of technical analysis and the character of the successful trader. Distinguished MIT professor Andrew W. Lo and researcher Jasmina Hasanhodzic interviewed thirteen highly successful, award-winning market professionals who credit their substantial achievements to technical analysis. The result is the story of technical analysis in the words of the people who know it best; the lively and candid interviews with these gurus of technical analysis.
The first half of the book focuses on the technicians' careers:
- How and why they learned technical analysis
- What market conditions increase their chances of making mistakes
- What their average workday is like
- To what extent trading controls their lives
- Whether they work on their own or with a team
- How their style of technical analysis is unique
The second half concentrates on technical analysis and addresses questions such as these:
- Did the lack of validation by academics ever cause you to doubt technical analysis?
- Can technical analysis be applied to other disciplines?
- How do you prove the validity of the method?
- How has computer software influenced the craft?
- What is the role of luck in technical analysis?
- Are there laws that underlie market action?
- What traits characterize a highly successful trader?
- How you test patterns before you start using them with real money?
Ralph J. Acampora, Laszlo Birinyi, Walter Deemer, Paul Desmond, Gail Dudack, Robert J. Farrell, Ian McAvity, John Murphy, Robert Prechter, Linda Raschke, Alan R. Shaw, Anthony Tabell, Stan Weinstein.
The non-trading or non-synchronous effect arises when time series, usually financial asset prices, are taken to be recorded at time intervals of one length when in fact they are recorded at time intervals of another, possibly irregular, lengths. For example, the daily prices of securities quoted in the financial press are usually "closing" prices, prices at which the last transaction in each of those securities occurred on the previous business day. these closing prices generally do not occur at the same time each day, but by calling them "daily" prices, we have implicitly and incorrectly assumes that they are equally spaces at 24-hour intervals. Such an assumption can generate spurious predictability in price changes and returns even if true price changes or returns are statistically independent. The non-trading effect induces potentially serious biases in the moments and co-moments of asset returns such as their means, variances, covariances, and autocorrelation and cross-autocorrelation coefficients.