Investment Research Retreat

The Research Affiliates' annual Investment Research Retreat (formerly Advisory Panel conference) brings together researchers to delve into economic and investment issues relevant to investors. The forum is intended to stimulate broad insights and lively debate. We highlight here summaries of the most recent Retreats.

INSIGHTS FROM SPEAKERS AT THE 2018 ADVISORY PANEL

andrew lo ap

"We need new narratives in finance. And if we have the right narrative, we can accomplish anything." 

—Andrew Lo, MIT

Adaptive Investing in an Evolving World
Lo’s adaptive markets hypothesis brings a welcome challenge to the traditional, largely efficient markets–based, investment paradigm and its assumptions, which he argues have been good approximations during the period in which the standard models were developed.  Over the past two decades, however, these approximations—the existence of simple static linear relations between risk and return, the rationality of investors, and the stability and efficiency of financial markets—have started breaking down. In Lo’s adaptive markets framework, investors act in their own self-interest, but they make mistakes, and they ultimately learn and adapt as financial institutions and capital markets evolve. Market competition drives this process of adaptation and innovation. Success in this new paradigm requires investors to be vigilant, creative, and cognizant of ever-changing risks as they emerge. In Lo’s words: “In the long run we’re all dead, but let’s make sure the short run doesn’t kill us first.”

"The core economic ideas in FinTech are cost reduction and customization." 

—Sanjiv Das, Santa Clara University

sanjiv das ap

Machine Learning/Artificial Intelligence in FinTech
As an accepted definition of FinTech is still being formed, Das defines FinTech as any technology that eliminates or reduces the cost of “the middleman” in finance and drives efficiencies. The explosion of FinTech over the last decade has been fueled by three big game changers in computing: innovation in analytical methods that “unlock” new information; increasingly agile and sophisticated hardware (often consumed as a service in the Cloud); and abundant amounts of new and often big data. Artificial general intelligence, or AGI, has moved beyond the earliest forms of AI, which was pre-programmed with fixed rules and thus could never be more intelligent than its creators. Today’s AGI is data driven and can adapt itself to reflect the data patterns it discerns, with the possibility that advanced skills can emerge organically. Given today’s high costs of financial intermediation, FinTech allows for disintermediation in raising, allocating, and transferring of capital, with applications in virtually every area of the financial and investment industry.

deborah lucas as

"Home equity [is] a giant, but very underutilized asset class, and…at least on paper, reverse mortgages are probably the answer to how people will be able to dip into that very important source of funds. As currently designed though, reverse mortgages are a disaster of a product." 

—Deborah Lucas, MIT

Accessing Home Equity in Retirement
At yearend 2017, US homeowners had accumulated equity in their homes totaling more than US$13 trillion, nearly rivaling balances in other forms of private retirement savings. Nevertheless, home equity is rarely considered a retirement asset class and consequently is severely underutilized in retirement planning and during retirement itself. In the abstract, a reverse mortgage is a potential way to create liquidity for what would be an otherwise very illiquid retirement asset. Yet reverse mortgages are particularly unpopular, as evidenced by their limited adoption. Lucas calls the unpopularity of this financial product, which happens to be a socially valuable strategy allowing seniors to access needed cash and to age in place, the “reverse mortgage puzzle.” In Lucas’s analysis, major program and regulatory changes designed to reduce costs and improve incentives are needed to resolve the puzzle. If these changes are not made, a key innovation in retirement planning will be left underutilized for the foreseeable future.

"Retail investors…[as well as those] that are very sophisticated, [such as] institutional investors and consultants, put far too much weight on noisy past returns. If you…recognize that bias, then you have a better chance of correcting for it." 

—Campbell Harvey, Duke University

cam harvey ap

Rare Effects and Investment Management
Investors—a subclass of the broader set of “human beings”—tend to poorly comprehend statistics, which leads them to make a number of errors in investment decisions. A pervasive mistake is their believing a strategy should be a winner in the future, based on past history, when ultimately it turns out to be a losing strategy; this is a Type I error or a false positive. Should we blame investors for this type of behavior if we believe this form of optimism is part of the evolutionary success of our species? Harvey explains that the combination of 1) frequent Type I errors to which we are evolutionarily predisposed; 2) poor research testing methods that fail to separate luck from skill and drift into “p-hacking” or data mining; 3) not controlling for implausible rare effects; and 4) failure to reduce noise provides important lessons for asset management. To lessen the false positives, investors are encouraged to look beyond Sharpe ratios and to assess other information such as the research culture of the asset manager, and to approach new research with caution, if not cynicism. The low-hanging fruit in long-term risk premia have now been picked, suggesting that most newly promoted empirical research findings may be false, that most managers are just lucky, that most smart beta products are not smart, and that there is no predictability in performance based on noisy past performance.

john cochrane ap

"If interest rates go up to 5%, debt service goes, within two years, up to a trillion dollars a year. It doubles the already unsustainable deficits. And then if that happens, markets charge even higher interest rates. So by having short-term debt and a large amount outstanding, we are in danger of a classic debt crisis." 

—John Cochrane, Hoover Institution

Eight Heresies of Monetary Policy
Cochrane challenges conventional thinking on monetary policy. He argues that conventional narratives are far overstated. During the years of near-zero rates, the Fed was not holding rates down, if anything it was pushing rates up from what market forces would have wanted. The massive QE operations had no visible effect on interest rates or the economy. Large quantities of interest-paying reserves don’t cause inflation and are to be welcomed as useful liquidity. The Fed is not stoking “bubbles” in financial markets. Markets are always high in expansions and this one is no different. Conventional theory, as used by the Fed, predicts that long years of near-zero rates should have resulted in a deflation spiral. That inflation is stable clearly invalidates those theories: inflation is stable when interest rates don’t move. Consequently, if the Fed were to raise interest rates and keep them there, inflation would likely rise. Cochrane closed by warning that the main inflation danger comes from fiscal policy

"When considering how to invest, we should ask ourselves: Are we comfortable with heroic assumptions of 3% real share-price growth? Or do we want to invest in markets where sensible returns can be expected, based on sensible assumptions about future growth and mean reversion?" 

Rob Arnott, Chair and Founder, Research Affiliates

rob arnott ap

CAPE Fear: Why CAPE Naysayers Are Wrong
Has the Shiller PE lost its usefulness as a predictor of long-term returns? Arnott looks at the evidence from US and international equity markets and shows that the arguments made to justify current elevated CAPE ratios are based on factors that are subject to mean reversion. Mean reversion skeptics rationalize the co-existence of sustained high CAPE levels and high future returns in various ways: increases in the structural EPS growth rate along with recent changes in earnings measurement; large numbers of working-age savers who are valuation-indifferent stock purchasers today for retirement spending tomorrow; a low discount rate as a function of current low interest rates; and a prolonged low macro-volatility environment. Arnott explains the market forces with the potential to cause CAPE to tumble and highlights why CAPE naysayers are wrong about the measure. For those investors willing to accept that a high CAPE is here to stay, they must also accept that low expected returns are also here to stay.

NOBEL LAUREATES VERNON SMITH AND HARRY MARKOWITZ HONORED

INVESTMENT RESEARCH RETREAT SUMMARIES

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