Andrew Lo and Financial Engineering

Where else but the Massachusetts Institute of Technology (MIT) would you expect to find a course track called Financial Engineering? For a while the Sloan School of Management was not really accepted at MIT though its graduates were among the most sought-after in the job market for newly-minted MBAs. But within the science-oriented faculty, business education was hardly taken as seriously as Alfred Sloan, the donor of the facilities, hoped it would be.

Now that has changed. Finance has gone quant: higher mathematics is a regular feature of security pricing, risk management and business strategy. Professor Andrew Lo is one of the key people responsible. He is a first-rate scholar who, like others in this volume, can straddle academe and business. His research output is huge, often in collaboration with other leading lights who appear in the Journal of Finance, the Journal of Financial Economics, the Journal of Econometrics, the Review of Financial Studies and the many other publications still being added to the reading lists of professors and practitioners.

The burgeoning field of financial economics has produced a group of young professors who now hold endowed chairs. Just a decade or so ago, they were pre-tenured stars full of research ideas sprung from the basic efficient market hypothesis. They were going on to the next level or two, testing and applying these theories to specific valuation, portfolio strategy and risk problems. They showed their students, who were to become the star practitioners in institutions, how to do investments the modern way. Many of this group won a coveted Batterymarch Fellowship for research when little other funding was available. Andrew Lo, of course, was one of the most promising of that group as a winner in 1989.
Lo's research interests run the gamut of today's financial interests and his papers are among the most thoroughly researched of the field. Students call him an inspired teacher, perhaps because he believes in the worth of his subject matter. And in addition to his heavy teaching load, he carries an administrative burden as the director of the Laboratory for Financial Engineering, in fact its founder, at MIT. Somehow, he also finds time to help leading investment firms through consulting projects as well as steadily maintaining active parenting of a young toddler.

In addition to being the co-author of the first major financial econometrics textbook, Lo has a book published in early 1999 entitled A Non-Random Walk Down Wall Street, an obvious counterpoint to Burton Malkiel's classic book of almost the same name (see Market Efficiency). As his title suggests, Lo's research indicates that there are some elements of short-term predictability in stock returns and that it may be possible for disciplined active managers to seek them out, exploit them and "beat the market."

Financial engineering is the key to superior performance. Lo uses the analogy of the exceptional profitability of a pharmaceutical company, which may be associated with the development of new drugs via breakthroughs in biochemical technology. Similarly, even in efficient financial markets, there can be exceptional returns to breakthroughs in financial technology. Of course, barriers to entry are typically lower, the degree of competition much higher and most financial technologies are not as yet patentable so the half-life of profitability of financial innovation is considerably smaller.