The Future of Financial Engineering

Andrew Lo's research results and the implication that there are pockets of predictability in the stock market lend support to contrarian strategies of buying losers and selling winners (see Contrarian Investing). But he is less convinced by investment strategies based on the insights of behavioral finance into psychological biases inherent in human cognition, which aim to take advantage of individual "irrationality" As financial engineering attempts to define itself as a field with connections closer to the engineering disciplines than more traditional finance, associations are being set up, and the general engineering community does not quite know what to do. Patenting is becoming a big issue. Recent changes in patent laws and interpretations, along with encouragements for universities to do more patenting have led to an explosion of new patents. Some of these are in financial engineering but it is not clear which can be defended. Certainly, financial patents will have an impact on the efficiency of markets and the rate of financial innovation.

Financial engineering is also having an impact on banking. Innovation in combination with electronic technology is creating a world in which maturity transformation turning short-term deposits into long-term loans, the central function of banks is unnecessary. Economic agents individuals, households, companies will no longer require this service. Their portfolios of assets and liabilities will be broadly matched in maturity terms: short-term assets will match short-term liabilities, longer-term liabilities will offset longer-term assets. As a result, as Peter Martin of the Financial Times suggests, "traditional banking is dying. But the grieving throng around the deathbed face a long and expensive vigil."

Finally, what about market innovations? Financial innovations have been fast and furious over the past two decades. But why are market innovations so slow in coming? We have known for a long time what to do: integrate global markets electronically; pay shares in decimals not fractions; open the specialist books and stock exchanges like the New York Stock Exchange; record and display publicly the questions and answers exchanged by companies and analysts. Indeed, we could even go further and encourage insider trading, bringing insiders' wisdom into the market sooner rather than holding out, waiting for culprits to take advantage of us. It could be done, merely by identifying fewer insiders and letting them trade, at which point they would identify themselves. All of these things and more could be done in a stroke.

Counterpoints to financial engineering

It includes traditional market efficiency arguments against active management, such as Bill Sharpe's arithmetic (see Active Portfolio Management). And even if it is possible to beat the market, and notwithstanding the fact that past performance should not be the sole criterion for judging investment managers, the riskiness of active strategies can be very different from passive strategies (see Indexing). Such risks do not necessarily average out over time, and investors' risk tolerance should be part of the process of selecting an investment strategy to match their goals (see Investment Policy).

A second counterpoint is the set of arguments against quantitative investing, and notably its reliance on backtesting and data mining (see Quantitative Investing). Engineering, by the very nature of its development and application, builds on whatever is accepted theory at any given stage of the cycle. Investment theories tend to lurch forward in leaps, usually after the disappointment of a prolonged bear market. New theories emerge, correcting the ills exposed by a calamitous decline and engineering applies the new wisdoms.

It should not surprise us that the applications of today's financial engineer seem internally consistent, sound and almost unassailable. That would always be found after decades of reconfirmation of market and portfolio theory. But we should not be lulled into complacency by a catechism built on data of only a few decades. Nor should we imagine that portfolio theory, as we know it today, is the end of investment knowledge. There will be new theory and new engineering to apply it. But it may have a different label than the contemporary financial engineering. Finally, one of the consequences of the development of computer and financial technologies (as well as the long bull market) is the incredible growth in electronic trading. This has both good and bad implications for ordinary investors. On the positive side, the tools developed by cutting-edge financial institutions over two decades ago are now available to the individual household. Yet as with most technologies, the tools are more advanced than the general population's understanding of how to use them properly. Although trading costs have come down dramatically for the individual investor, the possibility of doing serious damage to one's nest egg is even greater.

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.

Understanding Financial Engineering

Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations from adjustable rate preferred stock to zero-coupon convertible debt but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.

All these innovations are implemented using a few basic techniques, such as increasing or reducing risk (options, futures and other more exotic derivatives see Risk Management), pooling risk (see Mutual Funds), swapping income streams (interest-rate swaps), splitting income streams (stripped bonds), and converting long-term obligations into shorter-term ones or vice versa (maturity transformation). But to be truly innovative, a new security or process must enable issuers or investors to accomplish something they could not do previously, in a sense making markets more efficient or complete.

Finnerty describes ten forces that stimulate financial engineering. These include risk management, tax advantages, agency and issuance cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.

The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training, but had previously been fed from a haphazard network of different programs. Universities began to re spond to the demand by setting up masters programs in financial engineering and they were helped by the fact that the physics job market was at an all-time low due to the end of the Cold War.

The Future Trends of Emerging Markets

Perhaps rather it was a natural consequence of the modern portfolio theory taught in the United States, to diversify and take higher risks, coming on the back of what wsa then a ten-year-old bull market. From the developing countries' position, private investors were offering capital at no annual interest rate (we called it equity; they called it free, without management strings), which was more attractive than bank or government lending. It was a meeting of lovers and there was a love fest. And now, they have matured with all of the obligations and responsibility that come from the next age level.

Mobius selects the largest countries as the ones with best future potential presumably for the attractiveness of their domestic markets. The first rush of emerging markets was for export sales and that is now over. He is right to emphasize places like Nigeria and Egypt. And he is right in the sense that if he is wrong, these overpopulated countries will not tolerate a world with such huge disparities of communications and living standards.

But before we get to 2010, we must deal with the traumas of the late 1990s. Since the beginning of the Asian crisis in July 1997, there has been an approximately 50% decline in emerging markets. It started in Asia, became most visible and most illustrative in Russia, with about a 90% decline, approximately the same as in Indonesia, the fourth largest country in the world in terms of population. And pressure built up in Latin America.
rates, in higher markets, to take them out. And even if not at higher levels, they take them out anyway because emerging markets on the whole look like a considerably less attractive place to invest than they did five years ago. This is a world-wide phenomenon, not just limited to Indonesia, Russia and Latin America.

What is it all about? The mixture of rising nationalism and deflation is very potent negative medicine for emerging markets. Reform of banking systems means banks have to recognize bad loans. Interconnectivity means that when something happens in one part of the world, the rest of us all feel it. This is not necessarily a dramatic buying opportunity except for those people who can watch the hourly news. And yet, we are setting up the conditions by which the long struggle of the workout period can take place. It is probably some distance into the future, but the early dramatic decline has certainly been felt.

In the meantime, there will be continual turmoil in these countries, promoting more nationalism, more separation from the international community and yet more necessity on the part of the developed nations, especially the United States, to support them.

China may be different in the sense that it has a high surplus of dollars with its very positive trade balance with the United States, and it may come out of this phase as the dominant emerging market. Mobius is right about the necessity for structural reform but this country seems destined to dominate its region and possibly to be the next sole superpower. It is a tremendously powerful force in the region and in the world, and the group that is running China now and in the next decade is very competent. We should pay careful attention to them.

Meanwhile, the United States itself looks increasingly like an emerging market. As with most emerging markets, it depends entirely on an inflow from outside its own borders in order to survive. There is a negative savings rate, and debt cannot be liquidated on its own but only rolled over, a characteristic of an emerging market. And it is very much an overbought emerging market having extended a very great boom for essentially the last 18 years. But more than that, the United States is an emerging market that has turned over its financial responsibility to the rest of the world. The degree to which the country borrows in dollars is helpful. But the degree to which dollars are held by foreigners is harmful since foreigners can start liquidating those dollars in order to meet their own demands. As an emerging market, it is not clear that the United States would meet the IMF requirements for borrowing, a strange concept given the extent to which it is perceived to be the safest
Think of a swamp fire, or a fire in a coal mine, where underneath the ground there is a common smoldering heat source, which every once in a while flares up to the surface where it must be put out. Firemen come in and douse it with water and fire extinguishers and that flame goes away. Six months later, it comes up again.

This is what the conditions are today in emerging markets. In Indonesia, South Korea, Thailand, Malaysia, Brazil, Russia, Mexico one after another we get a flare-up. But it is all the same thing. It is a preference for risk-averse investing. It is a preference for guaranteed returns. And it is an aversion to the downside risk of a free market that extracts a penalty for over-exuberance. We have to treat the basic fire, rather than just the flare-ups.

Each emerging market considers itself unique in attempting to solve its own problems. But the problems are quite common. In order to rebuild their economies, most emerging markets have borrowed heavily in dollars in this capital-plentiful period. Investors have also invested dollars in those economies and now plan, at higher

The Trend of Investing Mindset

The ability to move from market to market assumes that investments and their environments are disconnected, that market movements are not strongly correlated. But in these days of global banking and instant communication, that condition is less likely. Markets and investments in those markets may be increasingly synchronized.
In the past two decades, as emerging market investment grew dramatically, globalization permeated our financial systems. Now there are some clues of a cyclical return to local and national interests. If so, investments by foreigners in any market may be treated harshly.

For example, some now argue that the rapid expansion of emerging stock markets in recent years is likely to hinder rather than assist faster industrialization. According to this view, while stock markets may be potent symbols of capitalism, paradoxically, capitalism often flourishes better without their dominance. The inherent volatility and arbitrariness of stock market pricing in developing countries make it a poor guide to efficient investment allocation. Portfolio capital inflows from overseas lead to interactions between two inherently unstable markets: the stock and currency markets. Such interactions in the wake of unfavorable economic shocks may exacerbate macroeconomic instability and reduce long-term growth.

Emerging market investment depends on steadily growing liquidity to be able to pay back investors at higher levels in a foreign currency. This works when the market is going up and money is coming in. But in the reverse, liquidity is tight; the ability to pay foreign creditors is lacking and confidence plummets.

Thus, emerging market investing may be a long-term cyclical phenomenon and not a steady, one-way path to riches. Certainly, the emerging market investment phase of more than the last decade is over. Not only has capital been destroyed and confidence shattered, but the idea of capital flows for superior return from developed countries to needy, developing ones is gone. The latter do not want the funds on anything like the terms that would be required.

A common theme of this book is that investment success is most often observed where the market requirements and investor personality are one. The old shibboleth that "investors don't pick markets, markets pick investors" is more true in emerging markets than elsewhere. And Mark Mobius's style, hard work and tough mind are exactly what was needed in emerging markets. These markets may undergo a change. Will he?

Five Central Investment Attitudes

Diversification: this is particularly important in emerging markets where individual country or company risks can be extreme. Global investing is always superior to investing solely on the investor's home market or one market. Searching world-wide leads an investor to find more bargains and better bargains than by studying only one nation.

Timing and staying invested: as Sir John Templeton says, "the best time to invest is when you have money." In other words, equity investing is the best way to preserve value rather than leaving money in a bank account. As a corollary, an investment should not be sold unless a much better investment has been found to replace it.

Long-term view: by looking at the long-term growth and prospects of companies and countries, particularly those stocks that are out of favor or unpopular, the chances of obtaining a superior return are much greater.

Investment averaging: investors who establish a program from the very beginning to purchase shares over a set period of intervals have the opportunity to purchase at not only high prices, but also low prices, bringing their average cost down.

Accepting market cycles: any study of stock markets around the world will show that bear or bull markets have always been temporary. It is clear that markets do have cyclical behavior with pessimistic, skeptical, optimistic, euphoric, panic and depressive phases (see Manias, Panics and Crashes). Investors should thus expect such variations and plan accordingly.

In assessing emerging market investments, Mobius stresses the importance of constantly being aware of influences and biases. These are strongest in the places where you spend most of your working and leisure hours and from where you obtain most information. For this reason, the emerging market investor must continually visit all the countries in the emerging market areas and read news and research reports originating from all over the world. (However, as a counterpoint, the internet now makes available a wealth of information on individual markets and countries perhaps better and less costly in time and effort than that obtainable on the ground.)