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RT18: Are markets really Efficient? ft. Andrew Lo & Sol Waksman – 1of2
16th January 2019 • Top Traders Unplugged • Niels Kaastrup-Larsen
00:00:00 00:40:51

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“Markets are efficient most of the time. Every once in a while, human behavior ultimately overwhelms the kind of rational deliberation that efficient markets are based on, and we do see periods of fear and greed that ultimately take over. But it’s not one or the other, it’s both.” – Andrew Lo (Tweet)

On today’s episode, host Niels Kaastrup-Larsen speaks with Andrew Lo, the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management, and Sol Waksman, the Founder and President of BarclayHedge, Ltd. Our guests today have many years of experience in the world of  investing and have watched the finance industry as it has gone through its many changes. Listen in to learn the historical importance of separating the alpha from the beta, the increase of the volatility of volatility since 2007, and common misconceptions about diversification in a portfolio.

In This Episode, You’ll Learn:

  • How our guests got their starts in finance
  • Why Andrew thinks that sometimes things need to be believed to be seen
  • Why separating the alpha from the beta has been revolutionary for the entire financial industry
  • How the narrative of finance and investing has changed over time in the futures industry
  • The increase in the volatility of volatility over the last decade and what that means for managed futures
“I think that for the most part, investors misrepresent what they want.” – Sol Waksman (Tweet)
  • How the abundance of passive investing tools has changed the investor’s experience during market changes
  • What investors are looking for in their tools and strategies
  • What alternative strategies are investors looking at now
  • The experiment Andrew does with his audiences he speaks to on their investment preferences
  • What investors need to understand about diversification and risk

Connect with our guests:

Learn more about Andrew Lo and MIT Sloan School of Management

Learn more about Sol Waksman and BarclayHedge, Ltd

“The one lesson we learn from academics throughout the whole process of passive investing is that diversification is really key.” – Andrew Lo (Tweet)

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

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This episode was sponsored by CME Group.



ell as the founder, and since:

First of all, welcome, and thank you so much for taking time out of your busy schedule to join to me to explore some of the things that go on behind the scenes in the managed futures industry. Now, before we jump into today’s topics let’s start out by you sharing a little bit of a short version of your background and how you got to where you are today. If I can kick off with you, Andrew, tell us a little bit about your journey and how that’s lead you to combine economic theory with practical applications within the investment management industry.


Well, first of all, thanks very much for having me on the show. It’s a pleasure to be here with you and with Sol. I got my start, really, through academia. I got my Ph.D. in Economics and right from the very start I got really interested in financial economics: applying mathematical concepts to making market predictions and trying to understand the risks underlying the various different aspects of the financial system.

At some time, in the:


o start your business back in:


Well, first of all, Niels, thank you very much. Andrew, I am honored to be on a panel with you. I’ve been a great admirer of your work for a long, long time.


Thank you.


y own futures account back in:

So, I stopped trading, and I looked into it. I researched it a little bit. That’s when I first learned about CTAs and disclosure documents and how you could see, by reading a disclosure document, exactly how much money a CTA had made or lost. That’s when I decided to get into the business.

Initially we were set up as a pool operator and then after I made a few mistakes on picking the wrong managers for all of the wrong reasons, decided to get more on the database side, and I’ve been there ever since we first started. How we continued to survive is really simple, I just never gave up.


Yeah, absolutely. That’s a great story. Thanks for sharing that.

Now, our conversation today will focus on a number of different topics within the managed futures industry, and, perhaps, a few that will fall a little bit outside of this. So, to kick things off in a slightly different way, I want to come to you, Andrew, first, and ask what you think of when I say Rabbi Mahony, Rabbi Mahony, Rabbi Mahony, and I hope you know what I’m referring to so that our listeners don’t think that I’ve completely lost it at this stage.


Well, thank you for bringing that up. That comes from one of my stories that I’ve written about in my book, Adaptive Markets. It’s an idea about thinking about financial markets more like a biological ecosystem rather than a physical system.

As you may know, most economists suffer from this disease that I call physics envy. We wish that we had three laws that explained ninety-nine percent of all behavior, the way the physicists do. In fact, we have ninety-nine laws that explain only three percent.

So, the idea behind adaptive markets is that we really have to think about these financial market dynamics as coming from human interactions, and trying to model those human interactions is really critical. So, the Rabbi Mahony story really has to do with the fact that I heard many years ago about a technique for getting parking in Harvard Square.

It’s a terrible, terrible challenge to drive a car into Harvard Square because there is never any parking. So, for years I just decided not to do it. But, a friend of mine said that, if you used this following algorithm: before you go to Harvard Square you utter the incantation, Rabbi Mahony, Rabbi Mahony, Rabbi Mahony, at that point you should be able to go to Harvard Square and get parking.

The amazing thing is this algorithm actually works. But, the more interesting reason is why it works. It works because it changes the way we behave. It changes our expectation for getting a space. Because now, once you utter the incantation, you must, somehow, in a part of your brain, believe that you might be able to get a space and that changes the way you drive. It changes how you look for parking, and, magically you actually increase the chances of getting a space. So, it really says that human behavior can actually change our reality.

Sometimes things need to be believed in to be seen.


Yeah, absolutely. Just out of curiosity, do you think that belief always precedes action and plausibility?


I think it is something that happens simultaneously, in many cases. Our beliefs have an impact on our behavior, but our behavior has an impact on reality, and that reality shapes our beliefs. So, it’s kind of a feedback loop that is happening and updating all the time. Unless we’re aware of that, it’s very easy for us to get mislead by various kinds of market events and ultimately end up down a rabbit hole of behavioral biases that ultimately end up hurting us in our investment strategies.


Yeah, well I look forward to finding out whether this little chant also works finding a parking place here in Switzerland.


You should try it.


Yeah, exactly. I want to talk about the narrative of finance and investing because, clearly, since the financial crisis, finance as an industry has received a very bad reputation in most people’s minds. Often it’s criticized. I’m not suggesting that it’s not deserved, some of it, but the industry that we all represent is also a place where a lot of good innovation takes place.

So, I want to start by talking a little bit more about each of you and your experience through your careers, and the narrative about finance and investing. Maybe I can come to you, Sol, a little bit. You’ve been reporting on the managed futures industry and the hedge fund industry for decades. How has your narrative changed over these years? Perhaps I can broaden the question out and ask how you’ve seen other financial media change their reporting on the alternative investment industry?


Well, I would say, in my mind, the biggest change has been the increase in understanding on how to separate alpha from beta in an alternative universe. I don’t mean an alternative universe like you would read about in Superman comic books but in the futures area and the hedge fund area.

Early on, what everyone used to regress performance against was the stock index. I don’t know the reason why that is. Maybe they looked at the S&P 500 as an alternative investment, or what have you, but a stock index, as we know, has no relevance to the performance of a CTA, maybe a little relevance, a little more relevance on the hedge fund side.

If you calculate alpha by regressing against the stock index, you have a number that is absolutely meaningless. Over time, and we’re seeing it more and more now in terms of smart beta strategies, investors and students of the market have come up with, I think, much better ways to approximate the underlying (for want of a better term) alternative betas that are used by managers within their trading methodologies to earn return. The obvious fallout from this is that the amount of return that’s attributed to alpha has decreased over the years and you have more and more people, I believe, competing on the beta side, which makes the environment a whole lot more competitive.

I would say that that’s probably the biggest change that I’ve seen over time. That’s what I see.


Sure, sure. I would love to hear your thoughts on this, Andrew, as well.


Well, you know, I couldn’t agree more with Sol that the idea of separating alpha from beta has been really revolutionary. In fact, I would go so far as to say that that has had a major impact in the entire financial industry, not just in managed futures.

investors. That began in the:

What I see, though, is a little bit of a slightly different perspective than Sol. That is certainly a phenomenon that he and I both observed, but my interpretation of it really comes from this notion of adaptive markets. In other words, I see these markets as various different species interacting with each other, and the species that Sol is referring to is this notion of passive investment vehicles. The creation of ETFs and futures and various different passive investment portfolios, that’s actually changed the dynamics in relation to other species like active managers.

So, the whole process by which these markets have evolved is really fascinating, and it really has changed the way that we interact with each other. Managers that don’t really understand this kind of interaction are really at risk of becoming extinct. So, it’s become a much more complex and competitive environment than ever before.


Yeah, yeah.

Staying with you, Andrew, just a little bit longer. I’ve heard you talk about the importance of language and the environment when it comes to creating new behaviors. I think we can all agree that the environment, in the financial markets, has changed dramatically in the past few years. Here, particularly thinking of the level of volatility we’ve seen in markets, and perhaps, first and foremost, the lack of volatility in the U.S. stock markets, at least until quite recently, so share with us why is it so important, and what are the risks that you see from a change in market environment like that?


Well, in fact, you bring up a very important point. The volatility of financial markets has become much less predictable than before. So, you’re right that volatility is quite low relative to historic levels. But I would argue that the volatility of volatility is actually quite high. That really suggests that we need to look at another dimension of risk, and that is something that very few of us are prepared to do.

Part of the reason why volatility of volatility is high is because we now see geopolitical events playing a much more important role in financial markets, really ever since the financial crisis. Prior to the crisis, it was rare that you got major central banks involved in the kinds of interventions that we see today. But, since the financial crisis, it has actually become expected for central banks and governments to start intervening in financial markets directly.

So, you now have very large players that feel no hesitation to engage in the kinds of activities that have a direct impact on market dynamics and, therefore, volatility can be actually affected to a great degree. It’s just over the last few months, in terms of current events, when there are concerns about trade wars or threats with various different geopolitical entities because of disagreements and concerns regarding policy. All of those issues, now, factor into markets in a much more direct way than over the previous ten years.


I completely agree with both of you about this alpha, beta, and so on and so forth. But in terms of bigger themes, I’m just curious. Have any of you started seeing what the next big narrative could be going forward so to speak? Are there any new things on the horizon that might become the next big talking point?


I don’t have an answer to that question.


Sure, sure.


But, Andrew, if I may, I have a question for you on what you had just said with regards to the increase in the volatility of volatility based on geopolitical events. Do you feel that this is... and you were talking about the last few months, but I remember going back for the last several years, while the U.S. still had a policy of keeping interest rates low, we saw that managed futures did not do well. A lot of what I would hear was that, although you have all these markets that are different from one another, the correlations came together because, in effect, there were just two trades: risk on, risk off. And in that context things would get very volatile. Do you see that in the same way as what we are seeing now, or do you think that was something different?


Well, you know someone once said that history may not repeat itself, but it sure does rhyme. I actually think that there’s a lot of rhyming going on right now. In other words, I do think that we live in a unique economic environment and so there are things going on today that really didn’t exist ten or fifteen years ago. But, the mechanisms by which those various different, unique challenges have emerged, they have very much the same impact on financial markets.

So, one example is this notion of a trade war. We’ve actually enjoyed a rather long period, prior to the most recent time, where we’ve engaged in open trade with various partners around the world. One of the reasons that mega economies like China and India have emerged as real forces in the twentieth and now the twenty-first century is because of international trade. So, this idea of a trade war, that’s actually pretty new. Obviously, there have been trade wars many, many times in the history of the world.

But the difference is today, because of the nature of the way we interact with various different economies. The fact that we’re engaged in trade at the speed of light, if you will, because of the internet and all the kinds of connectivity we enjoy across these various trading regions. The threat of a trade war, the mere threat of a trade war is enough to actually cause businesses to pull back and to change the way that they invest in their infrastructure.

So, we now have technology enabling all of these various businesses to react much more quickly. I think that’s what we need to worry about. That’s the new kind of perspective on how these old themes are emerging.


Yeah, you both talk about, I think it was you, Sol who brought it up about the low-interest rate environment and how that has certainly created some challenges for many investment styles including managed futures in the broader scheme of things. I was just wondering, from your point of view, Sol, what have you seen, or have you noticed anything: style drift, or anything else that is going on among managers to compensate for the lack of opportunities that we’ve seen in some of these strategies partly because of low volatility, but also partly, maybe, because of low interest rates?


The one thing that I’ve seen that, at the time, looked the most optimistic was the willingness of firms, primarily the larger firms that were able to do research, was the willingness to get into more exotic futures markets where there were regulatory issues, financial issues, liquidity issues. What they were finding was that because these markets were thinly traded and they weren’t widely participated in by their competitors, that these markets still reacted to more or less traditional trend following methodologies. I assume that, over time, these advantages would be arbitraged away. I haven’t been following it that closely to really know any longer. But, that was one of the things that I saw.

I think that when you look at different approaches to trading if a market is going up everybody is long. When that market turns, as it certainly does, people are going to get hurt. I think that’s a lot of what we’ve been seeing, as well, that’s been taking away from performance.


Yeah, sure.


You know, there’s one aspect, that Sol mentioned, that is worth observing about today’s markets which is that the rise of passive investing and all of the various different index products. What that means is that when markets go down, we now have a much larger shared experience of loss because now more and more people aren’t invested in the same thing.

So, that’s sort of the downside of the move towards passive investments. It has brought some great benefits to many people and allowed us to invest in a much broader way across these larger asset classes. But, at the same time, when there is a market downturn, it means that we’re going to be crowding for the exits all at the same time now.


What about demographics, Andrew? The markets have gone up, there’s been massive inflows in these passive products, not least because there has been a lot of people just putting money in, but as baby boomers start to retire in bigger force, the next four or five years, I think there are other issues with having so much money in passive investing or in mutual funds that I can see as a concern. But just the demographic, is that something that you’ve spent any time on?


I’ve certainly looked at that and I’m quite concerned about it. You and Sol both talked about the low-interest rate environment that we’ve been in. Well, think about what that means in a situation where you’ve got the baby boomer generation that retired and is really thinking about their fixed-income assets supporting their retirement years.

In a low-interest rate environment it becomes much harder for that to happen and it creates all sorts of pressures on the economy and on the consumers that are trying to deal with these issues. So, demographics play a huge role. Compared to the United States, China and India have a very different workforce that is in the process of emerging into the middle class so that the rise of the middle class in China and India have also had a huge impact on labor markets and on the international competition.


Yeah, well, certainly these points we talked about in low-interest rates and low volatility, they certainly must have had an impact on some of the economic theories that you’ve spent a good part of your life studying and teaching, namely the efficient market and the adaptive market hypothesis.

Perhaps you need to take us back, a little bit, to your school days and explain the basics and the differences behind these very important financial frameworks. I want to jump to a question that I also think a lot about as I meet with institutional investors around the world, and it’s just the question of what do investors really want? So, if you can combine some of your thoughts on these two topics.


Sure, I’d be happy to. There’s a really interesting dynamic between academic theories and market practice. For a very long time, financial market practitioners have been, obviously, managing investor money and have done quite well in many cases. But there has always been this skepticism on the part of academics that the kinds of fees that are being charged by professional money managers really may not justify the performance that they are providing to their investors.

So, in the:

So, this notion that prices fully reflect all available information, this notion of markets being efficient, that really came out of the academic literature and Fama was awarded the Nobel Prize for it and justly so. It’s a really important idea. For quite a few decades it actually was the way of thinking among academics, and, eventually, a number of market practitioners realized the wisdom of that approach and then adopted it and created the whole passive investment vehicles that we now see as a multi-trillion dollar industry.

The work that I’ve been doing, recently, is to try to understand how efficient markets relate to all of the behavioral anomalies that the psychologists and experimental economists have come up with. They argue, of course, that markets are driven not by logical deliberation, but by fear and greed - the kind of animal spirits that John Maynard Keynes wrote about decades ago.

So, if you believe that markets are driven by these kinds of irrational behaviors, then all of these kinds of efficient market arguments go out the window. What I’ve been trying to do is to demonstrate that there is actually an important middle ground. Markets are efficient most of the time. Every once in a while human behavior ultimately overwhelms the kinds of rational deliberation that efficient markets are based on, and we do see periods of fear and greed that ultimately take over. But, it’s not one or the other, it’s really both. We have both phenomena going on at the same time.

So, the question we should be asking is not so much, are markets efficient or are they not? But rather [we should be asking] what is the degree of efficiency at a point in time, and what are the different species in the market place that are working against each other to try and rule the roost? At which point do we see market efficiency overtaking the forces of fear and greed, or the forces or fear and greed overwhelming the kinds of efficient deliberations that give us rational market prices?


Now, I was just saying beforehand that one of the questions that I’m trying to come to terms with on my journey meeting these investors, is what do they really want? I’m going to come back to you, Andrew on this, because I know you have an interesting thing that you do when you talk to people. But, I want to go to you first, Sol.

Since you track all these investment strategies, so you probably have somewhat of a good bird’s eye view of the various strategies that appeal to investors and how this shifts over time. Perhaps you have some kind of an opinion about why we see these shifts and maybe where are investors looking at the moment in terms of alternative strategies when they don’t put all their money into the passive products we just talked about?


Well, at the risk of everyone finding out how unsophisticated a thinker I really am, I think that, for the most part, investors misrepresent what they want. That, in spite of all of the verbiage that talks about the importance of diversification within a portfolio, about all of the discussions back and forth between managers and large investors how the majority of large investors do not believe in trend following, that there’s no real strong academic case to be made for that type of approach.

I think investors, as a rule, based on their nature, are trend following. By that, I mean that what they are looking at, or what they favor once they look at everything are the strategies that have been profitable most recently and that the idea that non-correlation or diversification helps. It helps when they make more money, and when it doesn’t I think you start seeing a lack of interest in that particular category.


Yeah, sure.

Andrew, you do, as far as I’m aware, a little experiment, a kind of a survey among the audiences you speak to where you ask them to choose between four different investments. Can you, and I know it’s maybe hard to do on an audio only, but can you explain this experiment and what your findings are and how this fits into the theories and the practical implementation that we see from investors?


Sure, yeah, that’s a fun experiment because it really shows exactly what it is that investors are looking for and it actually goes to Sol’s point about trend following and why there is a very strong human element to that particular kind of investment approach.

So, the chart that I show my introductory MBA class every year is a chart that shows the growth of a dollar invested in four different financial assets. I don’t tell them what the assets are or even over what time period they span, I just show them this graph of these four curves that have very different properties.

One of them is a line that is almost flat. It really just is very, very smooth, but it doesn’t go up very much, so you’re not earning a very good return on that one dollar investment. The second line is way more volatile. It’s got lots of ups and downs, but at the end of the graph, it goes much higher than the first line. The third line is even more volatile, lots more ups and downs, but it’s even more rewarding. The fourth line, curiously, lies somewhere in between but it’s much, much smoother. It’s pretty much almost a straight line up. It’s more steeply sloped than the first line, but its endpoint is somewhere in between the other investments.

When I ask my students to pick which investment they would choose for their retirement money or their kid's college education fund, or their grandparent's savings, without exception the vast majority of them will pick that fourth line, that straight line up. In a way, that’s a kind of a trend. It’s a trend following type of a strategy.

Now, I then reveal to them what these four different investments are just so they understand what their risk preferences look like. The first line is U.S. Treasury bills. They don’t have a particular reward that is very exciting, but they’re certainly very safe. So, most of the students don’t pick that. The second line is the S&P 500 which is way more rewarding but also is way more risky. A few students pick that, but most don’t choose that either. The third line is a single investment in the pharmaceutical company Pfizer, way, way more volatile, but more rewarding. Again, a few more hands that go up, but, as I said, the majority picked that fourth line which turns out to be the returns for an investment in Bernie Madoff ponzi scheme.

They all feel very embarrassed and disappointed that they picked that one. I tell them that the reason that ponzi scheme grew so large is because of human behavior. It’s because all of us are seeking that high return, low volatility or high sharp ratio, as we call it in the industry, that high sharp ratio investment. It’s human nature.

So, part of the role of trend following is to capture that element of human nature. That human nature is also supported by a lot of institutional restrictions that, essentially, create trends. For example, when the Fed tries to manage a smooth landing by changing interest rates so as to allow the economy to grow in a way that doesn’t cause massive inflation, or allows the economy to cool down in a way that doesn’t cause a recession, the actions of the Fed to create these smooth landings are actually creating trends in various different market prices. So, once we understand that this kind of nature of investing automatically generates these types of patterns, it actually makes sense for investors to take advantage of them in some way.


Yeah, that’s a great way of visualizing these things. To me, when I hear that, one thing that springs to mind. I wanted your thoughts on that. We all crave this sort of trending behavior, but also crave this smooth trend to participate in. But, of course, trend following (as a strategy) is probably the least smooth investment strategy that you can find among the bigger ones, at least most of the time. How do we relate these to things?

How can we better explain to people that volatility and risk are not really the same thing? Some people would certainly argue that the more volatile strategies can often turn out to be the more robust strategies because we’re not trying to, as the Fed is doing, we’re not trying to make this smooth curve and then suddenly end up with a huge problem later on in life.


I think Sol can speak to this even better than I can, having been in the trenches, but let me start by pointing out that trend following offers a unique set of exposures to investors. That is very difficult to get anywhere else. Those exposures really show that they are uncorrelated, and, in some cases, negatively correlated with traditional equity investments.

That’s a very important point because the one lesson that we learn from academics throughout the whole process of passive investing is that diversification is really key. Diversification means that you want to hold investments that are not highly related to other investments. You want to be able to spread your risk across lots of different holdings. We know that nowadays the factors that are generating returns are becoming fewer and farther between. In other words, we see that there is a big equity factor, even in foreign currency markets, which traditionally had very little to do with equities.

Now there’s very strong coupling between foreign exchange and stock markets. So, trend following and managed futures, for many, many decades have provided investors with an alternative source of expected return. But, there’s a big but to that and that is they also offer some very important risks that investors may not be equipped to address. So, that’s one of the reasons why managed futures, for many years, was really a niche investment that institutional investors were focused on; sophisticated investors: family offices, high net worth individuals, people that understood that they were getting something very different.

This notion of crisis alpha that my former student and portfolio manager in her own right, Katy Kaminski has written about, I think that really highlights the unique aspects that managed futures brings to investors. What has happened in the last ten years, though, is the "retailization" of managed futures. That’s a very important trend.

It allows individual investors to be able to get access to this, but, at the same time, it’s also brought with it the kinds of risks that managed futures have and that not all retail investors are equipped to deal with. This means that, when you’re using managed futures in a retail environment, you need to be much more focused on risk management. You have to approach risk management in a way that you might not have had you been focusing just on institutional investors.


ot so much in practice. Maybe:


Without a doubt, that’s a great point. I think that’s one of the reasons why managed futures association and the podcast that you’re creating is so important. It really allows investors to develop a deeper understanding of this relatively unknown and complex investment style.

I say relative unknown because, of course, over the last ten years we’ve had a lot more money coming into this space. So, it’s no longer the niche investment that it used to be. You’re right, that investor education plays a really important role.

One of my former colleagues at AlphaSimplex Group, Pete Martin, a great marketing professional, he once said that if you’re earning positive returns in all of your investments, you are not diversified. Most investors would love to be able to earn money in all of their investments at the same time, but the whole point of diversification is that what you’re looking for is a good average return across your investments over an extended period of time. That means that, at any one point in time, you’re going to have certain underperforming investments. That’s just the nature of diversification.