Archive for January, 2013

Andrew Lo: How Do You Cope With Increasingly Complex Markets?

January 25, 2013

The sea change in the markets. Financial Thought Leader, Andrew Lo, renowned professor of finance at MIT and hedge fund manager says the markets are more complex and challenging than ever before. He shares strategies to survive and prosper. Continue Reading »


January 25, 2013
  • Determine the rate of return needed to reach your life’s goals
  • Ask yourself how much you can afford to lose over the course of any given year and reach those goals
  • Understand your emotional tolerance for risk

Watch this Episode

Consuelo’s interview with “On The Money”

January 25, 2013

Listen to Consuelo’s unique perspective on market game changers, the global economy and the outlook for 2013 on Wall Street on public radio’s show, “On The Money.” She describes how savers are being punished by the Fed and how many financial pros missed their predictions in 2012 when the U.S., parts of Europe and China experienced surprising rebounds in their stock markets.

Transcript: Andrew Lo 1-25-13 #931

January 25, 2013


#931- 1/25/13


CONSUELO MACK: This week on WEALTHTRACK, navigating the sea changes in the markets. Financial Thought Leader, MIT finance professor and hedge fund manager Andrew Lo guides us through the complexities and challenges of modern investing next on Consuelo Mack WEALTHTRACK.


Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. This is not your grandmother’s market. The days of buying a portfolio of blue chip American stocks, reinvesting the dividends, and living off the proceeds in your golden years, which is what my grandmother did, are over. Life has gotten a lot more complicated. As top rated investment strategist and former WEALTHTRACK guest Francois Trahan wrote his clients recently: “The past few years have produced some of the most challenging financial markets ever seen. Indeed, investors’ economic outlook has been to the abyss and back… several times.”


Given what we are still facing and will continue to face in this high speed, globally interconnected world, the abyss is never far from our minds. And it’s not just individual investors who are having a tough time navigating what’s being described as the new normal. Increasing numbers of professional investors are finding it extremely difficult too. As this chart from Trahan’s firm, Wolfe Trahan illustrates graphically, the percentage of U.S. equity funds that have outperformed their market benchmarks has been shrinking dramatically: 32% beat their benchmarks over the last five years, only 27% did over the last three, and a mere 10% did in the last year.


This week’s WEALTHTRACK guest has been thinking, writing, analyzing and strategizing about modern market conditions and challenges for his entire professional career. He is noted Financial Thought Leader Andrew Lo, named one of Time magazine’s 100 Most Influential People last year. Lo is a professor of finance at the MIT Sloan School of Management, director of MIT’s Laboratory For Financial Engineering, author of several books including A Non-Random Walk Down Wall Street, author of numerous articles in finance and economic journals, editor of several journals as well, and to top it all off, Chairman and Chief Investment Strategist of AlphaSimplex Group, an investment management firm that has created a series of hedge fund-like mutual funds under the Natixis name, including his flagship Natixis ASG Global Alternatives Fund launched in 2008. The funds are “designed to help investors achieve greater diversification than traditional stock and bond funds, while actively controlling risk and liquidity.” So far they have fulfilled their mission. I began the interview by asking Professor Lo to describe some of the biggest changes in the markets that investors need to understand.


ANDREW LO:  There are three really big seismic shifts that occurred over the last few years. The first is that you’ve got these macro factors that are at play that really didn’t exist before the financial crisis.  You’ve got …

CONSUELO MACK:  So… such as?

ANDREW LO:  Well, such as government intervention. So the government is very much involved in changing the financial landscape. The Fed, for example, is involved in monetary policy to try to keep interest rates low. And of course we know the Dodd-Frank Act of July 2010 is still yet to be completely implemented. You know, that act was 2,319 pages long, and there are a lot of things that still have yet to be put into practice. For example, the Volcker Rule. That’s supposed to be coming into play over the next couple of years. So I think that a lot of the macro factors that we see today really didn’t exist just a few years ago.


CONSUELO MACK:  So let me understand that, though, because we’ve certainly seen other periods of time when the government has gotten involved in the economy and when it’s gotten involved in regulating the market, for instance, usually is precipitated by financial crises. So what’s really different about it this time?

ANDREW LO:  Well, I think the difference is scale.


ANDREW LO:  I mean, because really we had a financial crisis of epic proportions. The last time something like this happened was 1929. And in the aftermath of the Great Depression we had a lot of new legislation and government was very heavily involved in changing things around. And so I think that we see the exact same things going on right now, lots of government intervention, lots of new rules. And not only that, but we see the landscape of global regulation changing, so we’re actually in some cases coordinating with the European Central Bank, and other foreign authorities. In other cases we’re competing with them, to try to see who can provide the most convenient kind of ways of doing business.

CONSUELO MACK:  From an investor point of view is, is that really changing, you know, what we should look for in the markets? Is it going to change market behavior?

ANDREW LO:  I think it already has changed market behavior. So for example, the volatility of volatility is actually quite high. Last year the S&P 500 had volatility that was relatively muted, and most people would argue that today volatility in the equity markets is relatively low. But that could change in a moment’s notice. And we’ve seen it change in a moment’s notice when Greece is about to default, or when there’s problems with Spain, or Portugal. So I think that right now we’re all on a hair trigger and just waiting for the next shoe to drop. That’s one big difference.

Another difference is what the Fed is doing with interest rates, keeping it relatively low. That means that for people that are focusing on fixed income investments, pensioners, people about to retire, they’re going to have a much harder time being able to retire by putting their money in safer assets. They’ve got to really keep their money in equity markets to some degree, and many of them are not happy about that.

CONSUELO MACK:  So let me ask you about what the Fed’s doing, because there are a number of people who have been very supportive of it, and have said that basically the economy, you know, we would never have gotten out of the financial crisis, the global financial crisis, had central banks not stepped up to the plate and done what they’ve done. And then there are the critics who are saying that basically by keeping interest rates artificially low, it’s really warping all sorts of asset prices, and what’s going to happen when the stimulus is withdrawn as well? So where do you come out in that debate, number one, and what do you think the repercussions are going to be, as well?

ANDREW LO:  Well, you know, the odd thing about the situation is that they’re both right in the sense that it is true that the regulators went to extraordinary measures to inject liquidity into the system in order to stave off the really serious part of the crisis. And I think they did a good job of that. In other words, had the Fed and other central banks not done what they did in injecting that liquidity, things could have been a lot worse. The problem is that ultimately, we have to acknowledge that the economy grew too fast and there was too much leverage. We’ve got to cut back. Where we were overextended…


CONSUELO MACK:  Right, going into the financial crisis, right.

ANDREW LO:  Right, exactly. And so eventually, we all have to acknowledge that we’ve got to basically tighten our belts. And tightening our belts is no fun. And so the question is, what’s the right time to do that? The Fed is still keeping monetary policy relatively loose. They’re still stimulating the economy. And at some point I think they have to get to the level where they can pull back on some of that stimulus. And if and when they do, the key is what the reaction of the economy is going to be. I think that we’re actually pretty close to that point now where we’re going to have to pull back from the stimulus. Otherwise, we may end up creating more problems as we inflate certain kinds of assets markets that really can’t afford to get that much larger.

CONSUELO MACK:  So the Fed is in this new policy of openness it’s had under Chairman Bernanke, has told us that they’re kind of targeting unemployment rate of six and a half percent.  And that from most economists that I’ve talked to are saying we’re a long way. We’re several years possibly from a six and a half percent unemployment, so could we have this repression of interest rates for several more years to come? And if so, what are the investment repercussions of that?

ANDREW LO:  Well, I think this gets to the second point about where our current financial system and economy is different than before. The second point is that the technological advances that we’ve pioneered in the financial system have really made it much more complex and it’s much harder now to basically make these kind of macro forecasts. You know, it used to be the case that when you said you wanted to achieve six and a half percent unemployment, you might wait another 18 months, 24 months, with loose monetary policy and then you could slowly and gradually change that policy around.


The problem is that our economy is just so much faster and more complex, and it’s not at all clear that we can micro manage it the way we used to. And so what I fear is that by trying to keep people out of risky assets, or rather, into risky assets, even though they want to stay out of risky assets, you’re ultimately trying to force a round peg into a square hole. And there may be a day of reckoning when, at the point where the Fed decides to take off that stimulus, you’ll get a massive reaction that goes back to riskless assets. And then we’re going to see, you know, much more dislocation than we would have otherwise.


CONSUELO MACK:  So we’ve got much more government intervention, and globally, in the economy. And also, and the second point was the financial technology…

ANDREW LO:  Financial technology.

CONSUELO MACK:  …and it’s much more complex. The markets are much more complex and harder to manage. So what was the third? You said there was another third, big change in the markets that we need to understand.

ANDREW LO:  Well, the third big change is that the world is a much larger pool of investors than ever before. So for example, today the population of the planet is about 7 billion; just 100 years ago that number was 1.5 billion. So in the space of a century we’ve actually increased the population by a factor of four, which is really astonishing when you think about that.

CONSUELO MACK:  Astonishing.

ANDREW LO:  And that has very, very significant repercussions for both individual investors as well as for macro policy. It means, for example, that we’re much more likely to step on each other’s toes because there are many more people that are really driving hard to get that little extra bit of return. It also means that from a job market perspective, things are a lot more competitive nowadays than before. It used to be the case that we produced TVs in the United States. We produced the world’s best TVs. And now of course a lot of those jobs have gone overseas, but the benefit of that is that we can now buy flat panel screen TVs for under $500, which is really remarkable.

So that kind of global competition has changed the landscape in which we operate as citizens. And that’s something that I think people need to get used to. The world is moving a lot faster. It’s a lot more complex. And we actually need to be more informed as financial consumers.

CONSUELO MACK:  So there’s a big debate going on that you’re very aware of on Wall Street, the passive versus the active investors. And a guest that we’ve had on, Charley Ellis, who you know as well, has basically said after 45 years of advising pensions funds about which money managers they should invest in, that a light bulb went off in his head and he said, essentially, because the standard on Wall Street is so much higher now, that there are so many smart people, you know, pooling their brain power to try to get that little extra advantage, that in fact, it’s very difficult to get a consistent advantage. And therefore, he said, just invest in index funds. So where do you come out in the active versus passive? And of course you are an active money manager as well as AlphaSimplex.

ANDREW LO:  Well, first of all I have a lot of respect for Charley Ellis, so I certainly wouldn’t want to contradict him. But I would have to say in this case, I actually have a somewhat different perspective than either the passive or the active camp, which is a bit of a different direction. It really has to do with the fact that the dichotomy between active and passive is a little misleading.  In the old days, when volatility was relatively steady, when the risk of investing in the stock market was relatively well known and stable over time, then active versus passive was a very sensible dichotomy. The problem is that over the last few years, because of the changing macro landscape, volatility itself has shifted so dramatically so that I actually think there’s a third category of investing which is, to be passive on the alpha side, meaning you’re not going to try to look for great stocks. You’re not going to try to do stock picking. You’re going to be passive about investing in asset classes. But at the same time, you can also be active in risk management.


So right now, because of the simple dichotomy, if you decide to be a passive investor, you’re also being passive about risk management. And a good example is the S&P 500. Last year the S&P 500 was up about 16%. And that seems like a pretty good return; except for the fact that as of July of 2012, the year to date return for the S&P was zero. And so if you were an investor sitting in July 2012, you would have said gee, the stock market’s going nowhere. I’m going to take my money out and put it in cash, and then you would have missed that 12% or 16% gain over the course of the following six months.  A passive investor putting their money in the S&P would have gone through that roller coaster ride of zero to 18, down to 16.

So it’s possible to actually be passive about not trying to pick stocks but to be active about risk management and managing your volatility over time. And there are new products and services out there that are trying to do it, but I think investors would be wise to think carefully, not so much about picking the next winners, because it’s really hard to do, and I agree with Charlie Ellis, and Jack Bogle and others, that it’s very hard to pick winners. But rather, think carefully about risk because risk actually is a much more factor nowadays than ever before.

CONSUELO MACK:  And let me follow up on that, because the proponents of the passive investing, as you well know, are saying that, number one, that the biggest mistake that individual investors make is to try to market time. And therefore, if you want to participate in the growth of the world economy, the best way to do it is in the stock market. And just hold on through those swings.

ANDREW LO:  Well, the first point I would make is that there’s a difference between market timing and risk timing. I agree 100% that market timing is a very difficult thing to do, and individual investors shouldn’t try to do it at home. On the other hand, risk timing is something that is almost unavoidable. When risk is high, generally it tends to stay high. And when risk declines, it generally stays low. And so even though it’s hard to market time, it’s not nearly as hard to risk time. And there are professional money managers that do this. Hedge fund managers risk time all the time.


CONSUELO MACK:  You do it.  Right.

ANDREW LO:  So I think investors can think about that.

CONSUELO MACK:  So you’re saying that risks, when it’s a high risk environment, those tend to last for a long period of time and low risk… so are we in a high risk environment now?

ANDREW LO:  Well, interestingly enough, over the course of the last few months, the volatility of S&P has actually been low. It’s been muted.

CONSUELO MACK:  Right. It’s declined.

ANDREW LO:  So we are in a low risk environment except for the fact that there are a couple of very big macro events that are coming to roost, once of which is the debt ceiling debate. If the debt ceiling debate goes the wrong way, then it could be a very bad event for markets. Risk could shoot through the roof overnight, and we can have a big decline. So that’s an example of where risk timing is actually important. You have to understand dynamics of risk and as the risk starts to increase, you may want to think about being a little bit less exposed to equities, more to fixed income and other assets that are less correlated with these kind of assets.


CONSUELO MACK:  So let’s talk about some of the macro events that you are watching. And there are several big policy events that are going to be happening in the first quarter of this year, and one of them is the debate over the debt ceiling. There’s a possible sequester coming up, those automatic cuts which could happen on March 1st. And then we’ve got the federal budget. So what specifically are you watching, and how will you react, depending upon what happens?

ANDREW LO:  Well, I think the biggest event coming up is, in fact, this debt ceiling debate and whether or not Congress can actually start working together. It’s been quite dysfunctional for quite some time now, and I think this is a real problem for the U.S. economy. You know, we’re at the early stages of a recovery. And so this is a very important time. If the politicians end up getting caught up in this kind of partisan bickering, it will actually turn the recovery into another recession. They could easily do that. And so I think that’s a really big concern.


But then, we have to also look abroad and see what’s going on in Europe. The European debt crisis is not over. In fact this year, there are going to be a number of issues with Greece, with Spain, Portugal, a number of issues that could actually turn into a global crisis as well. We have to also look at Asia. China has been a huge juggernaut for economic growth for many years, but of course they’re slowing down. And they’ve got a real estate bubble much the same as we had years ago. It’s  not clear how they’re going to be able to manage through that. So I think those three areas, the U.S. debt ceiling, Europe, and Asia, are areas where we’ve been watching quite carefully, and where I think that there is some source of concern.

CONSUELO MACK:  Now, I know at AlphaSimplex, some of the hedge funds that you have devised strategies, where you limit the annual volatility to, let’s say, eight percent in your flagship fund. So is that something that individuals, I mean, how do we as an individual… how should we approach risk management?

ANDREW LO:  Well, I think this is really an important aspect of the investment process for individuals. It’s actually key to spend time thinking about how much risk you’re able to withstand before you get these really bad events.

CONSUELO MACK:  And how do we do that? How do I know what my risk tolerance is? How can I put a number on it or…

ANDREW LO:  Well, the way you would start is by saying, take a look at your portfolio. Look at your financial objectives. Ask the question, you know, how much expected rate of return do you think you need in order to reach your life goals? And a financial planner can do that, or an individual with a spreadsheet can do that. And then ask the question, how much can I afford to lose over the course of any year?

CONSUELO MACK:  Of a year?

ANDREW LO:  Of a year, right. Is it five percent, 10%, 20%? And the amount that you can lose is really a way of gauging what your risk tolerance is. If you can only afford to lose a couple of percent you should obviously not be invested in equities. On the other hand, if you’re younger and you’re able to lose 15 or 20%, then you can actually take on some really significant risks, like emerging markets or small cap stocks. So understanding your pain threshold, your ability to withstand losses, is really key towards being able to plan out how much risk you can take on.


CONSUELO MACK:  But Andy, in this particular time in our financial history, with interest rates so low, is that, you know, where I would naturally go as an investor if I did not want to have a lot of volatility would be the treasury market. But the returns are so low. So how do we get better returns and with less risk? Is there an answer to that?

ANDREW LO:  There are a number of new financial products that are focusing on alternatives to the traditional stock-bond mix. And I think really that’s the key. Now, the Fed is really keeping interest rates low because they want Americans to invest in the stock market. They want to create more investment capital to increase our economic growth. But I think that the other way to deal with it when, if we’re not comfortable with much higher volatility, and hopefully eventually higher returns of the stock market, is to think about commodities, currencies, other asset classes, and fixed income instruments, but with corporate bonds as opposed to treasures. The problem is that many people really don’t want to take on that risk. And this is where …

CONSUELO MACK:  Because those are volatile, too.

ANDREW LO:  Absolutely. And not only are they volatile, but the kind of risks that they entail in some cases are quite a bit more subtle and complex. It’s not just market risk. It could be liquidity risk. It could be emerging market debt risk. And those kinds of risks typical investors really do not understand as well as they do equity risk. So I think the short answer is, investors need to get smarter. They need to spend more time looking at all of the different food groups, looking at the various different vitamins and other risks of the various different types of investments. And then make a decision that’s going to be more informed than ever before. It’s a harder task that they have in front of them.

CONSUELO MACK:  So does broad diversification among different asset classes, does that protect us more?

ANDREW LO:  It does. But on the other hand, it requires much more effort to get that diversification. In the old days, if you put your money in 500 stocks in the United States, you were diversified. So the S&P 500 was a great source of diversification. But because of all these macro shocks, now owning the S&P is like owning one big asset that’s an expose to these macro factors. So in order to get truly diversified today, you need to invest in stocks, bonds, currencies, commodities, long and short, across 15 different countries. You really need to make an effort to focus on diversification in much broader asset classes, long and short formats, and in a variety of different kinds of vehicles.


CONSUELO MACK:  And as you said, there are vehicles now, I mean, ETFs for instance, that enable you to do that. So that we have a better chance of doing that and investing like professional investors, but it requires much more intelligence and…

ANDREW LO:  And time, really.

CONSUELO MACK:  …and time. Yeah.

ANDREW LO:  Yeah, I mean, I think the financial landscape has gotten a lot more complicated. And not that different from health care. Nowadays, we have to worry about cholesterol and the good kind, the bad kind, you’ve got carbs and whether or not we’re getting the right amount of fiber. So in order for us to stay healthy we actually have to be much more informed consumers. Well, I would argue that our financial health is equally challenging. We need to spend more time thinking about our financial health, looking at our portfolios, and looking at all of the different options.

CONSUELO MACK:  One Investment for long term diversified portfolio, what would you have all of us own some of?

ANDREW LO:  I think that for the coming years, probably some kind of managed futures product, something that involves commodities, but also financials. But that are futures contract based, so that they’re betting on trends as well as dynamically readjusting their risk to take into account some of  these macro factors.

CONSUELO MACK:  And is that a diversification tool in your portfolio as well?

ANDREW LO:  Absolutely. Managed futures has often been called crisis alpha, because they tend to do well when there are big shocks in the marketplace. Now, they didn’t do well last year when the S&P was up 16%. I think managed futures may have been down five or ten percent. But that’s just the point. The point is that they do well when the stock market doesn’t, and so they provide a nice counterweight to the traditional stock-bond investments.

CONSUELO MACK:  So Andrew Lo, it is always such a pleasure to have you on WEALTHTRACK. We learned so much from you. I wish I were one of your students at MIT, but this is the next best thing, at any rate.

ANDREW LO:  It’s a pleasure. Thanks for having me.

CONSUELO MACK:  So thanks for being with us from MIT, and also from AlphaSimplex.

ANDREW LO:  Thank you.


CONSUELO MACK:  Professor Lo isn’t just applying his analytical skills to conquering the financial markets. He and some colleagues have come up with a new approach to finding a cure for cancer. It’s called cancer megafund financing and he will talk about it on our website, in the WEALTHTRACK Extra feature. It is fascinating.


In this week’s Action Point, we are following Professor Lo’s advice on managing your investment risk. This week’s Action Point is: assess your risk tolerance with a financial advisor. Knowing what it is will largely determine the asset allocation guidelines for your portfolio. As Professor Lo told us: first, determine the rate of return you need to reach your life’s goals. Second, ask yourself how much you can afford to lose over the course of any given year and still reach those goals. If it is just one or two percent a year, then seriously limit your exposure to stocks. If it’s 15-20%, then feel free to invest in more volatile, but historically higher return securities such as emerging market and small company stocks. Another key consideration is understanding your emotional tolerance for risk. If portfolio volatility causes you to make rash decisions, then figure that into your asset allocation decisions. Knowing thyself is critical to reaching your financial goals.


Next week, we are sitting down with two top global strategists whose jobs are to manage portfolio risk over long periods of time. New York Life’s John Kim and Fort Washington Investment Advisors’ Nick Sargen will join us. If you have missed any of our past Great Investor or Financial Thought Leader guests you can find them on our website You can also see our new programs 48 hours in advance as a premium subscriber, and see additional and extended interviews in our WEALTHTRACK Extra feature. And that concludes this edition of WEALTHTRACK. Thank you so much for watching. Make the week ahead a profitable and a productive one.

Andrew Lo on his Cancer Megafund

January 23, 2013

Our WEALTHTRACK guest this week, Andrew Lo, M.I.T. economist extraordinaire and Chairman and Chief Investment Strategist of the alternative investment firm, AlphaSimplex Group is applying his formidable analytical skills to a pressing humanitarian cause, finding a cure for cancer. Consuelo asked him about his latest and very personal project, the “Cancer Megafund.”

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