Myron Scholes on the Challenges the Investment Management Industry Faces
“You cannot spend relative performance,” I recall a colleague saying when I was starting out as an equity analyst at a mutual fund many moons ago. Of course he was talking about how funds should be run. Should the focus be on achieving investment goals or beating the benchmark?
Recently, in Tokyo, I picked up the conversation again, this time with Nobel laureate Myron Scholes. Here’s what he had to say:
An investment model based on relative performance achieves the wrong results.
The main message of Scholes’s recent research paper, co-authored with Peter Blaustein and Ashwin Alankar, is that the tracking error constraint we put on investment managers — coupled with their need to keep cash around for unexpected withdrawals — contributes to the underperformance of active managers. Their analysis shows that (institutional) active managers as a whole would actually have beaten the benchmark otherwise.
This makes intuitive sense. In the previous article in this multi-asset strategy series, I argue that there is often a conflict between investor demands that managers focus on the long term and, at the same time, not stroll too far from the benchmark during any given period of time — say a month, a quarter, etc. So when a good manager is catching on to something in a big way, that unfortunately coincides with big tracking errors, and we will pull them back with tracking error constraints.
Dynamic strategies can help investors achieve their long term goals.
Scholes also shared with me the main message of a talk he went on to give before a full house at a CFA Society Japan event: The investment management industry should focus on the long term. “We have got a model for cross-section diversification,” he explained. “We have to balance that with time-series diversification because, when time diversification fails, cross-section diversification fails too.” (For those not quite fluent in the language of statistics, cross-section and time-series diversification roughly translate into static and dynamic asset allocation.)
“The greatest reward comes from time diversification,” Scholes observed. And I agree. For example, the best move most investors could have made in this lifetime is probably getting out of equities in 2008.
“There is a cost to [pursuing purely] static asset allocation,” Scholes said. “Is the risk of passive index strategies constant?” Instead of reflecting investor risk preferences in terms of a static asset allocation — which has fluctuating risk levels over time — Scholes thinks it makes sense to tie it directly to a target risk level. “Then the industry has to be proactive in estimating risk,” he commented.
“Many managers do not want to worry about risk,” Scholes continued, “so they leave the problem for the asset allocators, like the pension funds, to solve. ‘I only have to pick the winners. If the risk of my benchmark is changing, it’s not my problem.’ If the world gives you the same risk at each period, then it’s fine. But (laughter) . . .”
From left to right, Yasuhiko Nakase, CFA, and Katsunari Yamaguchi, CFA, of CFA Society Japan, with Myron Scholes and Larry Cao, CFA.
The investment management industry could be facing profound changes.
To the extent that one agrees with Scholes’ arguments, the industry is facing at least two major changes.
In a way, we’re now looking at a different piece of the puzzle. This places a different kind of demand on investment managers — we may need different skills to achieve the desired outcome. Managers think about alpha and asset allocation people think about beta but in the sense of static asset allocation. We’ll need more people thinking about dynamic asset allocation — that’s quite a change in both the mindset and skill set required.
Another important change that will have to take place is investor education. “You’ll need a whole new way of interacting with investors, ” Scholes said.
A helpful example is the Morningstar Style Box. It has been a great investor education tool that has made complex investment concepts accessible to retail investors. And yet, as we discussed, the benchmark-tracking error process embedded in the style box methodology makes the investment management process difficult. Many active managers feel they do not fit neatly in a box and hence are not properly evaluated. (I recently had a conversation with Haywood Kelly, Morningstar’s head of global research in charge of equity, fund, and credit research. He offered his perspective on the subject, which I’ll share with you in a forthcoming blog post.)
“We have to design new measures,” Scholes said. “If you do not have an objective-based measure, you’ll need a different measurement. I don’t think there is a good measure yet for judging long-term performance. I would say if you have a five-year track record, how do you evaluate a five-year performance, because you have one five-year period? You’ll need a lot of five-year histories to do it.”
This is the fifth article in the multi-asset strategies series. The first four posts were: “Multi-Asset Strategies: A Primer,” “Three Key Decisions in Formulating an Asset Allocation Strategy,” “An Advance in Portfolio Construction,” and “Portfolio Evaluation: Benchmarking for Success.”
For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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