Thursday, June 6, 2013

Those who can, do; those who can't, teach

You are probably familiar with the phrase in today's post title. It's clearly a "shot" at teachers and professors, is it not?

Its presence was inspired by Steve Campisi's retort to yesterday's post. It was evident that he is, at least at times, uncomfortable with the ideas that come out of academia. I think there is some validity to his position, and perhaps it's worth some discussion.

Three individuals have been named to the inaugural class of The Performance and Risk Measurement Hall of Fame:
  • Gary Brinson
  • Peter Dietz
  • Bill Sharpe
Brinson is a practitioner who, for us in the world of performance measurement, is known for the attribution models he helped develop. Dietz worked for Frank Russell, and so can be described as a practitioner, though he did spend some time in academia, I believe. His legacy is the concept of time-weighting and the formulas he developed to measure performance. And Sharpe is known for CAPM and his risk-adjusted measures; he is clearly from the academic side.

In writing my doctoral dissertation (which will soon (hopefully) be defended), I have cited more than 100 articles. There is an expectation that most come from academic journals (e.g., the Journal of Finance). And while there are many that are included, the reality is that most come from practitioner publications (e.g., The Journal of Performance Measurement).

Many investment professionals regularly read academic journals, and probably get inspiration from them. As practitioners, should we generally dismiss their ideas or consider them? What degree of influence should they have on what we do?

If you've read Nassim Taleb's The Black Swan, you're then familiar with his total disregard for the likes of Sharpe and Markowitz. Sharpe's CAPM has not been proven (and in fact, is often criticized, even by academics), and  yet is still typically part of finance courses, MBA programs, and doctoral studies. Taleb finds great fault with Sharpe and Markowitz, and suggests that they should return their Nobel prizes. How valid are his arguments?

What should the sources of models and formulas be that the industry uses? You may recall that AIG reportedly paid a Yale academic quite a lot of money annually to develop and maintain a model for their credit default swap investments. As it apparently turned out, this model never met a CDS it didn't like. And, we're aware of some of the problems that befell AIG. Long Term Capital Management (LTCM) employed several academics, including Nobel prize winners. Roger Lowenstein (in, When Genius Failed) pointed out how these individuals did not help in making LTCM a long term company.

While this may be an academic (pardon the pun) subject, it may be worthwhile to chat about it, nonetheless.



    I have no qualms with academics or academic theory: that's just a way to describe and communicate the world around us in a well-defined way so that we can share ideas within a common language and nomenclature. There is no gap or disagreement between theory and the real world. After all, a theory that doesn't work in real life or which cannot be observed is simply a bad theory. So we can agree on the general ideas and the value of constructs such as the "efficient frontier." What is clearly bad is a practitioner who doesn't understand the fundamentals of academic theory, but who nonetheless spouts it "vigorously" and creates little more than noise and confusion. My example of "deteriorating" Sharpe ratios along the efficient frontier is definitional; it's the "law of diminishing returns" at work. That is, it's the nature of returns that you must take increasingly greater (and therefore disproportionate) increases in risk to earn an additional increment of return. This "flattens" the efficient frontier and produces decreasing Sharpe ratios. The problem is the practitioner who is either confused by this or who thinks that there's a problem. There are many examples of this type of confusion amongst poorly trained practitioners. For the record, I doubt that even a novice academic would have even a moment's confusion with this.


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