Blog Posts — April 18, 2018

Q&A with Professor Myron Scholes

Our annual Innovate2Invest flagship conference, under this year’s title “The Future of Investing and Investing in the Future,” will be held on Apr. 25 in London. The conference has grown every year, becoming a date not to be missed for investment leaders and professionals. Once again, a strong line-up of expert guests will lead an enlightening debate.

This year we are honored to have Professor Myron Scholes, Nobel laureate in Economic Sciences for his work on options pricing, as keynote speaker. He will present on the importance of risk management in an evolving asset-management landscape.

PULSE ONLINE caught up with Prof. Scholes ahead of the conference to get his view on various topics around the current state of financial markets.

You teach a class called The Evolution of Finance. What’s a main trend to highlight about the way in which finance has evolved in recent decades?

Finance today aims to provide its functions more efficiently, faster, and in more idiosyncratic and flexible ways than before. These functions include: transacting, financing projects, savings for the future, risk management, pricing signals, and reducing asymmetric information. Technological advances, using, in particular, computing and telecommunication, have been the main drivers, as well as changing demographics and scarcity in our global societies.    

And which distinctive characteristic would you pick if you had to describe the finance of the future?

Technology will allow us to migrate further and further away from the long-standing major focus on products to a focus on solutions that individuals and entities want. There are myriad embryonic examples from P2P lending, crowdfunding, robo-investing, ETFs for individual solutions, etc. This trend will continue to accelerate.

Have we learned from the 2008 financial crisis, or are regulators overlooking the roots of the next market crisis?

The conditions for a financial crisis are known for many generations. For example, excess risk taking, debt bubbles, illiquid assets requiring rapid liquidation on the advent of a knowable shock but unknowable time at which it might occur. As a result, shocks created by macro events such as central bank or fiscal events, or excess concentration of risks in financial intermediaries due to an unanticipated demand for liquidity, or excess country debts needing restructuring, lead to the intermediation process breaking down, until intermediaries can understand the magnitude and duration of events. How are regulators to know? Capital requirements might be the best alternative.  

I need to ask you about listed options. The global derivatives market is clearly not the same it was when you first studied it. Has it evolved in a positive way?

Certainly. Nothing grows and continues to grow and flourish unless it has huge value. This is certainly so with derivatives. They provide tremendous opportunities to hedge and transfer risk.  

Certain volatility vehicles have recently been blamed for exacerbating market pullbacks during sudden downtrends. Do you have an opinion about this?

Selling options provides insurance. From time to time, it is necessary to pay off on the insurance claims. This is true in options, high yield, debt, commitments, etc.   

What role will computers and algorithms have in financial markets in coming decades?

I think that they have quite an important effect. Artificial intelligence is using algorithms (or incentives and penalties) and then using data or results to determine a path forward. Humans are best suited to develop algorithms and approaches. Computers store and access data more efficiently. Both working together will make for tremendous enhancements in societal outcomes. It is not one versus the other.

You argue that the compound returns of a portfolio should be the key focus of comparison, rather than average returns or returns relative to a benchmark. Is that a criticism of current practices in the asset management industry?  

The current focus on relative returns or tracking error constraints impose an implicit cost in the form of lost returns. Although constraints are imposed for monitoring purposes and might reduce direct costs, the implicit costs hurt performance. These must be traded off. It is my feeling that these implicit costs are quite large and not truly appreciated.  

How can an active investor focus on outperforming their benchmark and also think of risk management? Can both co-exist?

They can both exist. The more a manager has the ability to outperform, the more tracking error they should assume. A manager cannot outperform a benchmark if they are too constrained to stay close to it. Risk management comes in controlling ‘alpha’ risk and ‘beta’ risk. Most managers concentrate on alpha, stock or asset selection or obtaining risk premia. I would like for more focus not on premia but on the management of the risk of the portfolio, its overall beta risk after the selection of the ‘best’ strategic portfolio.