Andrew Lo On New Challenges For Investors

Andrew Lo, hedge fund manager and director of MIT's Laboratory for Financial Engineering, is a long-time student of investor behavior, especially the sort that belies the notion that markets move with cool efficiency. Particularly today, he sees animal spirits lurching about in some worrisome ways that could have long-term consequences for markets and the economy. "The big message is that right now all, of us are in a state of emotional shell-shock," he says. That goes for investors, regulators, bankers, and anyone else unlucky enough to get caught up in the fear and uncertainty flowing through the current financial crisis.

In this two-part Q&A with U.S. News, Prof. Lo discusses the best way to build a robust regulatory system for the financial sector (part one is here.) Below, he considers what massive changes in the investment landscape over the past few years might mean for your investments:

This crisis has shown some flaws in a lot of widely accepted beliefs about investing. Is it possible anymore for average investors to make informed, reasonable decisions based on the a limited amount of information at their disposal?
I think it is possible, but I think you point out a very good observation that the world has changed and in particular the old investing wisdom has changed pretty dramatically over the past couple of years. We've learned some things about investing that a lot of [members of] the public were not aware of, and probably still aren't aware of just yet. For example, this notion of diversification we all hear about. It sounds good, but that used to mean you buy lots of stocks or an index fund. But if you bought lots of stocks or an index fund, you still got killed this last year. So then what are you supposed to do? It turns out diversification has changed. In other words, what we used to think about as highly diversified is not diversified anymore because so many people are doing the same things. We're victims of our own success in a way because all of us have taken all of our wealth and diversified it to all these different mutual funds, so they all end up doing the same thing when all hell breaks loose.

How do you guard against that in the future?
The idea is to create different kinds of diversification, to diversify not just across stocks, but across different kinds of asset classes--stocks, bonds, currencies, commodities, real estate--and then on top of that be able to short. The whole notion of shorting up until recently seemed like voodoo. It was viewed as dangerous and mystical. It's really not, but it does take some time and effort to educate the public on what it is. If you were short even a little bit last year, it made a big difference to your portfolio. But if you buy mutual funds, most funds by law cannot short, so you are stuck with this infrastructure that hasn't caught up to the new realities of financial markets. Shorting and diversification are the two big messages of what we learned that we didn't know about retail investing.

How about a quick outlook for the hedge fund industry generally? After all we've been through there haven't been too many blow-ups. I sort of thought it would be worse.
First of all, it may be worse. We're not over it yet. But I'll say two things: First, you haven't heard about a lot of hedge funds losing money for the simple reason that it's not news. When investors invest in hedge funds, they know they can lose money. Actually, most hedge fund investors are perfectly prepared for that. During certain good times, they're earning 30 to 40 percent a year. The quid pro quo is that during certain bad times, you can lose everything. Hedge fund investors, by and large, know that. The reason we have this crisis today is not because people have lost money. The source of the crisis is that the wrong people have lost money. In other words, the money market funds, the banks, and the insurance companies. They put their money into AAA [rated] securities. When you put your money into AAA securities, you're expecting that maybe once in a hundred years you'll lose everything, not once in every five. There was a misallocation of risks. That's why the hedge fund industry is in relatively good shape. Those folks were prepared for the risks.

The second thing I'll say about the hedge fund industry is that it has definitely contracted, probably by about 40 percent. What this does is put the industry's assets back to the level of about 2005. Now, that's a pretty severe contraction, but it's not blasting the hedge fund industry back to the stone age. It's a very vibrant part of the financial services industry, and I bet within nine months, we'll see tremendous inflows back into the hedge fund industry. The reason for that is pretty simple. After a year and a half of sitting on the sidelines, pension funds, which over the past five years have been the largest source of inflows into the hedge fund industry, are going got realize they can't make their asset liability targets by putting their money in [Treasuries], which is where it is now. They can't sit on the sidelines forever. By law, they have to have sufficient returns to meet pension-plan payouts. In another six to nine months, these pension funds are going to figure out they need to reallocate to higher yielding investments. And what is that higher yielding investment? It's not the S&P, it's not bonds, it's not money market funds. The only thing that will provide the kind of returns they need to make up for such lost ground will be hedge funds, because hedge funds by definition can engage in much more risky investments. Pension funds will ultimately have to take on more risk to generate those returns. Right now, there's a backlash against the hedge fund industry. In about two or three quarters, there will be a backlash to the backlash, and we'll see even more assets flow to the industry than ever before.

That implies for the rest of us who can't invest in hedge funds that the long-term rate of return on most traditional investments is going to be less lucrative than in the past.
It will be, and it will be a tough issue. Hopefully, if you put your money in a defined benefit plan, it will invest in hedge funds. Eventually, retail investors will be given certain access to hedge funds (gradually and carefully, I hope). But I think ultimately, mutual funds will become more like hedge funds and hedge funds will become more like mutual funds in terms of regulatory oversight. The hope is that will happen quickly enough so we won't create lots of problems for retirees. But you are absolutely right. It's a real problem that retail investors typically don't have access to the same opportunities as so-called "qualified" investors (and the only thing that makes them "qualified" is that they're rich.) It's an unfair and unfortunate state of affairs, but one has to be very careful of opening that spigot. Once you allow retail investors access to hedge funds, you then have all sorts  of excesses and potential abuses you have to clamp down on before they get out of control. 

So it sounds like everyday 401(K) options for the next 10 years are between a rock and a hard place?
It's going to be tough. I don't know about 10 years, but certainly for the next five, the S&P won't be as lucrative as it has been over the past 20.