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June 24, 2007
David Warsh, Proprietor

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From Mister Johnson to Beta, and Back Again

For the last few years, my favorite way of keeping tabs — very loose tabs — on the heavy waves of new technology transforming the financial markets has been to glance twice a week at Financial Engineering News.  I don’t mean the occasions when breaking news requires aggressive reporting and interpretation — like the attempt last week by Bear Stearns to relieve the pressure on its High-Grade Structured Credit Strategies Fund with a loan (while leaving alone, at least for now, another internal hedge fund, larger and more highly leveraged). For emergencies, and longer term trends as well, The Wall Street Journal and the Financial Times can’t be beat.  I mean the wash of talk that goes on continually among professionals about what is most worthwhile in the highly remunerative discipline of financial engineering and what is expensive (and sometimes dangerous) froth. 

James Finnegan, a graduate of Harvard Business School who later studied investment management at Boston University (and passed his CFA exams at the same time), who possesses an old-fashioned sense of civic responsibility as well, bought FEN in 2001 from James M. Clark, who had founded it in 1996 to keep practitioners abreast of the latest trends in business schools and research universities, and vice versa.  Under Finnegan, it has appeared twice a week as an HTML email, once every other month a print edition in the mail as well. (Sticking to print, he says, was his big mistake.)

Its columnists — Aaron Brown, Nina Mehta, Ross Miller among them — were some of the most distinctive voices in financial journalism, thanks to the relative impunity conferred by their day jobs as trader, writer, teacher. There was something of the open-source movement about the enterprise. It’s free; the advertisers paid — at least they did. For FEN  has gone out of business. Finnegan has taken a job in American Century Investment’s quantitative group in San Francisco.

Finnegan did an extraordinary job.  But these things often don’t work for long. Does anyone remember Tim O’Reilly’s Web Review? What remains is O’Reilly Radar, a free sample of what is otherwise a highly profitable publishing business, including the $495 bimonthly Release 2.0. Meanwhile, I subscribe to Business Week.  Their weekly tour d’horizon remains pretty good.

With financial markets nervously parsing the newest wrinkle in the market (or non-market) for mortgage-backed derivatives, I turned to Peter Bernstein’s latest book, Capital Ideas Evolving, a follow-up to his remarkable 1992 bestseller, Capital Ideas: the Improbable Origins of Modern Wall Street. “Keep in mind,” he writes, beginning his account of the latest excursions in behavioral finance, functional finance, and other attempts to come to grips with the inner nature of markets, “that the powerful body of knowledge motivating this whole story was conceived in the space of only twenty one years, from 1952 to 1973. That is a remarkable fact. The resulting theoretical structure had no prior existence and only a few scattered roots in the past.” As I read along in the account that Bernstein gives of the skirmishes since his seminal book appeared, however, I grew curious about the public reception of those new ideas over an even longer span of time.  And before I knew it, I was back re-reading the first piece of financial journalism that I ever encountered, The Money Game by “Adam Smith.” (Remember, the topic here is keeping abreast of things.)

It was more than forty years ago that “The Day They Red-Dogged Motorola” appeared in  New York magazine, that citadel of the New Journalism not yet having been spun out of the New York World Journal Tribune. That look inside the community of Wall Street analysis was just the beginning. The Money Game itself appeared in 1967, all snap and jazz. The adventures of Odd-lot Robert and The Great Winfield (he of the cocoa futures), of Poor Grenville and the Gnome of Zurich sent the book to the top of the best-seller lists and kept it there for a year. It took a while longer for the author to be outed as all-arounder George J. W. Goodman (Rhodes scholar, Green Beret, three novels, a spy thriller, a children’s book, and a couple of pretty good screenplays). He had wanted a nom de plume because at the time he was still working as a stock analyst. An editor casually changed it at the last moment from “Procrustes.”

After the obligatory tribute to the investing acumen of John Maynard Keynes, The Money Game opens with a chapter called “Mister Johnson’s Reading List,” Mister Johnson being Edward C. Johnson II, the founder of Fidelity Management and Research, whose performance even then was the benchmark of success in the mutual fund industry. (Johnson’s son Ned has since built it into a giant firm.) And what was on the reading list? The Sophisticated Investor, by Burton Crane; Security Analysis, by Graham and Dodd; The Battle for Investment Survival, by Gerald Loeb; The Crowd, by Gustav LeBon; Sherlock Holmes, Marcus Aurelius, even Alan Watts’ Buddhist mediations, The Wisdom of Insecurity. “He talks as though he were on a quest for truth,” wrote Goodman of the legendary investor. And how did Mister Johnson explain himself?  “[T]his is no science. It is an art.  Now we have computers and all sorts of statistics, but the market is still the same, and understanding the market is still no easier. It is personal intuition, sensing patterns of behaviorÉ.”

Tucked away in the middle of The Money Game, in a section called “Systems” (chartists, fundamentalists and all that) was a chapter called “What in the Hell Is a Random Walk?” To underscore the point that the mathematics were abstruse, Goodman reprinted two pages of calculus from a paper by William Steiger of the Massachusetts Institute of Technology.

Goodman stayed with the story for the next thirty years, as charter editor of Institutional Investor (it was he who first caricatured fund managers as Superman, Batman, Captain Marvel, etc., establishing an approach that persisted for decades), an as author of several more books and host of a long-running TV show. Other important titles followed, by other authors, notably Burton Malkiel’s A Random Walk down Wall Street in 1973.  But not until Bernstein’s Capital Ideas appeared in 1994 did the public gain a proper narrative of the intellectual revolution that had swept through money management in those years.

Bernstein’s book was a tour de force. It described a revolution in the way market participants thought about risk, elevating it from a mere afterthought to parity with what before had been goal the investors pursued single-mindedly:  return. The revolution had taken place in Chicago; Cambridge, Massachusetts; and Berkeley, California.  None of the essential work had taken place in New York City, home of the greatest financial market on the planet. “Most of the pioneers were professors with a taste for mathematics,” Bernstein wrote, “strange bedfellows for the hardnosed veterans of boom and bust.  Few of them ever played the market with more than a few thousand dollars of their own. Nor did they shout their theories from the rooftops.  With only a couple of exceptions, they were content to publish their ideas in academic journals and to debate them with their colleagues.”

And what were the “capital ideas”? No longer were they to be found in books but rather in scientific papers.  They were not  theories but models: Harry Markowitz on portfolio selection, Franco Modigliani and Merton Miller on corporate finance and market behavior, William Sharpe, Jack Treynor, Jan Mossin and John Lintner on capital asset pricing; Eugene Fama on the efficiency of markets;  Fischer Black, Myron Scholes and Robert Merton on options pricing.  All converged on the idea that the really important characteristic of any asset — the aspect that Sharpe described in his equations with the symbol beta — was understanding its volatility relative to that of the market itself.

Wrote Bernstein, “When the beta concept came to the attention of professional portfolio managers [in the early 1970s], they reacted with confusion, then disgust, then annoyance, and finally total skepticism.” Trading risk for reward was surely much more complicated than that! Within a few years, however, the practitioners were converted to the new philosophy in droves, with far-reaching implications. The scientific papers eventually would garner five Nobel Prizes. With admirable clarity, Peter Bernstein told the story of how and why.

How did Bernstein do it?  He was 70 years old (b. 1919) when he sat down to write the book.  It helped, surely, that his friend since the age of five was Robert Heilbroner, author of The Worldly Philosophers: The Lives, Times and Ideas of the Great Economic Thinkers, a book of similar ambition.  The two men talked nearly every day. It helped, too, that he had known Paul Samuelson since 1936, when the future Nobel laureate was his section-man in the freshman economics course at Harvard College. Perhaps most important, Bernstein had been a successful steward of a family money management firm for twenty years. 

“At first I found the new theories emerging from the universities during the 1950s and 1960s alien and unappealing, as did most other practitioners.  What the scholars were saying seemed abstract and difficult to understand. And beyond that it seemed both to demean my profession as I was practicing it and to prescribe radical changes in the way I should carry out my responsibilities.”   The recession of 1974, with its accompanying market turbulence convinced him otherwise. So taking a leaf from Alfred Cowles, a similarly confounded money manager of half a century before, he started the Journal of Portfolio Management to learn what the new theories were about. 

After Capital Ideas appeared, Bernstein kept his wits sharp with a study of risk and insurance (Against the Gods, 1996), a history of humankind’s obsession with gold (The Power of Gold, 2000), and an economic history of the Erie Canal (The Wedding of the Waters, 2005) — not to mention the running market commentary for clients he keeps up by e- and postal mail.  And now the book I was reading last week, Capital Ideas Evolving.  It is, he says, a continuation of the story.

The book is a series of profiles:  behavioral economists Daniel Kahneman and Richard Thaler; theorists Paul Samuelson, Robert Merton, Robert Shiller and Andrew Lo; engineers William Sharpe, Harry Markowitz and Myron Scholes; practitioners Blake Grossman of Barclays Global Investor, David Swenson of Yale Endowment Fund,  Martin Liebowitz of Salomon Brothers and TIAA-CREF, Rob Litterman of Goldman Sachs Asset Management. There is a theme, of course.  It has to do with the pursuit of  Alpha, a residual term from Bill Sharpe’s original equation for the Capital Asset Pricing model that reflects the difference between predicted and actual return. Known only after the fact, alpha reflects the extent to which (if it is positive) a particular asset “beat the market” for the period it is held.  Alpha has become professional money managers’ new Holy Grail, its pursuit increasingly sophisticated and elaborate.

And so apparently the wheel has turned back again — not to Mister Johnson, but to myriad “portable alpha strategies” designed to capture subtle mis-pricings in the market wherever they exist. Money managers comb the latest reports from students of behavioral finance in hopes of finding some new anomaly.  Eventually the imperfections will disappear, Bernstein says, in the press of some unfathomably clever new arbitrage. Then there will be only the news.

Long before that, however, another book will be required.  There are no revolutionary new theories of finance, as Bernstein says.  That game is over, and he captured it. But the great tasks of engineering, not just financial markets but the regulatory authorities that govern them and the social institutions they must serve, are still in their early stages. A new and younger author will describe that evolution eventually, in terms that can be widely understood. The interval probably will be about the same as between The Money Game and Capital Ideas. (For a remarkable glimpse of the way ahead, see The New Financial Order: Risk in the 21st Century by Robert Shiller, especially Part V.)  Look for the next must-read book about how financial engineering has changed our world in about ten years. In the meantime, there is the world of FEN and its cousins, somewhere between grand narrative and news.

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