Author(s): Robert C. Merton, John and Natty McArthur University, Harvard Business School
Date published: Jun 2008
The Marjolin Lecture 2008 was given by the Nobel Prize Winner Robert C. Merton, John and Natty McArthur University Professor at the Harvard Business School, Boston. The title was: “Observations on Future Trends in Asset Management: Challenges and Opportunities.” The speaker started by referring to the enormous changes in the financial system that had changed life for producers, users and overseers of financial services. Development of derivatives has affected risk allocation and made separation of risks possible. Risk is today a separate dimension of management decisions. There seems to be a conflict between two fundamental dictums in international economics and financial theory: “Exploit your comparative advantage and diversify your portfolio.” The core of asset management activity is to reconcile them.
“Barbell” strategies imply decomposition of the investment process. Very efficient, low-cost sector exposures (Beta) can be acquired through index funds, ETSs and derivatives. The implication for institutions is that they will increasingly move into alternatives, whether captive or outsourced. Greater transparency of strategies and sources of value-added should reveal costs related to alpha and beta strategies. Institutions will have a much greater need for “portfolio assembler” functions to put components together. Investors will need integrated risk measures for alternative and traditional asset classes. The speaker explained the stages of a production process by means of a diagram in which passive well-diversified portfolios are combined with active asset class allocation and aggregate excess-return portfolios (“Alpha Engines”). In the next stage, the resulting efficient portfolio of risky assets is combined with a portfolio of riskless assets to produce an optimal portfolio of assets. Investors should always ask where extra returns are coming from. What kind of risk do I accept to be exposed to in order to obtain extra return? Hedge funds do provide a risk-transfer service that they are paid for. The increasing un-sustainability of public pension systems implies that people must increase their savings for retirement. Unfortunately, they are not qualified for investing in the appropriate portfolios themselves. They need intermediaries.
The speaker then turned to Sovereign Wealth Funds. Although the execution of sovereign wealth funds, reserves and debt management can be decentralized, the objective function from which the optimal policies for each are derived should reflect an integrated generalized Asset/Liability Management perspective on overall country risk exposures. He used a Government Economic-Risk Balance Sheet with data from China in order to illustrate the point. He recommended that foreign currency reserves should be managed by the central bank and that risk-return considerations should be decided by the Government. Modern financial technology permits the separation of risk-exposure selection and management from physical investment choices, capital expenditure plans, ownership and governance of assets. Risk exposures can be radically changed without effecting capital, trade or income flows or the balance sheet. Thus, risk is a separate dimension of management decisions. In the last part of his lecture, Professor Merton explained the enormous potential in using swap-contracts among countries in order to preserve comparative advantages and obtaining efficient risk diversification. He listed the advantages of using the instrument: It minimizes moral hazard of expropriation or repudiation. Locals still perform industrial governance so that the political risk of “selling the crown jewels of the country” is avoided. There is no principal amount exposed to credit risk. Policy is non-invasive and reversible etc.
By means of a risk-return diagram illustrating the performance of world equity and bond markets from 1972 to 2001 and a CAPM line, he concluded with a very rough estimate of the potential gain to emerging market countries of moving by means of swap contract closer to the CAPM line. These countries would have been much better off both in terms of higher return on assets and lower risk if they had used swap-contracts with the rest of the world. Responsible managers of financial institutions, academics, overseers, central bankers and politicians must try to understand the wonderful opportunities that come out of this. We can use these innovations to improve the world. The very lively discussion following the Marjolin Lecture concerned the counterparty issue in the proposed swap-contracts, portfolio home-bias, the need to make decisions on incomplete data etc. Professor Merton’s final remark was: “I am an engineer by education, and I want to be a problem solver.” The applause frome the audience lasted a long time.