Moderated by Robert Litterman, Kepos Capital LP
William F. Sharpe is STANCO 25 Professor of Finance, Emeritus, at Stanford University’s Graduate School of Business. Before joining the Stanford faculty, he taught at the University of Washington and the University of California at Irvine. Mr. Sharpe was one of the originators of the capital asset pricing model and developed the Sharpe ratio for investment performance analysis, the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns-based style analysis for evaluating the style and performance of investment funds. He has written seven books, and in 1990, he received the Nobel Prize in Economic Sciences. Mr. Sharpe received his bachelor’s degree, master’s degree, and PhD in economics from the University of California at Los Angeles.
The key questions Prof. Sharpe will address follow.
- Understanding theory and practice in investment management
- Improving retirement security: State pension funds, government-sponsored social security programs, defined contribution plans, and retirement income strategies
My session notes follow. As always, these are contemporaneous notes. I make no guaranty as to their accuracy or completeness.
Litterman (L): Review the intellectual environment that led to the development of CAPM?
Sharpe (S): Working at the Rand Corporation and getting his PhD at UCLA. Those environments were key. Markowitz came to Rand and they began to collaborate. CAPM dissertation was initially rejected due to alleged unrealistic assumptions.
L: Did he understand how important it was?
S: Yes and no. It clearly was the best paper he would ever write though.
L: Why have you focused so much on practical solutions?
S: In PR mode, focused on “useful theory.” Loved programming (still writes code regularly) and it was just coming into the fore in his early days. Crucial skill. Monte Carlo simulations vital for “getting our arms around” many difficult issues in our world.
L: CAPM lessons – co-variance matters?
S: Others need to answer usefulness. Co-variance mattering more than variance was from Markowitz. Two big messages: “The market portfolio is a really cool thing” and “has very attractive properties.” It’s probably the best portfolio. Expected returns should correlate to risk.
L: Early simplifying assumptions have since been relaxed. Important more recent developments re CAPM?
S: Big issue. On the theoretical side, multiple new asset pricing models. Many helpful. More practically, “the real world doesn’t seem very kind to our theories.” Empirical work is central and illuminating, but in a real world where everyone is trying to win, “beating the market carries the seeds of its own destruction.” Index will outperform as a matter of simple arithmetic.
L: Q: Has behavioral science changed your thinking?
S: Yes. He was an early adopter. “We ignore it at our peril.” Also, “I’m now worried about people trying to finance their retirements after they retire” – he questions “smooth utility functions.” And, “I’m really perplexed” about how to apply it in the real world.
L: Main pension fund issues?
S: Pension issues keep coming back. “Problem” and “disaster.” Sensible valuation of liabilities is astronomical. “If the state has promised a series of payments…it’s simple to value” using treasuries to defease. Self-evident, but not what’s done. 7.5% assumption is “crazy.” “Phony accounting drives even worse investment decisions.” It’s “a very bad situation.” In the private sector, the shift from DB to DC, there is somewhat better accounting, but still a problem.
L: Implications from financial crisis?
S: Not a banking expert, but much higher capital reserves (15-20%) should be required.
L: Low interest rates a consequence of financial crisis. What are the implications for investors?
S: Concerned about people when they reach retirement – retirement income. “That problem has become…much more dire with [negative] real rates,” resulting in a real shift of capital from borrowers to investors.
L: Asset allocation…?
S: Adaptive asset allocation comes out of the mindset that if something is good, almost everybody will want to do it. Average person should want the market portfolio with adjustments for adding or subtracting risk. Result: “Don’t do something, just sit there.”
L: What has the market portfolio gone from 60/40 to 70/30?
S: “I have no clue.”
L: Smart beta?
S: “Beta” was market sensitivity historically – a measure of how sensitive a security is to a market change. Factor models relate to it. “When I hear ‘smart beta’ it makes me sick.” To Arnott: “Are you telling me this is good for everyone…and indexers are dumb?” “Is this a way to exploit stupidity?” If so, the market will arbitrage it away. “Smart beta” adds to confusion and isn’t likely to work in the future.
L: Focus on expense – but does alpha exist?
S: Definitionally, active will underperform. But we also need people to look for anomalies. Old-fashioned security analysis is really valuable, but the markets keep taking the advantage away.
L: have the markets become more efficient?
S: Guess is “yes,” but “I have no substantive notion.” More indexing and closet indexing (r-squared is going up).
L: Advice for audience?
S: Re retirement income – has turned attention to distribution phase of retirement. Everybody now wants that market (ads are everywhere). “It’s the hardest problem I’ve ever looked at.” Retirementincomescenarios.blogspot.com provides his latest research in this area. Also, it’s “a problem of increasing practical importance.” Social Security is a problem, but not nearly the problem Medicare is. Problem is huge unfunded liabilities. Not broken going forward (although rate assumptions are problematic), but the unfunded liabilities are immense. As a policy matter, doesn’t want SS to be diminished.