From aiCIO Magazine's June Issue: What the Human Genome Project teaches us about risk factor-based investing. Angelo A. Calvello reports.
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As is typically the case, the genesis of my column is a discussion I had with an asset owner—in this case, Tony Day, former head of strategy for Australia’s US$90 billion Future Fund. Tony and I have been exchanging emails about the advantages of a risk factor-based asset allocation model over the conventional asset class-based model. We share the view that asset classes and the corresponding investment strategies are blunt instruments, crude in their design and stultifying in their application, and that an asset class-based model is a historical artifact, hidebound and sclerotic. A risk-factor model offers a much more granular way to sculpt return and risk and allows for the configuration and implementation of a more elegant asset allocation model. (It also offers a more robust approach to risk parity.) Tony forecasts that “in 20 years time everyone will allocate to a finite list of risk factors, and that they’ll allocate to each factor across all asset classes rather than within asset classes.”
Our discussion turned a bit philosophical when we debated which discipline investing should most emulate. GMO’s James Montier recently made the case for physics (“The Flaws of Finance”). For me, biology is a much stronger choice. And, specifically, the human genome project (HGP) is the archetype that would best facilitate the broad adoption of risk factor-based investing.
One of the main goals of the HGP was to identify all the approximately 20,000 to 25,000 genes in human DNA. By transposing this process to our world, we can think of investment strategies as chromosomes and risk factors as the genes that make up those strategies. (A few asset owners are thinking along these lines. Theodore Economou and Gregoire Haenni at CERN talk about understanding the DNA of strategies.)
Like the HGP, we need to come up with a methodology that allows us to study the genetics of strategies—a way of sequencing a strategy’s DNA so we identify the factors that make up a given strategy and eventually compile a list of factors that comprise the entire investment genome. This ambitious project could provide us with the genetic blueprint for investing.
The HGP has led to the creation of the new discipline of synthetic biology, which combines science and engineering with the goal of creating biological functions and systems not found in nature. It uses nature as a manufacturing platform and DNA as the raw materials. Understanding the investment genome would allow for synthetic investing: rigorously combining discrete risk factors to construct new risk/return profiles that do not exist in “nature” (i.e., in a consultant’s database). The proverbial rocket scientist is displaced by the biological engineer.
Applying the HGP to investing produces some far-reaching consequences. First, it would make possible robust factor-based investing and the creation of genuinely custom investment solutions. For example, it would provide a high level of transparency. We could identify and separate beta from alpha. Currently, alpha is the “not beta.” I would argue that most of what passes for alpha today is simply unidentified risk factors. Alpha, in this scenario, is likely to be the skill used to create and manage custom factor-based solutions.
If we followed the model of the HGP, the risk factors themselves would be available online in an open-source platform, and crowdsourcing could be used to create new strategies. This, of course, would radically alter the business models of asset owners, asset managers, and consultants—effectively all service providers—and rationalize fee structures. And just as the HGP has opened the door for personalized medicine, applying the same methodology to investing should have the same type of impact on the DC and retail markets.
I think it only fair to mention that in spite of the persuasiveness of my argument, Tony rejected it, claiming that a fundamental incongruity made it inapplicable: a gene has a physical and relatively stable existence, while a risk factor has no physical existence. “Everyone will agree that a particular piece of DNA says cgatataat. This won’t be the case in investing. A return is a collapse of a stochastic variable into a single event.” To Tony, a risk factor is not so much a gene as it is a meme.
My counterargument: the gene is a meme. The essential attribute of a gene is not its physical nature but rather the information or instructions it carries. Richard Dawkins captured this idea in The Blind Watchmaker, when he wrote that “What lies at the heart of every living thing is not a fire, not warm breath, not a ‘spark of life.’ It is information, instructions.” Factors, like genes, carry the information that provides instructions on risk and return.
In our December issue, I asked who is the Steve Jobs of our industry. Upon reflection, it might make more sense instead to ask who will be the James Watson and Francis Crick of our industry. Or, perhaps more appropriately given our current situation, who will be our Gregor Mendel.
Angelo A. Calvello, PhD, is CEO of Impact Investment Partners LLC, the wholly owned affiliate of Impact Investment Partners AG. He is responsible for developing and marketing investment strategies that seek to generate real returns, including environmental infrastructure and private equity strategies.