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Executive Education - November 30, 2015

Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management programme – an interview with Will Goetzmann and Lionel Martellini

In this month's interview, Will Goetzmann, Edwin J. Beinecke Professor of Finance and Management Studies, Director of the International Center for Finance at Yale School of Management and Lionel Martellini, Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute, discuss Yale SOM and EDHEC-Risk Institute's shared history of bringing theory to practice, provide further details on the second edition of the seminar series, present the key success factors for this partnership, share their objectives and initiatives for the future and give us their thoughts about trends and paradigm changes that are affecting the investment industry.

Will Goetzmann, Yale School of Management and Lionel Martellini, EDHEC-Risk Institute

November 2013 saw the beginning of a series of joint executive education seminars around the unifying theme, “Advanced Risk and Investment Management”, throughout the U.S. and Europe. The second edition of the seminar series will start again from January 2016. Can you remind us of the reasons behind Yale SOM’s decision to join forces with EDHEC-Risk in this way?

Will Goetzmann: The partnership with EDHEC-Risk Institute gives Yale SOM a chance to engage with top professionals in the investment industry. One of SOM’s key missions is educating leaders for business and society. Investing is one of society’s most important activities. It is how we save for the future, hedge important risks, and maintain key institutions. Investment methodologies – particularly with respect to risk analysis and control – have advanced in recent years through academic research. We and our EDHEC-Risk Institute partners share a strong interest in translating this research into practice. The executives who participate in our programmes are ideally positioned to make use of this knowledge, and to provide useful feedback to instructors about important current issues they face. This dialogue is fruitful for researchers and practitioners alike.

The focus of these seminars is on utilising the latest academic insights to help investment professionals better understand and implement advanced investment approaches and methodologies. Can you give us more details?

Lionel Martellini: The investment industry is currently experiencing profound structural changes, in the face of new challenges that are faced by both institutional and individual investors. For pension funds in particular, the shift in most accounting standards (FRS 17, FAS 87, and IAS 19) towards the valuation of pension liabilities at market rates (mark-to-market), instead of at fixed discount rates, has resulted in an increase in liability portfolio volatility. On the other hand, this new constraint has been reinforced in parallel by stricter solvency requirements that followed the 2000-2003 pension fund crisis, and ever stricter solvency requirements are also increasingly imposed on insurance companies in the US, Europe and Asia. These evolutions in accounting and prudential regulations have subsequently resulted in a massive shift from defined-benefit pension to defined-contribution pension schemes across the world, which implies that individuals are becoming increasingly responsible for making investment decisions related to their retirement financing needs, investment decisions for which they have no expertise. In this highly challenging environment, it is becoming increasingly recognised that institutional and individual investors alike are facing problems, for which they need dedicated investment solutions, as opposed to off-the-shelf investment products. This recognition is leading to a new investment paradigm, with substantial welfare improvements expected for asset owners. This paradigm, has been labelled liability-driven investing (LDI) for institutional investors, whose problems are broadly summarised in terms of their liabilities, and it has been labelled goal-based investing (GBI) for individual investors, whose problems can be fully characterised in terms of their specific consumption of bequest goals throughout their lifetime. Contributing to solving these formidable investment problems has become the key challenge that the investment industry has to face, and some changes with respect to existing investment practices are needed to help overcome this formidable challenge. In particular, the need to design an asset allocation solution that is a function of the kinds of particular risks to which the investor is exposed, or needs to be exposed to meet liabilities or fulfil goals, as opposed to purely focusing on the risks impacting the market as a whole, makes standard approaches (based on policy portfolios invested in a mixture of asset class portfolios actively and passively managed against market benchmarks) mostly inadequate. The focus of the Yale SOM – EDHEC-Risk Institute seminar series is on providing relevant academic insights with respect to some of the these novel dimensions of the investment process, including implementing disciplined risk and asset allocation decisions, efficiently harvesting factor risk premia across and within traditional and alternative asset classes, and designing truly meaningful forms of multi-asset multi-factor investment solutions.

What do you see as the key success factors for this partnership?

Will Goetzmann: Above all else, a common interest in advancing research in investment management and communicating this to practice. EDHEC-Risk Institute and the International Center for Finance at the Yale School of Management discovered this mutual focus and then built a programme around it reflecting the relative strengths of the two organisations. Two important areas of joint interest are: first, the definition and solution of problems in investment management using quantitative tools and empirical market data, and second, understanding the emergence of new asset classes and new investment vehicles. Both organisations are interested in the rapid development of the investment industry as well as the fundamental tools of finance.

What are the objectives for the future? Are there any new initiatives?

Lionel Martellini: Our objective is to expand the scope of our partnership so as to reach an audience that would extend far beyond the target audience for the current seminar series, which is typically formed of sophisticated investment professionals with a relatively high level of seniority in their organisation. We actually envision that the current programme could be expanded into an ambitious three-layer educational and outreach platform that would include our current programme as the “middle” layer, a digital course as the “lower” layer and an annual high-level international forum for top decision makers on reshaping the future of investment management as the “upper” layer. The lower layer will heavily rely on Yale SOM’s state-of-the-art technological infrastructure, as well as EDHEC-Risk Institute’s powerful digital marketing platform. A preliminary stage of project could be launched around the autumn of 2016 and include not only digital complements to the residential seminars, but also dedicated educational material that would be specifically engineered to reach a broader audience. Such an audience would include more junior and possibly less sophisticated investment professionals, but also independent advisors and possibly intellectually curious individual investors looking for academically qualified answers to questions related to their investment problems. In a later stage, we could envision enhancing the level of engagement from the wider public by providing financial education and including some initiatives based on dedicated digital tools that could contribute to addressing the financial literacy gap and could help an increasingly large number of individuals to better understand the impact of meaningful investment decisions on relevant goals such as financing their children’s education or generating attractive levels of replacement income in retirement. The upper layer, on the other hand, would require face-to-face, as opposed to digital, interactions with a limited number of top decision makers. The focus would be on approaching a number of leading asset owners, asset managers and investment banks, and offering them a unique opportunity to interact with academic experts within the context of an annual forum dedicated to the exploration of the main trends that are impacting our industry. This step would have strategic relevance for Yale School of Management and EDHEC-Risk Institute, since its ambition would be to further enhance the position of these institutions as key thought leaders with a strong impact in the field of investment management.

The investment industry is experiencing profound structural changes, and a number of new challenges are increasingly being faced by both investment managers and institutional investors. How are your institutions evolving to adapt to these changing trends that are expected to reshape this industry?

Will Goetzmann: Lionel and I share much the same view on the shifting industrial organisation of asset management. This is an important period in financial history. An increasingly larger share of the world’s population has access to asset management services. These are offered in very different governmental environments with different degrees of investor protection, government oversight and government guarantees. The asset management industry must adapt to these circumstances and seek ways of delivering high-quality, low-cost, trustworthy planning and management services globally. In this respect it may go the way of the innovative spread of telecommunications and internet services which have extraordinary world-wide penetration. I believe no single model will work for all circumstances, but I predict that a few global brands will come to dominate some fraction of asset management. Like the rapid global adoption of a few high-end consumer products, customers of asset management firms will likely use brands as a signal of manager integrity, talent and high-quality service.

The biggest challenge in my view is to motivate investors to plan for the future. Behavioural Finance was a major advance in articulating this challenge and in understanding the barriers to adequate planning. I do not think solving the individual investment decision will materialise through widespread educational efforts at the individual level. I expect people to continue to delegate the long-term planning and investment decisions to informed intermediaries – institutional managers who specialise and have demonstrable talent and proficiency.

Although neo-classical financial models characterise the individual investment decision as a choice that reflects personal risk preferences and economic circumstances, in my view, the need for bespoke services is of a lesser order of magnitude than the simple imperative of establishing an agenda or programme that shifts current consumption to the future. Hence, I believe the industry will evolve towards quite general investment offerings managed by highly visible and experienced institutions, as opposed to a myriad of and complex intertemporal schemes.

Lionel Martellini: I do believe that our industry is about to experience somewhat of an industrial revolution, an industrial revolution which will take place within the next 5 to 10 years or so. We currently are at the confluence of historically powerful forces. On the one hand, liquid and transparent access to risk premia-harvesting portfolios is now feasible with smart factor indices, which are cost-efficient and scalable alternatives to active managers. On the other hand, distribution costs are bound to go down from their stratospheric levels as the trend towards disintermediation is accelerating through the development of FinTech and robo-advisor initiatives, which are putting the old business model under strong pressure, and forcing wealth management firms to entirely rethink the value that they are bringing to their clients. Risk management – defined as the ability for investors, or asset and wealth managers acting on their behalf, to efficiently spend their dollar and risk budgets so as to enhance the probability of reaching their meaningful goals – will play a central role in this industrial revolution that will eventually lead to scalable, cost-efficient, investor-centric and welfare-improving investment solutions. Sophisticated financial engineering techniques have been used in the past to hide fees and risks within often-opaque structures that were sold to investors as safe and inexpensive products, and which were entirely irrelevant with respect to investors' meaningful goals in any case. It is about time that we use the same financial engineering techniques to help investors address the most important challenges that they face, including the retirement financing challenge. In the profound soul-searching process that is currently under way in investment management, I believe it is important for all parties involved to maintain a proper perspective and see what is happening as what it actually is, namely a unique opportunity for our industry as a whole to add value to society. As leading academic institutions, our main mission is to pave the way for these changes by providing asset and wealth managers, but also institutional and even individual asset owners with practically relevant academic insights that could help them clarify the truly meaningful sources of added-value in the investment management process.

About Will Goetzmann and Lionel Martellini

William Goetzmann is the Edwin J. Beinecke Professor of Finance and Management Studies and the Director of the International Center for Finance at the Yale School of Management, where he has been since 1994. He has taught investments, real estate and financial history among other classes. From 1990 to 1994 he taught investments and real estate at Columbia Business School. Goetzmann is an expert on a diverse range of assets, including stocks, bonds, mutual funds, hedge funds, real estate and art. His research topics include asset pricing, the equity risk premium, arbitrage strategies, selecting investment managers, global investing and financial history. His work has been featured in most of the major financial news publications and his academic research has been published in all of the major academic finance journals. His published books include: The Origins of Value: The Financial Innovations that Created the Modern Financial Markets (Oxford, 2005), The Equity Risk Premium: Essays and Explorations with Roger Ibbotson. (Oxford, 2006), Modern Portfolio Theory and Investment Analysis, with Elton, Gruber & Brown, (John Wiley and Sons, 2006 and following) and The West of the Imagination, with W.H. Goetzmann, (Oklahoma, 1986 & 2009). His most recent edited volume is The Great Mirror of Folly, Finance, Culture, and the Crash of 1720 (Yale University Press, forthcoming). His current work focuses on endowments, financial history, operational risk, securitization, credit risk and behavioral finance.

Lionel Martellini is a Professor of Finance at EDHEC Business School, the Director of EDHEC-Risk Institute and Senior Scientific Advisor for ERI Scientific Beta. Lionel holds Master’s Degrees in Business Administration, Economics, Statistics and Mathematics, as well as a PhD in Finance from the Haas School of Business, University of California at Berkeley. He is a former member of the faculty at the Marshall School of Business, University of Southern California, and has been a visiting fellow at the Operations Research and Financial Engineering department at Princeton University. Lionel is a member of the editorial board of The Journal of Portfolio Management, The Journal of Alternative Investments, and The Journal of Retirement. He conducts active research in a broad range of topics including long-term asset allocation decisions, equity and fixed-income portfolio construction, risk management and derivatives valuation. His work has been published in leading academic and practitioner journals and has been featured in major European and global dailies such as The Financial Times and The Wall Street Journal. He has co-authored reference textbooks on topics related to Alternative Investment Strategies and Fixed-Income Securities. Lionel has served as a consultant for various institutional investors, investments banks and asset management firms on a number of questions related to risk and asset allocation decisions, and is a regular speaker in seminars and conferences on these subjects.