Real Engineering versus Financial Engineering

Here are two clips from e-mails I have received. The first is from a leading European University that teaches financial engineering. The second is from the prospectus of a fixed income mutual fund company. The first is a theoretical argument. The second is a CYA disclaimer statement.

FirstClip

SecondClip

Ever since the CAPM claimed that it was less risky to borrow money and invest it in the market portfolio than invest in a portfolio on the efficient frontier that lies below the security market line, both academics and practitioners have argued that leverage and going short are beneficial strategies for investors. Of course, the CAPM assumes there is such a thing as a risk-free rate and investors can lend and borrow at that rate, plus a few chapters of additional assumptions. Financial engineering is the latest development in this theoretically correct but practically wrong ruse. I am not opposed to the use of derivatives to alter the risk-return characteristics of portfolios but we need to keep in mind that engineers build real things and we build paper things that do not hold up unless a lot of assumptions prove to be correct. The misuse of financial instruments is not solely responsible for the financial collapse of 2008 but is certainly not blameless and does need to be regulated, not eliminated, to prevent future avoidable calamities.

I agree with professor Ducoulombier-investors should be fully informed of the risk-return characteristics of esoteric strategies. The investor should be entitled to the same disclosure protections by the SEC as the FDA provides to consumers of medications. For example:

  1. The investor should be told the percentage of the portfolio in derivatives, the resulting leverage and the effect that could have on losses, fees and expenses.
  2. An explanation of the assumptions being made should include examples of the consequences if those assumptions do not hold and a record of past occurrences.

“Order is indeed the dream of man, but chaos, which is only another word for dumb, blind, witless chance, is still the law of nature. You can plan all you want to but… “ Wallace Stegner

We are told that there is nothing to fear now. The fiscal cliff….a thing of the past. The sequester disaster….came and went. To paraphrase Stegner, never underestimate Govertment’s ability to make dumb, blind witless decisions that will upset the plans of learned men and women.

The flaws in our global financial system have not been corrected. That’s a shark that is still swimming out there in our sea of contentment. The promises of Governments, businesses and theories to transform our world of uncertainty into something we can count on have been proven unreliable. That pension benefit you were promised….here’s your 401(k), lots a luck. Remember this: we live in a world of uncertainty. There isn’t any knowing what is going to happen. But, there is a professional way to manage that uncertainty that might tilt the odds in your favor. That’s as good as it gets.

So, what are we professionals to do for those who put their trust in us? DON’T LET THEM SWIM WITH SHARKS! Make them stay in unleveraged shallow water. Don’t let them go beyond the diversified reef that provides some modicum of protection. Chasing the next Google will attract sharks.

About Frank Sortino

Frank Sortino is finance professor emeritus from San Francisco State University and Director of the Pension Research Institute which he founded in 1981. For 10 years he wrote a quarterly analysis of mutual funds for Pensions and Investments Magazine and he has written two books on the subject of Post Modern Portfolio Theory. He has been a featured speaker at many conferences in the U.S., Europe, South Africa, and the Pacific Basin. Dr. Sortino received his Ph.D in Finance from the University of Oregon and has carried out research projects with many institutions like Shell Oil, Netherlands and The City and County of San Francisco Retirement System.
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