The role of Myron S. Scholes and Robert C. Merton as partners in Long-Term Capital Management LP raises questions about academics in money management.
The investment community has seen a lot of brilliant ideas come from academia that have been applied to portfolio management.
Harry Markowitz spawned modern portfolio theory, diversification and the efficient frontier of risk and return.
William F. Sharpe pioneered the capital asset pricing model as a methodology for valuing equities and risk.
Rolf W. Banz found the small-stock anomaly.
With the late Fischer Black, Mr. Scholes and Mr. Merton developed the options pricing model.
Many of these academic ideas, to list only a few of them, have produced impressive advantages for investors and the capital markets.
Messrs. Scholes and Merton were the best minds in derivatives in the world. Yet, their firm, Long-Term Capital, took on a huge amount of risk that turned out to be beyond its ability to manage.
Any investor rightly should ask, if these people failed, does anyone know what they are doing?
Academics have an aura of objectivity and thoroughness in their scholarship. Messrs. Scholes and Merton, more than that, have their award of Nobel prizes in economics (although one has to wonder whether the Nobel committee would have recognized them this year had they not won last year). In entering money management, academics trade off their scholarship credentials, influencing clients.
Some academics feel a need to get their hands directly in the business of investment management. For them, theory alone is insufficient for understanding markets. They want real world details. They want to apply their theories. And they want to make money, as well.
Efforts to apply theory to the real world ordinarily shouldn't be disparaged. A question is how well academics can balance the inherent conflicts of serving both the academic and investment communities.
Were these Nobel laureates mad scientists out to profit enormously from their secretive, complex strategy?
One wonders how well hedge fund investors themselves understand the risks in investing. Even the name of Long-Term Capital seems bewildering: What was long-term about its investment strategy?
Hedge fund investing is limited to so-called sophisticated investors, who are supposed to be able to understand and afford the risk. But what about the millions of other ordinary investors, individual and institutional, in the market who aren't invested in hedge funds and, in fact, are prohibited from investing in hedge funds? Whether they like it or not, these uninvolved investors have to bear the threat to the market's stability caused by hedge funds and perhaps pay indirectly for any hedge fund's bailout.
Messrs. Scholes and Merton now join the long list of people with great reputations to have been brought down by the market. Experts, whether in or out of academia or investing, are most often wrong in predicting the future. Professors have no greater ability than nonacademic practitioners to profit in the market. But they at least can hang their hats at Harvard or Stanford or wherever and return to the world of theory.