Practical applications for winners’ ideas

Money managers all know there's a relationship between stock prices and earnings, but it was Clive W.J. Granger who demonstrated that when the two get out of whack, they are likely to come back closer together.

Equally important, Robert F. Engle helped lay the foundations for value-at-risk, an essential building block of modern-day risk modeling.

The two academics last week were awarded the Nobel Memorial Prize in Economic Sciences for their contributions that have affected money managers and pension executives in very direct ways.

Both were cited by members of the Royal Swedish Academy of Sciences, presenters of the awards, for their work on analyzing economic time series.

Mr. Granger, a retired professor of economics at the University of California, San Diego, developed a method — called cointegration — to understand the relationship between two economic variables, such as stock prices and earnings, or short- and long-term interest rates. Mr. Engle, a professor of economics at New York University's Leonard N. Stern School of Business, developed a model for quantifying and forecasting volatility.

John Campbell, managing partner of Arrowstreet Capital LP, a quantitative asset management firm in Cambridge, Mass., that manages more than $4 billion, said both bodies of research have major implications for institutional investors.

Mr. Campbell, the Otto Eckstein Professor of Applied Economics at Harvard University in Cambridge, said Mr. Granger's work is used by institutional investors searching for abnormal market conditions.

"Very often economic and financial variables come in pairs and if they wander off, they wander off together," Mr. Campbell explained. He said Mr. Granger's work showed that if those two variables — stock price and earnings, for example — move too far apart, the spread between them will eventually narrow.

In the case of price and earnings, if an investor or financial analyst is trying to determine where the stock price will go — whether it is overvalued or undervalued — he can look to the earnings to determine whether the earnings will move toward the stock or whether the stock will move toward the earnings.

"It's a very simple idea, yet very powerful," Mr. Campbell said.

Bruce Jacobs, a principal of Jacobs Levy Equity Management Inc. in Florham Park, N.J., which manages $10 billion, said Mr. Granger's work gives portfolio analysts and managers the tools to determine whether assets are overpriced or underpriced vs. their long-term trends.

He added that Mr. Engle's volatility model helps institutional investors gauge future volatility.

"Pension sponsors may use time-varying volatility when making their risk budgeting decisions — when apportioning their assets across different managers or different asset classes," Mr. Jacobs said. "Banks, hedge funds and investment managers use estimates of time-varying volatility when computing value-at-risk, which is a key statistic measuring the potential losses a portfolio might experience over a given time period."

Aamir M. Sheikh, president of BARRA Inc., Berkeley, Calif., said Mr. Engle's work on the volatility and correlation of assets has been applied extensively within financial markets.

Mr. Engle had served on a scientific advisory board at BARRA in the early to mid-1990s, along with Mark Rubinstein and Hayne Leland, founders of the defunct portfolio insurance firm Leland O'Brien Rubinstein and now professors at the University of California at Berkeley's Haas School of Business.

At BARRA, the firm used Mr. Engle's work and extensions of it to understand, for example, how the volatility of automotive stocks and value stocks are correlated.

"We take his stuff and we use it," Mr. Sheikh said. "In understanding time-series models, his work just has huge applications."

Referring to Mr. Engle's research, Mr. Campbell said "These are applications for anyone worried about risk or tracking risk — whether you're a regulator looking at banks, a brokerage firm managing the activities of traders, or a plan sponsor concerned about measuring the risk asset managers are taking on, or doing asset allocation."

Financial experts agree that even though the work that won Messrs. Engle and Granger the Nobel prize has been around for more than a quarter century, it is likely to continue to have an impact on portfolio management and investing far into the future.

"I have no doubt this is going to last," said William Greene, a colleague of Mr. Engle's at NYU's Stern school.