By Conrad de Aenlle
Financial theory has proven over and over that it is capable of scaling the walls of the ivory tower and finding its way to Wall Street. Over the last fifty years, ideas developed in the academy, such as efficient market theory and the capital asset pricing model, have been credited with spurring the creation of the complex machinery of modern finance.
Little wonder. Financial markets are an unceasing competition in which millions of people are constantly searching for some advantage they can exploit—whether better information, faster reactions, or a new idea.
Hedge fund heavyweights like Renaissance Technologies and D. E. Shaw & Co. were founded by former professors. Other firms are looking for ways to monetize the latest ideas coming out of business schools and economics departments. AQR Capital Management, a firm that focuses on a rigorous, quantitative approach to investing, emphasizes its use of academic research and close connection with the academy. “We embrace financial theory as the foundation of our business,” the firm declares on its website.
Andrea Frazzini, Ph.D. ’05, a principal at AQR Capital Management, spoke with Yale Insights about what it takes to turn a research insight into an investment advantage.
“Lots of financial economists are testing hypotheses” developed in academia, Frazzini said. “Once we get comfortable with a particular tilt, we think about how to deploy that tilt in a variety of assets classes,” such as stocks, bonds, or commodities. It’s essential, he added, to look for factors that research has shown to work across different asset classes and historical periods.
One of Frazzini’s research areas is behavioral finance, the emerging school of thought in and out of academia whose central contention is that certain psychological and emotional traits lead investors to make mistakes in consistent, predictable ways. These include herding, a tendency to flock to the same sectors or markets in search of growth during good times and safety during bad, and anchoring, in which investors are slow to react to changes in fundamental economic, corporate, or market conditions.
“Behavioral finance is a big part of what we do day to day” at AQR, Frazzini said. It “helps you think about why some investors have portfolios that are not optimal, . . . why they under-react to corporate news announcements.”
But while Frazzini is active in this cutting edge field, he points out that it’s also important not to overreact to developments in the markets and assume that they constitute a phenomenon that can be capitalized on reliably. The value of academic research is not just the findings that it produces but the rigor that goes into producing them.
“As academically minded financial economists, we have a very, very high bar for removing something or making small [changes],” Frazzini said. “What we usually say is that it takes about 30 years’ worth of evidence to put something in your model, and it takes 30 years’ worth of evidence to take it out of the model.”