I have seen the transfixed faces of market professionals who after watching crescendos and crashes often look a strange mixture of perplexed and befuddled while seemingly operating in a trance like state. Most of these professionals do their level best to try to avoid the oft asked question “When will the markets come back again?”
The volatility and uncertainty of this market has even the most hardened traders and financiers unsure as to which direction the market is going. The determination of the course of the market over the medium term is seemingly equally opaque.
Although I am market professional and I study them intently on a daily basis– I still find myself having multiple questions daily. I can only imagine the chagrin and questions that individuals ponder.
On that basis I decided to turn to one of the smartest people on the planet that I know–Dr. Christopher Geczy (http://www.wharton.upenn.edu/faculty/geczy.html)– for answers. I refer to Dr. Geczy as “CG”, “Dr.G” or very often simply “Dude”. Most people in finance know him as a well published econometrician who teaches who teaches at Wharton where he is the Academic Director of the Wharton Wealth Management Initiative (http://executiveeducation.wharton.upenn.edu/wmi), but he also recently acted as the Academic Director 2009 Securities Industry Industry Institute, having taken over the position from legendary finance professor Dr. Jeremy Siegel, the author of “Stocks for the Long Run”.Prior to this position, Dr. Geczy taught at the Pension Funds and Investment Management Program at the Wharton School (where he was my professor!) among many other program Directorships and teaching assignments (including those in partnership with the CFA Institute, IMCA, IFBEP and the Institute for Private Investors, among others)
So it is needless to say that Professor Geczy is used to explaining complex issues to both institutional investors and high net worth individuals alike. The good Dr.Christopher Geczy also actively consults highly sophisticated, multi-billion dollar investment management firms with his cadre of PhD talent. Chris is incredibly high priced, intellectual talent and served as an advisor for my investment bank during our $60 billion underwriting participation along with speaking at several of CMG’s conferences to institutional investors and plan sponsors. I personally couldn’t think of a more knowledgeable person to begin the wealth management questions for a clear answers than Chris…having said that let’s begin.
Shawn Baldwin: Can we start off with a little about your background beginning from your time as an undergrad at Wharton until now?
Dr. Christopher Geczy: I was an undergrad in the College of Arts and Sciences at Penn, and I majored in economics. I ended up working in the social sciences and computing area as a work study student, and I co-wrote software with two economic professors for a widely-selling macro-economic textbook and that led to some work that I did on econometric modeling. I ended up having a pretty strong interest in macroeconomics, which led me to start working at the Fed in Washington. I used to always joke and say, ‘I worked for the man, who worked for the man, who worked for THE man: Alan Greenspan,’ but it’s not so funny anymore. I was a research assistant working on some of econometric models that the Fed maintained. I did that at a fascinating time–I graduated in 1990s–I worked during the recession in early 1990s. While I worked there, I developed a pretty strong interest in finance as a result of the modeling work we did, and when I helped out on the financial markets side of the modeling.
So I applied around and got into the University of Chicago Graduate School of Business and went there in 1992 for my Ph.D in Finance and Econometrics and ultimately graduated in 1999, though I was on Wharton faculty for 2 yrs–faculty tenure [consideration] begins when you defend your Doctorate. I became a professor in Wharton. I also spent a year at Ohio State as a pre-doc, writing my dissertation and doing research, though I didn’t teach.
Shawn Baldwin: How did you become involved in wealth management, privately and at Wharton?
CG: There are at least two dimensions–maybe three. First thing is I’d always been entrepreneurial. I had been involved in consulting problems in Chicago, and I even started developing trading strategies. I collaborated with a trader from the Board of Trade, and for a few years we ran quantitative equity strategies, I’d been involved in hedge funds and the investment space from a research and private perspective ever since joining Wharton, and I started the first class on hedge funds. I also became involved in the executive education area.
My research has always been practical and oriented toward the way the world works–corporate risk, management, factor models, hedge funds and equity lending are substantial parts. My research and outreach work have had direct impact in the real world. I’m proud to say I’ve always been interested in how the real world works–not just the mechanics but also the economics–and how it should work even if it doesn’t work that way.
On the Executive Education side, I was initially invited to teach at executive education by my colleague, Jeremy Siegel. I liked it and it gave me an opportunity to talk to people who are in the market quite often–for example, financial advisors and high net worth investors, portfolio managers, regulators, trustees, consultants. These people gave me a really interesting view into the market and what they were experiencing and thinking about it. It also informed my research and really allowed me to familiarize myself with the practical as well as the theoretical.
One of the agenda items for the Wealth Management Initiative at Wharton is to treat Wealth Management as a discipline. Wealth management is very, very diverse and it has many facets, so what we’re doing at Wharton requires a portfolio of approaches. Of course, wealth management involves portfolio management and wealth allocation, but it’s also involves questions of investor risk aversion and behavioral considerations. it also has to do with communication, marketing, management and entrepreneurship, family dynamics, taxation and asset location, legal structures and their consequences, public policy and the eternal problems of principals and their agents of all types…. and even engineering–for example we’re exploring programming in the area of infrastructure where certain ideas from engineering are critical–and government and government authorities and institutions. It’s not just this notion of wealth as how you to a trade–it’s very broad, in fact. To me that’s incredibly exciting. The breadth of the topic and the depth are almost daunting, but it’s at least very interesting, and that’s what’s driving me to it.
Shawn Baldwin: What was it like creating and teaching a course on hedge funds?
CG: I organized a conference on hedge funds with a colleague a few years ago, and during the conference Leon Metzger, a distinguished Wharton Alum and industry expert and I started talking about the fact that Wharton had no hedge fund course. So we basically created that class and co-taught it. Right now I teach investment management MBA students and undergrads. But I also teach regularly about alternative investments and hedge funds in our executive courses whereI direct a number of programs dedicated to alternatives and hedge funds and where I teach in broader terms.
Shawn Baldwin: Are you still teaching the hedge funds course for undergrads?
CG: No–we stopped and no one picked it up. There’s only so much time in a day.
Shawn Baldwin: What’s your involvement in the Wharton Wealth Management Initiative?
CG: We just launched it–its purpose is to really serve as a point of departure. We have organized our Wealth Management Initiative as having 3 components or parts, the first of which is of course to develop and get programming for financial investors and investors. The second involves aggregating, collecting, supporting and sponsoring research in wealth management and promulgating what Wharton has done for years as a leader in the components of wealth management. We’re trying to advance Wharton’s mission and vision and purpose of thought leadership in the space.
And it’s engaged in outreach–to Penn alumni and Wharton alumni and also to people in the industry and though leaders. In fact, we just finished a series of round tables on wealth management. We had one for high-worth investors, tough folks from financial advisories, broker-dealers, multifamily offices, some single family offices. What’s really important to note there is that we had folks from all over the industry and we had faculty presentations. For Wharton to hear what’s going on in the industry is so important at such a critical time in the industry.
Shawn Baldwin: Let’s shift gears a little. Can you talk a little about what you think caused the crisis and what sort of impact it has had or will have on the financial industry?
CG: It has engendered a tremendous shift in the way the industry is organized. It’s pushed further some of the trends already in place–for example, the number of professional financial consultants who are interested in becoming independent as opposed to being associated with a large firm has increased. Part of the shift has been motivated by investors have become angry with or distrustful of Wall Street. The brand of some firms at least for some time had gotten between the clients and their advisors. As a result, the industry is reorganizing itself. There will be increased regulation almost surely, and the notion of fiduciary responsibility very broadly construed will almost surely be put into place more broadly than it has been in the past.
The crisis has also fomented a lack of confidence on the part of investors and many of their advisors and in fact was itself was caused in part by lack of confidence, which has been so well covered in the press. If there is a bright side to some of this including situations like that of Bernie Madoff and others is that they have sped the movement toward transparency and openness, a continued shift from product to process which started in the last 10 years. Much of financial advisory will be about a service proposition as much as product. While a great deal of that change is ultimately due to the advent and application of modern portfolio theory, I think recent events will ultimately prove to have been pivotal. I think also you’re going to see government everywhere more–you see that already. The danger, of course, is that it’s probably easier to turn the government on than it is to turn it off, without even taking a political position on it. It’s just going to be part of how the US operates at least in the medium term.
Shawn Baldwin: What are your thoughts on the stimulus package? How do we get out of this mess?
CG: I think the Federal Reserve and Treasury have in a way done a good job that, while in the long run may force us to pay a hefty price, in the short run has moved the crisis from something that had a very substantial probability of being a worldwide meltdown to what is basically a deep-set recession in which we’re trading off some of the future for today. I’m very concerned that the magnitude of the stimulus is so large that it does raise the question of how we pay for it and what kind of incentives we are creating, however.
I think the big thing about the government experience and partially what sped the lack of confidence was the failure of Lehman. The government gets a bad grade for that, in my view. There were other ways it could have handled the situation.
Shawn Baldwin: To what extent do you think hedge funds and PE firms and other alternatives play into all this?
CG: I’ll give you the perfect economist’s answer: that depends. One of the most important things about the alternative space that is important to understand is that it encompasses an exceedingly wide range of strategies and risks. It’s very difficult to lump them all together in any meaningful way except around themes such as regulation or compensation. Those strategies are often very difficult to implement under US regulations like the Investment Company Act of 1940–restricting leverage for example. It’s also the case that while alternative trades and strategies may be very difficult to implement in “vanilla” investment vehicle form, they may also have very useful economic roles, including diversification of university endowments and pension plans. Alternative investments really become a question of asset allocation including the problem of what a portfolio should look like given some financial or non-financial goal. I think the role of what we now call alternative investments in the future will be strong. Certainly surveys that I have seen are reporting that, and institutional investors and financial advisors who have come through Wharton say that–and partly because investors have reassessed equity risk. At the end of the day, diversification across sources of risk and hopefully return is a part of the physics of the investment world. And for many investors including institutions, full diversification is broader than simply allocating to domestic stocks and bonds.
For instance, current institutional interest lies in investments like distressed debt, which in the US at least are very difficult to access outside a private fund context (like 144A securities). But that’s just one small example. There are many others. Another case in point is the area of infrastructure investment over which there exists a whole movement. Infrastructure investing (in toll roads, bridges, tunnels, airports, power generation, schools, hospitals, large-scale energy production and distribution, water distribution, etc.) which is often considered an alternative investment. And there are real reasons why infrastructure is a very important thing to think about in the US when framing the next 25 years of public policy. It may be an important asset class for investors who have large pools of cap and long investment horizons, so the private market may be right for those kinds of investments to take place.
Shawn Baldwin: Do you think we’ll have–or need–more transparency?
CG: Yes, although I generally believe that it’s best that that comes from investors and not from the force of government regulation. That may be somewhat counter-cultural to say right now, but I think history bears it out. We’ve already seen the government make important mistakes in lurching to regulate…for example, last October. The SEC prevented investors from short selling financial stocks. If the SEC bans or over-regulates the short sides of some of the trades thought to be useful in the private space, they’re making it more expensive or harder for investors to gain negative exposures or hedges. My view is that the short selling ban of 2008 will have proven to be much more costly than it was helpful.
That said, one of the areas where the government really needs to continue to spend resources is in reforming the prime brokerage and banking industries, yet again. For example, there needs to be, in my view, better tracking of aggregate risk and those that facilitate risk taking. The President’s Working Group issued some guidance several times in the last couple years connected to hedge funds, but the notions espoused didn’t really see practice when the crisis unfolded as quickly as it did. There have been many other proposals that have emerged. For example, there has been talk of requiring derivatives to be exchange-traded or cleared. Mandating the absolute that all derivatives be exchange traded is frankly rough to swallow from the perspective of a financial economist. It’s probably pretty important for things like credit default swaps to have some standardization, to have better price discovery, for example, but it’s not necessary for all CDS and certainly derivatives more generally construed to be exchange-traded.
Shawn Baldwin: How about advisor/investor relationships?
CG: I think investors are going to be more active in their own financial lives. I think they lost substantial faith in the advisory business. As a result, the advisory business has the task ahead of it of re-creating trust and acting in a way that will allow advisors to re-create that trust.
I also believe that the advisory industry will be more diverse in the future. You’re going to see a mix of models, with the industry becoming more fragmented from a service delivery perspective. There are going to be more do-it-yourself opportunities and as well as models like the multi-family office that will be extremely customized or more independent, at least prima fascia. That means investors are going to need more education, which is why I’m so excited about the work of the Wealth Management Initiative at Wharton. Investors are going to need more practical education in construing and managing their wealth, in thinking about how the concept of the family interacts with their wealth, about whether they can count on the government to be watch over their wealth, about new investment opportunities that will arise, about how to choose and interact with their advisors, all of which will be a multi-disciplinary activity.
You’ll see things like treatment of emotional intelligence in our courses—topics that you might not typically expect from a pure technical finance course. Our industry outreach work continues to uncover the need for advisors to have improved communication skills, business acumen, and to focus on emotional intelligence in order to connect and deliver service to clients, and we’ve responded to that need. It’s what some people consider to be soft skills, which are actually not that soft. The idea is about the integration of those “soft side” elements with the pure finance that we think is important for investors and their advisors alike. We still will do what our faculty has led the world in doing. We’re simply making important links across the various important elements of Wealth Management.
Shawn Baldwin: How do you think Obama’s presidency will affect all this?
CG: I think this president has a social mandate that I can’t remember another president in my life time having, even maybe Ronald Reagan, plus he has both houses of Congress. So I think he has a chance to be truly transformational at a deep level. Of course everything has a cost–I think he along with Congress is going to lead the transformation the financial services industry in an important way, although I think it’s a transformation that will not be without risk. For example, as I mentioned earlier, I think we need more monitoring of some derivatives.
Shawn Baldwin: You have often mentioned to me the idea of total balance sheet management. Can you explain this idea?
CG: Total balance sheet management is an issue that arises as a very practical matter in wealth management. A portfolio needs to be as broadly construed as possible. The notion of a portfolio, for example, needs to include family operated businesses, or capital that’s not very easily traded like an individual’s human capital, and can include private real estate, artwork–any asset that facilitates the transfer wealth through time. Total balance sheet management takes all assets into account, mapping everything that delivers coupons or cash flows against asset protection considerations, for example. All of that taken together I call total balance sheet management. It’s too often the case that you see an advisor manage only a small part of an investor’s portfolio, either because they haven’t been given the right to consider the entire portfolio or the data that are relevant for the task. The problem that you get is that the portfolio that’s being advised does not take all the risks present into account. In the recent crisis, for instance, we’ve seen that there was effectively a large amount of market exposure embedded in investor portfolios when considered broadly. And it got many institutions in trouble–you see that today where many institutional pension portfolios have become substantially underfunded.
Shawn Baldwin: You’ve also done some research on the idea of social responsibility–can you talk about your work and any conclusions you’ve arrived at?
CG: I’ve done some research with Rob Stambaugh, my colleague at Wharton, and David Levin, now a former student at Wharton. I think it’s the third most influential paper on social responsibility and investing, according to one met-analysis I recently read. In our work, we modeled the position of an investor who in a classical context wants to maximize expected rewards over risks in the form of the Sharpe Ratio by investing in domestic diversified equity funds and asked whether that investor could expect a shadow cost of investing only in socially responsible funds? The basic results were that you should expect some cost if you’re going to eliminate investment choices that weren’t fully ‘socially responsible.’ We found that those expected costs were very low in cases in which investors wanted to be market indexers, but if they wanted to be more diversified—considering small versus large caps, and value versus growth oriented funds, for example—they can expect to pay costs in the form of a constrained investment opportunity set.
The interesting thing is that the reason they could expect a worse expected investment result was that they would not be able to diversify adequately. Simply put, in our sample, there were just not that many value funds that you could characterize as socially responsible. You can imagine how much harder it is for value funds versus growth funds to appear as socially responsible, for example.. We found opportunity costs that were something like 30 to 40 basis points per month for reasonable parameterizations of our models. That’s potentially a big number when cumulated over a period of time. It’s important to realize, though that our work in no way represents a value judgment. We’re not saying that if you’re socially responsible, you’re making a mistake. Instead, we’re simply saying that those who invest in socially responsible mutual funds must see it as very important because they should perhaps expect an associated cost. And that’s ok.
It was a pretty controversial paper–defenders of social responsibility saw this as an attack. I think some in the industry had promulgated this idea that there’s no cost to be socially responsible. What we pointed out was that there’s likely to be a cost. It was a surprise that people were surprised.
Shawn Baldwin: You’re also involved with the Securities Industry Institute–can you talk a little about that?
CG: It was a great honor last year to step in for Jeremy Siegel act as the Academic Director of the Securities Industry Institute. It’s the longest continually-running executive education program in the world, to my knowledge. I don’t know if you’ve been on campus during spring break, but it’s a program we run in partnership with the Securities Industry and Financial Markets Association (SIFMA), which is one of the largest industry organizations. Between 600-700 investor professionals of all kind come back to Wharton for a week of classes–it represents a three-year program with different courses each year–and get really get tooled up.
As I mentioned, this year I stepped in for Jeremy, which was a bit daunting. Jeremy himself has led it for 32 years, and this year, it was at a time when the industry was in crisis. To let people know what programs will look like this year, we did a conference call which hundreds of people attended. I gave a short presentation on the economy, colleagues talked, as did financial professionals and advisors. You heard them saying, what do I do when everyday is a bad day? When clients are always angry? You hear the sobs in the background–it was a crushingly poignant moment. It was an honor to be part of the leadership team. Since I’ve taught in the program for nearly a decade, our friends at SIFMA and program attendees have kind of grown to be like family, but to be the Academic Director was a whole new thing.
Shawn Baldwin: How does your past work in the private sector impact what you currently do?
CG: It affects my view of nearly everything I am currently doing from research to teaching and programming at Wharton to other private sector work. To be around people who are at the vanguard in developing investment ideas in the real world that are just cutting edge is an incredible piece of feedback into my research and the modeling. I feel very lucky to have been able to straddle both academia and the private sector as a result.
Shawn Baldwin: Are you involved with any additional work at Wharton outside of your various job responsibilities?
CG: I’m still involved with students and am a faculty supervisor to Delta Sigma Pi, one of the coeducational business fraternities at Penn. I think I may have supervised more student independent study projects than most Wharton professors –maybe more than 100 projects over the years. I’ve found that that’s a good way to give back.
I’ve served on the Economic Advisory Board of NASDAQ, on a committee at the Chartered Alternative Investment Analyst Association (CAIA), as a founding Board Member of the Mid-Atlantic Hedge Fund Association, and on the editorial Boards of the Journal of Wealth Management and the Journal of Alternative Investments. From an educational perspective, those multiple sources of outreach are important because the industry is and its link with academia serves both sides. From a personal perspective, I focus on alternatives and markets. Those are all markets in transformation, and so being more involved on the industry side has been important. Having an industry standard, for example, in the alternative space with CAIA is, I think, incredibly important because of how heterogeneous and multi-faceted the alternative space is.
Shawn Baldwin: What about your personal interests?
CG: I have two kids, so I spend as much time as possible with them and my wife, Nichole. Our family is very important to me. It’s embarrassing to say, but I used to be a decent (and aspiring) musician. I used to play the trumpet and sing when I was a student at Penn. I have a continual yet apparently declining interest in being active in sports. I also have been involved in a number of commercial ventures over the years, mostly related to institutional portfolio management, wealth management and trading strategies.
Shawn Baldwin: Final question: when will the recession end–or has the worst already passed?
CG: Because of the policy and structural intervention that the government has pursued, and because it’s been more surprisingly coordinated here and around the world, it’s not going to be as bad as many initially expected and priced by the markets in the Fall of 2008. However, I have deep concerns. For example, I think pension plans are still in grave danger relative to funding levels. I think municipalities and local governments are in danger. Or as another, I think commercial real estate has yet fully to bottom out, and that certainly has consequences. For instance, if you talk to commercial real estate holders who are currently negotiating tax abatements, they’ll say, “I just negotiated down four cops’ jobs”. Of course, they have to do it because they’re running a business and they have responsibilities to their stake holders, but it’s not very easy. We have 10 percent unemployment and it may persist longer than many folks realize. In addition, the US consumer is still dead in the water. In a consumption-driven economy, it’s a problem.
I’m hoping you’ll see an end of the recession in 2010. If it’s in 1009 I’d be surprised, but I wouldn’t be surprised if there will be sectoral remnants in 2011 (or longer for some sub-sectors). We’ve seen some changes in economic direction where negative trends aren’t trending downward as quickly as they have been in the first part of the year. Some businesses are starting to turn around and we’re seeing some thawing, but the problem is that you could easily see a double dip recession or worse.
Consumer funding is still in extremely short supply, but also in short demand and consumption has been strongly curtailed. The retirement system is essentially underfunded from both private and public perspectives. Americans simply need to save more and spend less. We Americans don’t like to hear that. At one point in the last few years, in the US, we had a negative savings rate which went up recently but only because of the crisis. It needs to go up more, and I hope that it does.
Shawn Baldwin: So would you recommend investors and others in finance shift their focus to internationally?
CG: In some sense, perhaps, you can think of the US and Western countries as having transformed from growth to value. Emerging economies are much more volatile in many ways, but they don’t have the same problems that developing countries do with hangovers from overuse of leverage, low savings rates and the like. They generally don’t find their financial institutions in the same conditions as we do. In fact, countries like China to which some economists are looking as an engine for post-crisis growth, while not unaffected by the crisis, have grown in importance more quickly than they were before the recession. China’s already buying a lot of the financing of this situation. They may be an engine of not just growth in Asia but growth in the entire developed world. In any case, even in the short run, emerging markets are going to come out of it first, I think.
For more information on Dr. Geczy please go to the following link: