by Mark K. Bhasin, CFA
James Owen Weatherall, Assistant Professor of Logic and Philosophy of Science at the University of California, Irvine, tells the story of physicists in finance in The Physics of Wall Street: A Brief History of Predicting the Unpredictable. He begins by describing the extraordinary success of Jim Simons, a physicist and the founder of the hedge fund Renaissance Technologies. Simons's Medallion Fund earned an unparalleled 2,478.6% return from 1988 to 1998 and a 73.7% return in 2007. Approximately one-third of Renaissance employees have PhDs — not in finance but, rather, like Simons, in such fields as physics, mathematics, and statistics. According to an MIT mathematician, Renaissance Technologies is the best physics and mathematics department in the world. That, say Simons and others, is why the firm has excelled.

Weatherall explores how the quants came to be and how to understand the "complex mathematical models" that

by Ron Rimkus, CFA

There are lots of reasons that a bubble might occur. One often suggested reason is that animal spirits are to blame. As humans, sometimes we investors simply can't resist the temptation to participate as an asset's price starts moving upward. Can this explain market phenomenon like bubbles? It's possible. But it is far from the only explanation.

An important question to ask, let alone answer, is: How much of a bubble is caused by "irrational exuberance," and how much is caused by government intervention? Because government intervention into markets distorts the natural balance between supply and demand, it is an obvious place to start. So, any serious discussion of bubbles must ultimately separate investor behavior from government intervention. Importantly, government interventions into the economy distort price signals that market participants need to make decisions about where and how much to invest. So, much of what

By Matt Waldron, CPA

“Sunlight is said to be the best of disinfectants.” – U.S. Supreme Court Justice Louis Brandeis

As the Public Company Accounting Oversight Board (PCAOB) marks its 10-year anniversary since its formation under the Sarbanes–Oxley Act (SOX), investors should be reminded that, under this law, public disclosure of pending disciplinary actions against audit firms is restricted. Under SOX, the PCAOB is prohibited from disclosing the identities of audit firms and auditors accused of wrongdoing while disciplinary proceedings are underway. This delays providing meaningful information about investigative matters to investors who rely most on the audits.

In the meantime, the auditor is free to serve existing clients and even acquire new clients who are unaware of the serious allegations that auditor is facing. The auditor, on the other hand, is incentivized to drag out the proceedings for as long as possible. This does not serve the investing

By Linda Rittenhouse, JD

When former SEC Chairman Mary Schapiro was unable to muster the votes needed for a money market fund reform proposal, the Financial Stability Oversight Council (FSOC) stepped in to address what it considers the funds’ potential systemic risk. Whether the SEC’s recent proposal will be enough for the FSOC to now defer to the securities regulator for a final resolution remains to be seen.

Under the guidance of new Chairman Mary Jo White, SEC commissioners last week voted unanimously to propose for public consideration and comment reforms to the current money market fund regulatory scheme that are aimed at reducing the risks that a fund’s “breaking the buck” would cause a run on money funds industrywide (the so-called contagion effect). Under the proposal, the public is asked to consider two approaches that could be implemented alone or in tandem:

• Floating NAV:

By Jason Voss, CFA

Our intial discussion with C. Thomas Howard about his ”Behavioral Portfolio Management” has done so well we thought you would like to read more of the discussion about how to deploy behavioral finance practically. Particularly germane to implementing behavioral portfolio management is understanding Howard’s views on emotions and volatility, and how he handles them when managing money. Recall that Howard is professor emeritus at Daniels College of Business, University of Denver, and co-founder of AthenaInvest, whose Athena Pure Valuation is one of the top performing portfolios in recent years.

CFA Institute: So when you are implementing your behavioral portfolio management you are equating emotions with irrationality and with volatility?

C. Thomas Howard: Yes, short-term volatility is largely the result of emotional investor overreaction to unfolding events. But this is not unique to me, it was first proposed by Robert Shiller over

By Kurt Schacht, JD, CFA

Could this really be “The End” of this saga? Not just to rotten movie sequels but to sequentially rotten treatment of investors. The ever-growing avalanche of news stories reporting mega-billion-dollar client withdrawals from Steven A. Cohen’s once proud $15 billion SAC Capital have reduced it to a mere shadow. To hear tell, nearly all outside client money is being pulled, reducing the once-stellar hedge fund to essentially the Cohen family office. Does this offer the tantalizing prospect that the times may be finally, and perhaps significantly, changing?

From mighty Blackstone (BX) and its handling of $40 billion in pension funds to Magnitude Capital and the $3 billion in hedge funds it manages, several major investors have notified SAC of redemptions and withdrawals, as SAC navigates the treacherous shoals of federal prosecutions for alleged insider trading, news reports indicate. Prosecutions focus on insider information

By Lauren Foster

In May, when the Dow Jones Industrial Average closed above the 15,000 milestone for the first time, the Washington Post ran a story with a seemingly innocuous question: “The Dow’s cracked 15,000 and the S&P is at record highs, so it’s time to pop open the champagne and celebrate, right?”

The sober response: No.

“We face a jobs crisis, a schools crisis, an immigration crisis, an infrastructure crisis, an inequality crisis and a college affordability crisis (just to name some current favorites),” wrote Matt Miller. “But the sleeper crisis, the Next Big Shoe To Drop, is the retirement crisis.”

Whether or not we call it a crisis, the situation is dire.

On the same day the Dow hit its new high (7 May 2013), Larry Fink, chief executive of BlackRock (BLK), took to the podium at New York University Stern

by Mark Harrison, CFA

Quantification, in an earnest endeavor to get something as slippery as risk under control, has exercised and almost exhausted some of the finest minds and most advanced technologies of a generation. Even so, the efforts of some financial institutions to quantify value at risk (VaR) and other uncertainties, and to establish an effective culture of risk management, have blown up spectacularly at both an organizational and a portfolio level.

One explanation suggests that changing the risk culture of some organizations is about as easy as getting captive pandas to breed. Risk strategies within organizations and in the field of policy and regulation can actually lead to the incubation of paradigm blindness, or unquestioning adherence to one dominant but incorrect point of view, which prevents effective interventions. An organization in which the decision-making process is driven by unquestioned consensus is doomed to failure. By analogy, inflexible

Reviewed by Martin S. Fridson, CFA

Eugene Fama, whom many regard as the father of modern finance, was asked in a May 2012 interview what he thought was the cause of the 2007-08 financial crisis. Fama replied, "I think the global crisis was first a problem of political pressure to encourage the financing of subprime mortgages. Then, a huge recession came along and the house of cards came tumbling down." This not-unconventional assessment is precisely what Yale economist Gary B. Gorton seeks to refute in Misunderstanding Financial Crises. He argues that the latest crisis resulted from the same phenomenon that has triggered most financial crises -- namely, a bank run.

Economists failed to foresee the bank run and did not recognize it when it happened, according to Gorton, because they were using obsolete definitions of "bank" and "money." In today’s economy, he writes, not all banks are depository

By Rhodri Preece, CFA

The European Securities and Markets Authority (ESMA) recently published its evaluation of the impact of the European Union’s short-selling regulation, which came into effect on 1 November 2012. The regulation imposes transparency requirements on the reporting of net short positions in stocks, sovereign debt, and sovereign credit default swaps (CDS). It also prescribes a mandatory “locate” rule for short sales and bans uncovered or “naked” sovereign CDS transactions.

Although the regulation has only been in place for a short period of time (a caveat acknowledged in the report), ESMA’s evaluation reveals some interesting findings. On the positive side, the incidence of settlement fails has fallen. However, the regulation appears to have had a mixed effect on market liquidity, and a negative effect on the efficiency of price discovery. There have also been mixed effects in sovereign CDS markets. All in all, these findings are

By Christopher R. Pavese, CFA

Earlier this month, we outlined our investment thesis in shares of Hospira (HSP), which can be found here (PDF). Since publishing our report, HSP has appreciated rapidly over the past few weeks on light news flow. While we are pleased with the recent action in the shares, we see far greater upside potential in this high-quality business as the company's true earnings power, currently depressed by temporary regulatory issues, is discovered by investors over the next few years. By this time, HSP is likely to be changing hands at significantly higher levels, so we would encourage investors to do their work up front. As Michael Price said at this year's London Value Investing Conference, "An investor should spend all of his or her time working on calculating intrinsic values, waiting for the market to throw out an opportunity. The definition of luck is

Reviewed by Ronald L. Moy, CFA

In 1602, Vereenigde Oost-Indische Compagnie, otherwise known as the Dutch East India Company, became the first modern company to issue shares to the public, thus launching the first initial public offering (IPO). Nearly two centuries later, in 1782, the Bank of North America became the first IPO in the United States.

Over the next 200 years, a number of high-profile IPOs, such as Ford in 1956 and Genentech in 1980, captivated the investing public, but these headline-grabbing deals were comparatively rare events. On 9 August 1995, however, all that changed when Netscape ushered in the dot-com boom. The success of Netscape’s IPO, the commercialization of the internet, and the growing number of 24-hour news channels hyping IPOs created a frenzy as the investing public eagerly looked forward to the next big offering.

Despite the enormous success of IPOs by Netscape, eBay, and Amazon.com, initial

By David Schawel, CFA

As the market debates whether the Fed should “taper” the pace of QE asset purchases, an uncomfortable truth is beginning to face market participants. With the majority of QE benefits already having been felt, the tapering of QE is inevitable at this point and the market’s reaction, when it occurs, will not be pleasant. We will look at what the market is pricing in, how QE has impacted the economy thus far, and why it’s time for the Fed to stop incremental purchases.

1. Tapering of QE is being priced in. One of the major goals of the Fed when implementing QE was to reduce “real interest rates.” Market participants observe real interest rates through the TIPS market. Each given interest rate is made up of the nominal rate less the breakeven rate. The breakeven rate tells us how much inflation is being built in.

by Julie Hammond, CFA

"I see many similarities to 2006 and 2007 in the credit markets today," Edward I. Altman, professor at the Stern School of Business at New York University, said when speaking recently at the 2013 Asset and Risk Allocation conference in New York. A highly respected researcher of the high-yield bond markets, Altman took the audience through his analysis of current economic conditions and his outlook for corporate and sovereign credit markets. Altman presented his new research on sovereign default risk. "When you think about credit risk today, sovereign default risk is the number one concern for investors, while the corporate bond market has been relatively benign since 2008–2009."

Altman outlined what he believes are the major risks for 2013 (and beyond) that could negatively affect both bond and equity markets:

1. Size of the Fed's balance sheet, the impact on the money supply, and

By Charlie Henneman

The notion of socially responsible investing (SRI) has been with us in some form for a very long time, but as a professional category of investing, it has faced challenges of definition, not least because social responsibility is to some degree a subjective term (as competing political parties are all too willing to demonstrate). Even when we agree on what the goals for SRI ought to be, the other challenge is finding an investment thesis that allows professional money managers to meet their fiduciary obligations and achieve returns sufficient to avoid losing clients.

These challenges may explain why the naming convention for this style of investing has migrated from SRI to "ESG investing," the short name for "environmental, social, and governance" factors, and now, more often than not, "sustainable investing."

A passionate talk entitled Sustainability: An Investment Perspective at the 66th CFA Institute Conference in

by Rebecca Fender, CFA

The financial industry today faces a crisis of confidence that threatens its future. Without trust, markets don't function properly and growth prospects are limited. So what can the financial industry do to change its trajectory? A panel at the 66th CFA Institute Annual Conference in Singapore, moderated by CFA Institute CEO John Rogers, CFA, provided some answers:

Investment professionals must truly believe that client interests come first — and act accordingly. As Mark Delaney, CFA, chief investment officer and deputy CEO of AustralianSuper, the pension fund, stated, "The first thing is that it's always someone else's money." He urged the audience to think about how they look after other people's money and what goals their clients need to achieve. As an industry, he observed, the investment profession has lost sight of that purpose and replaced it with self-interest.

Fred Hu, chairman of

By Julie Hammond, CFA

In 300 BCE, Euclid developed the concept of mathematical “proofs” using deductive reasoning to uncover truth. Several thousand years later, in his search for economic truth, Grant Williams, portfolio manager and strategy adviser for Singapore-based Vulpes Investment Management, laid out four mathematical “proofs” at the 66th CFA Institute Annual Conference that address the disconnects and incongruities between financial markets and the global economy.

Problem #1 : If we have a global economy that is barely growing, why are major equity markets hitting all-time highs?

With the global economy limping along at 1.4% growth, Williams identified the disconnects between the underlying fundamentals and equity prices in major countries. Manufacturing and trade indicators (in the United States, the eurozone, United Kingdom, Japan and China) are stalling, including the Purchasing Managers’ Index (PMI), the Baltic Dry Index, and the U.S. Macro Index. About 25% of

Reviewed by Martin S. Fridson, CFA

Consider the following:

• The food-locating strategy used by Native American hunters and Norwegian fishermen is the same as that used by ants.
• Human neurons operate several orders of magnitude more slowly than silicon chips.
• There is evidence that Islamic physicians in Morocco treated mental illness as early as the eighth century.

These are not facts that business schools typically expose their students to. But in Investing: The Last Liberal Art, Robert Hagstrom maintains that the knowledge conveyed in a liberal arts curriculum begets wide understanding that improves investment skills. Hagstrom's success in the profession -- he is senior vice president and portfolio manager at Legg Mason Capital Management -- makes his opinion on the subject worth considering.

Lest investors miss the relevance of studying the disciplines for which Hagstrom provides overviews (physics, biology, sociology, psychology, literature, and mathematics), he connects a few dots.

Reviewed by Mark K. Bhasin, CFA

John Coates, senior research fellow in neuroscience and finance at the University of Cambridge, offers a number of fascinating lessons from a booming new field, the biology of risk, in The Hour between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust. He reveals how risk taking and stress transform our body chemistry, driving us to irrational exuberance or pessimism. He asserts that under some circumstances, the chemical surges can overwhelm us, and when that happens to traders and investors, they tend to suffer either euphoric overconfidence or extreme timidity.

Coates contends that these extremes can destabilize the financial markets and wreak havoc on the wider economy. In this reviewer’s opinion, it is reasonable to conclude that this overconfidence could contribute significantly to market bubbles. Conversely, it is also reasonable to conclude that traders and investors may

By Daniel Kim, CFA

Generating new investment ideas is a process that is usually glossed over and generally underemphasized in money management. But it is also an area investors take great pride in. Naturally, this pride leads to the formation of investment biases, which have adverse effects on this important first step of the investment process. For some reason, most people consider themselves exceptional stock pickers, no matter how poor their historical performances have been or how little they actually know about investing. In a more extreme example, a large portion of the middle-aged housewife population in South Korea spend the day at home trading online. Almost all of them consider themselves on par with the top fund managers because of their natural talent and superior market timing capabilities. In the United States, the usual “talking heads” in the media love to barrage us with self-gratifying commentary about their previous