Robert C. Merton Shares Some Common Sense Advice for Index Investors and Robo-advisers

Over the years I have been quite disappointed with investment research provided by academia. The majority of this research mines some data, wraps it with some pretty mathematics and presents it to the world in a format that very few can understand. One group of people who can understand this research refer to themselves as “financial engineers.” It is this group that takes a look at the research, determines if the research has some marketing qualities and, if it does, creates or engineers a product that can be sold to us, the investors. Most of these products have little chance of creating long-term wealth for us, but they can easily give a short term boost to the profits of the sponsors of these engineered products.

Even though we take a dim view of most academic investment research, every so often someone comes along whose research changes the world. This is an exception, and these individuals are for the most part richly rewarded for their work. One of these individuals is the subject of our letter this month, Robert C. Merton. Dr. Merton and Myron Scholes were awarded the Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel in 1997 for their pioneering contributions to continuous-time finance, including the first continuous-time option pricing model, the Black-Scholes formula. This work truly changed the world of finance.

At this point, you probably expect me to provide you with details and maybe even a little math or a couple of graphs to wow you with my knowledge. However, if I did, the majority of you would promptly crumple up these few pieces of paper and throw them in the trash, which would be appropriate, as my attempt to wow you would just prove how little I really know. Understanding how much we don’t know is a trait I believe I share with Dr. Merton, which we will explore shortly. First I want to share another non-investment related tidbit regarding an interest Dr. Merton and I happen to share as well. In the biography Dr. Merton provided to the Nobel Prize Organization, he spoke of one of his joys as a young man:

As I had known all the batting averages and pitching records of big league baseball players, so I came to know the horsepower, cubic inches of engines size, and other detailed specifications of just about every automobile in the post-war era. Going to auto shows and stock car races and handing tools to older, amateur buffs working on their cars were outlets for my passion until, at age 15, I bought and rebuilt my first car. After getting my driver’s license, I built street hot rods which I raced at drag strips in upstate New York and Long Island.

Finding ways to push a little more air or fuel into an internal combustion engine provides real satisfaction for the builder. If done successfully, the reward comes from being shoved back into your seat under hard acceleration, the sound of the exhaust as the engine reaches towards maximum power, and the adrenaline rush that comes from a combination of fear and extreme pleasure. Yes, Dr. Merton received praise and adoration as a Nobel Laureate, but I would wager a dollar or two that his youthful pursuit of speed also ranks very high on the joyfulness scale of his life.

In April of this year, Dr. Merton participated in a panel discussion along with Dr. Andrew W. Lo, Seven A. Ross, and Jeremy Siegel at a meeting of the Q Group. The topic was “Looking to the Future,” and the discussion was moderated by Martin Leibowitz. It is fortunate for us that this discussion was reprinted in the Financial Analyst Journal, a publication of the CFA Institute. All of the participants are leaders in the academic or practicing field of finance and each, in their own way, has influenced the world.

The Q Group was started in 1966 by Dale Berman. From its beginning, the intention of the group was to explore the application of “Modern Capital Market Theory” (MPT) as theorized by Harry Markowitz. Q is the first letter in the word quantitative, which is an appropriate term to describe the group’s purpose. However, I like to believe that Dale Berman was watching a James Bond movie and admiring the antics of Bond and the special assistance provided by Q. Q, with his Q Branch cohorts, created memorable gadgets that saved Bond and the world. Maybe Berman wanted to do the same in the world of finance. What better way than by assembling a group of exceptional quantitative wizards who could create financial gadgets to save each and every investor?