Lo's lab offers lessons for investors

LONDON (Reuters) - Hedge fund manager Andrew Lo has spent the better part of his career applying complex financial theory to the real world but, coming from a family of scientists, says he was the black sheep for choosing economics.

The acorn didn't fall too far from the tree, however.

After moving from Taiwan to New York when he was five, Lo did poorly at elementary school due to mild dyslexia, but blossomed when his third grade teacher made him class scientist.

His first experiments included making a battery out of a lemon, but now, as chief scientific officer at his hedge fund company AlphaSimplex, he is trying to build fixes for some of the world's biggest investment problems.

"Academia generally isn't interested in application, and business isn't really interested in theory," he says. "But we try to apply our ideas to develop products. Having a great idea is a wonderful experience, but seeing it implemented is a rush."

After graduating with a PhD in economics from Harvard in 1984, Lo combined a career in academia with consulting projects for a number of Wall Street firms, helping them develop their proprietary investment products and trading technologies.

AlphaSimplex, the firm he founded in 1999, was acquired by Natixis Global Asset Management (CNAT.PA) in 2007.

The 49-year-old argues that there has been a seismic shift in investment in the last few years, and the old-school adages about diversification that have been handed down by academics to investors no longer hold water.

HEDGE REPUBLIC

To address this, Lo is taking hedge fund techniques to the masses through his hedge fund beta replication products. Sold to retail investors via the Natixis platform, these seek to capture common risk factors or "betas" of a broad group of hedge funds.

The aim is to provide the diversification benefits of hedge funds, but more cheaply, and with greater liquidity and transparency.

Lo -- tenured at Massachusetts Institute of Technology, where he is finance professor at the Sloan School of Management and director of the Laboratory for Financial Engineering -- is also working on active volatility management, to develop a kind of "cruise control" for portfolios.

Investors have typically controlled risk in their portfolios by allocating between stocks and bonds, depending on their age, investment timeframe and risk appetite. But in the last 10 years, stocks and bonds have become more correlated.

"That mechanism for controlling risk is just not sufficient," Lo told Reuters.

"Everyone lost out last year due to the tremendous volatility in markets. But the typical retail investor is left to their own devices in managing dislocation, and some product innovation is needed to help with this."

Lo's approach is to raise equity exposure when volatility is low and cut it when volatility is high, via futures contracts.

"This will change the way people invest -- the markets have become so unstable, we need to be smarter about the way we construct portfolios," he said.

An alumnus of both Yale and Harvard, Lo has also tried to reconcile the efficient markets hypothesis with behavioural economics, arguing that the fight or flight response is no use when we are threatened financially.

"The evolutionary mechanisms developed on the plains of Africa don't work very well on the floor of the New York Stock Exchange," he says.

PSYCHOHISTORY

He cites Isaac Asimov's Foundation series as a big early influence. This outlines the fictitious academic discipline of psychohistory, whereby mathematicians can predict the future using the law of "mass action".

"I became enamoured with the idea of using maths to predict the course of human evolution," he says. Lo is concerned that the existing financial market infrastructure is not up to the challenge of putting all the available investment capital to work, which could lead to further market meltdowns.

"One of the reasons market dislocation is more frequent is because we're getting in each other's way," he says. "We're in a very crowded space, and we have to be careful about the impact we have on each other. The largest ships have to go slowly or they create a wake, and even small ships struggle to move quickly in a crowded harbour."

To address this, he says regulators have to realise over-crowding is a permanent issue, not a temporary one of over-enthusiastic investors. "Over the next five years we will continue to see dislocation if this is not resolved," he warns.

Lo is perhaps better placed than many to spot where the bombs might drop. His experiments in third grade might have been small, but in adulthood he would build computers -- and model rockets:

"You have to calculate carefully where they will land," he says with a smile.

(Editing by Will Waterman)