Swiss financial expert Rolf Banz says precision in asset allocation is an illusion. Predictions spanning five or seven year periods are hazardous, the father of the «Small Cap Effect» told finews.ch in an exclusive interview.

Mister Banz, with your thesis of 1978 you acquired the unofficial title of «Father of the Small Cap Effect», according to which small caps yield more than blue chips on the stock exchange. Why haven't you received a higher recognition for your work?

I have, in expert circles. You have to recognize that the thesis only applies to the long term. There have always been times when it didn't work. It is important to keep a very broadly diversified portfolio.

You can't simply replace blue chips with small caps. Small caps are important, but shouldn't be overestimated. A lot of investors say small caps are intrinsically better. But by purporting this they leave costs and liquidity of small caps aside.

You studied at the University of Chicago in the 1970s and briefly taught at this institute. You met quite a number of academic stars.

Yes, it was a most interesting time. The committee examining my thesis was formed by Myron Scholes, Merton Miller and Eugene Fama – they all later won the Nobel Prize. They didn't like my findings though.

Why?

When I studied in Chicago, the efficiency of the markets were not in question. My findings didn't conform with the «Capital Asset Pricing Model» (CAPM). The conclusion was that either CAPM was wrong or the theory of the efficient markets.

Harry Markowitz: «A Modern Day Saint»

I remember so well that Merton Miller during my presentation turned to Myron Scholes and whispered: «What's his mistake?» It wasn't easy for me to convince that something was true about my thesis.

In your doctoral thesis you said that the principle of efficient markets by Harry Markowitz doesn't apply at all times. Nevertheless, his model enjoys widespread popularity among institutional investors. Why is that?

Ever since Harry Markowitz was awarded the Nobel Prize in 1990, he's considered a modern-day saint. But his principle has to be understood in the context of when it was defined. In 1952, there was no computer power. His thesis was much more of a game, a game moreover designed for the equity portfolios.

The original book of his thesis is the only book I would ever have wanted to steal. For a long time, it was available at the University of Chicago with Markowitz' handwritten notes and additions. The achievement of Markowitz are extraordinary and without his work, a lot would have turned out differently in the financial markets.

You warned that the precision of Markowitz enticed pension fund managers to follow an illusion. Could you be more precise?

Pension fund managers are able to make pretty precise predictions about the passives in his balance sheet, because of the nature of the contributors. He knows exactly when a 35-year old will retire. The time horizon of the actives however is five to seven years. And that's where many pension fund managers assume a precision that is completely misleading.

What's wrong about it?

To propose an asset allocation with for example 42 percent bonds is absurd because it is impossible to predict something like that over the course of five years. You can be right, but you can also be completely wrong.

The pseudo precision is there to help the amateur board members of the pension funds to sleep well at night, because they can feel safe. But even the most precise assumption is an assumption that can be wrong.

Isn't it all about the proper diversification?

In principle yes. Compared with other countries, we have a lot of very small pension funds in Switzerland. Publica, the federal administration's pension fund, is an exception to this rule and has the means to diversify strongly. Smaller institution very quickly face the problem of the minimum investment.

«Smaller Funds Are at a Disadvantage»

I understand when these funds say they won't invest in anything «exotic», things they don't understand. Smaller funds are at a disadvantage compared with larger ones, both in respect to the asset allocation as well as costs. That's why the question about diversification is relative.

Given the enduring interest rate situation the problems will likely intensify. What do you recommend to do?

We will need to rethink and slaughter some sacred cows. I'm at an age where I profit from the young who indirectly work for me. In the long term, and if this low rate situation endures, I cannot possibly imagine that the sacred cow of pensioners rights will be maintainable.

Why not?

As soon as you're not able to meet your performance targets, pensioners will be called upon to contribute to the restructuring of a pension fund. The question will be how to avoid too much collateral damage.

Aren't you miffed about not having won the Nobel Prize, unlike your PhD-examiners?

No. The academic achievements of Eugene Fama are enormously broadly based. He moved empirical research to a remarkable new level. His work is extraordinarily well founded. At the age of 74 he remains a reputable and distinguished researcher. He earned his Nobel Prize beyond the shadow of a doubt. The same applies to Myron Scholes and Merton Miller.

Myron Scholes participated in the Long-Term Capital Management hedge fund, which collapsed in 1998 with the loss of billions of dollars.

Correct. It goes to show that even Nobel Prize winners can err.

Rolf Banz is one of Switzerland's best known financial experts. After studying engineering at the ETH in Zurich he went on to do research and to teach at universities across Europe and the States, notably at the Graduate School of Business at the University of Chicago.

Together with his wife and some partners, Banz founded an investment boutique in London, which they sold to Alliance Capital (today AB) in 1991. Later, he worked in various leading positions at Pictet Asset Management, whose chairman he remains to this day.

The interview was conducted at the end of October 2015 at the conference for professional asset allocation organized by Uhlenbruch publishing house.