Two friends of ours — both of them also former colleagues — are getting married later this month in Florence, Italy. Our flight is booked, our rooms reserved; our three-ounce bottles await inspection by counter-terrorism experts. We’re looking forward to the wedding and to the week or so that we plan to spend in the Cinque Terre and Verona.

But at some point, we feel that the time we have spent preparing for the trip has surpassed the time we’ll actually spend in Italy. Is there no escape from the hamster ball?

We know what you’re thinking: our butler, Baines, has once again made a hash of our travel arrangements. And you’re right — he has us changing hotels every two or three days, and we suspect at least half of those reservations exist solely in Baines’ imagination.

But there is another force at work here, as well, and one that we think connects to an observation made by Peter Bernstein in the current issue of CFA Magazine.

Modern Portfolio Paradox

Bernstein is a jack-of-all-trades investment guru: part practitioner (through his consulting firm), part academic (through his ongoing editorship of The Journal of Portfolio Management, and as an ex-professor), and part investment populist:

       

Bernstein’s recent essay, “Capital Ideas in Today’s World,” opens with this startling observation:

When I first set out in mid-2004 to write a follow-up to Capital Ideas… I was confronted by a paradox. Not a single theoretical advance had appeared in finance since the development of the options pricing model in 1972. Amazing!

We agree. In the early days of financial engineering, practitioners were selected from graduate-level physics programs, theoretical-physics labs, and other exotic corners of sometimes ivy-covered geek factories. But the field expanded as rapidly as it grew, and the curricula of traditional university-level math departments kept right up. Today, investment banks and hedge funds need not plumb the dateless ranks of university science departments to find the quant skills that will help them lose billions in subprime mortgages. Those skills may be had directly from the math and engineering programs.

So the Black-Scholes baptism of modern portfolio management has had its full effect not just in the field, but in the universities. The transformation has been broad and deep; the level of quantitative knowledge at work in finance has never been greater; the number of qualified professionals, never higher.

So where is the innovation? Where are the “theoretical advances” that one might expect to develop out of all this sophisticated, well-funded quantitative finance, both among the practitioner ranks and in the university “feeder” and research programs?

We can’t unriddle this paradox of Bernstein’s. We have long felt that as science, and not just finance, continues making ever greater advances, fewer people seem to understand the basic concepts on which these advances depend. (She can buy the most advanced mobile-communications device ever made, but she can’t calculate the change back from a hundred. The smart get smarter and the dumb get credit cards.)

But the sheer number of competitive, well-educated, well-funded practitioners currently at work should, one might think, yield the odd eureka moment every generation or two. No?

Maybe that’s an unrealistic expectation. Or maybe these advances have happened, are happening — just not in the light of day.

Black Boxes

If you were to come across a neglected, overlooked doctoral thesis, put forth by an unknown graduate student working decades earlier — and it laid the conceptual groundwork for the application of stochastic calculus to financial markets in such a way as to demystify, to some extent, the behavior of stock prices — what would you do? Would you put the title back on the shelves of the University of Paris library? No.

Would you write an article for the Financial Analysts Journal, in hopes of attaining some measure of academic recognition? Maybe at one time, but probably not anymore.

Most likely, you would forgo a shot at the Nobel prize in exchange for wielding your newly discovered information advantage in the market. Assuming you had a little business savvy, you might seek to establish enough of a track record to entice an emerging-funds sponsor to raise “seed” capital in exchange for 25% of the general partnership. Whatever. But that FAJ article would not be high on the list — especially for non-academics or think-tankers for whom recognition in the realm of academia is out of the question, anyway.

None of this is lost on Bernstein, who points out how even the great theoreticians of modern finance are currently shucking and jiving for non-academic rewards. Or, as he puts it in the subtitle: “The focus in modern finance has shifted from theory to implementation.”

Ars Gratia Pecuniae

Which is enough to leave one wondering about the great financial innovations that may have been made, proven and refined, codified and back-tested; and which even now, quietly, are leveraging an information advantage to grind out returns for their owners and investors.

Or not. Perhaps the widespread practice of quantitative finance should no more be expected to lead to true innovation, just because it’s widespread, than growth in the popularity of feminist literary criticism, say, should have been expected to yield true insight. Maybe the very competitiveness and corporatization of these skill-sets, and the hamster-wheel quality of modern finance careers, make the opposite expectation just as compelling. But as a model — an expectation — it is accurate to expect the kind of innovation that grew out of Bechalier’s doctoral thesis (the rotting book in the University of Paris library, referenced above) to stay hidden in black boxes today, where in different times it found the light.

In any case, it will give us something to ruminate on as we fall asleep under the stars outside the train station in Corniglia, because Baines foozled our booking. ♦