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How to be a Smart Investor

Professor Lacey's academic work has led to over 50 publications in finance and economics. His work in interest rate risk management and control led to the development of higher order closed form solutions for duration and convexity.


Nelson J. Lacey is the Director of Examinations for CAIA, a position he has held since 2004. In this role Professor Lacey directs a team that is responsible for managing the exam process from creation to post exam analysis. Professor Lacey also directs the CAIA grading sessions (or Grading Jamborees, as they've come to be known), when members of the Association come to Amherst to evaluate Level II candidate essay responses. Professor Lacey has been with the CAIA Association since inception, and, as CAIA’s first Director of Program, he was part of a small team that launched the Association through the creation of CAIA’s curriculum and study guide.

In an interaction with BW Disrupt, Nelson Lacey, PhD, CFA Director of CAIA Examinations, speaks about ‘How to be a smart investor’.

How has been your journey with CAIA so far?

As one of the founders of CAIA, I’ve been engaged in finance education throughout a career now in its fourth decade. My main areas of research span corporate finance and investments, mostly in the direction of the dissemination of information, and how the flow of information impacts the investor.  For example, in one study I found that the equity value of a particular branch of technology firms is tightly dependent on signals of new product development.  From my experience, the smart investor, whether they be institutional or retail,should spend the requisite time to become aware; aware of an asset’s sensitivity to outside factors, aware of a portfolio view, and aware of not only the risk bearing attributes of the asset class but aware of one’s own proclivity to take risks.

As high net worth investors (HNIs) constitute a major part of your client base, how do you help them become smart as well as profitable investors?

It should be first noted that high net worth investors are sometimes referred to as accredited investors. Thus, it is assumed that the HNI has the requisite knowledge and experience to be exposed to the full spectrum of risk. A corollary is that the regulator need not watch over the HNIs portfolio with the same vigilance offered to smaller retail investors. In other words, these institutional investors are already assumed to be smart.

The CAIA Association’s main mission has always been to increase investor IQ. We do this through pedagogy built on a careful development of each of the asset classes we cover. Let’s for example consider hedge funds.  By first noting that hedge funds are really just a set of investment strategies, CAIA explains each trading strategy in depth, places each strategy in the context of expected returns and risk, describes the necessary due diligence, and finally reports historical performance over rising and falling markets to gain portfolio perspective.

This addresses the “smart” part of the question, but what about the “profitability” part. While all investors are return seekers (i.e. looking for high profits), at CAIA we take great care to separate the notion of an expected return with that of a realized return.  An expected return earns a return commensurate with its risk.  Earning a higher than average expected return is what is referred to as “alpha” or the extra return that comes with skill.  The message at CAIA is that investors who believe they have earned alpha through skill based investing should be able to understand where the extra value is coming from, and to realize that alpha is likely to deteriorate through time.

What should be the focus of the retail investor while investing in the capital markets?

This is an interesting question, and is well placed with respect to the contrasts between retail and institutional investors.  Small investors are not inherently different than large investors.  Both are looking generally for the same investment characteristics, such as being return seekers and risk avoiders.  But one of the biggest differences is the role of the regulator. It was noted earlier that institutional investors have assumed knowledge and thus accept the responsibility to self-regulate.  Not so for the retail investor.   Major regulatory platforms, such as the Investment Company Act of 1940 in the USA and UCITS in Europe, govern the amount of leverage, concentration, and liquidity that must be maintained.  The result is that the retail investment advisor must adhere to these constraints.

The result is that, in general, there is not much intersection between the specific investment universes of the retail investor with that of the institutional investor.  This, however, is, changing.  For example, the appearance of liquid alternative investments that seek to provide the retail investor with a new class of investment choices has emerged. Some hedge fund trading strategies (e.g. equity long short and global macro) can be delivered within the constraints of the aforementioned regulatory acts.  CAIA has been following liquid alternatives with interest, and has generally found that they are being managed as advertised, and provide good diversification potential.

In summary, retail investors, like all investors, seek to earn a return commensurate with the risks taken.  A long term view and one that provides portfolio diversification has provided solid historical performance over the previous fifty years, and should take the same focus going forward.

What asset classes should the smart investor be most interested in?

I believe that CAIA has much to say about this.  If you look at what might be the most typical long-term investment portfolio – 60% in equities and 40% in fixed income – you can see why alternative investments have added much to this story.  Here at CAIA we’ve run hundreds of simulations over very different historical periods and have shown why diversifying outside this typical 60-40 portfolio is indeed a smart strategy.  Take a look at this one recent example over the latest eight year time period:

January 2008 – February 2016

Average Return

Standard Deviation

Correlation to Equities

S&P 500 Index



JP Morgan Global Bond Index




60% Equity, 40% Bond



Managed Futures Index




60% Equity, 40% Managed Futures



As you can see, the benefit of diversifying into alternative asset classes can result in higher realized return (5.88% versus 5.65%) and lower volatility (11.14% versus 12.19%)!  The magic of this result comes from the fact that the particular alternative investment strategy shown, managed futures, had approximately zero correlation to equities over this time period.

Of course, this is just one (relatively) simple example of why investors are smart to consider building portfolios across many different asset classes, such as real assets, private equity, commodities, hedge funds, and structured products.  As Markowitz taught us all, diversification can offer the “free-lunch” of adding return without adding risk.

How would you distribute Rs 100 into different asset classes?

I must admit this is a difficult question to answer.  I would want to know the type of investor that I’m advising, the universe of choices that I realistically can mobilize, the investment horizon, and perhaps even the tax regime that I’m operating under.  But let’s consider a retail investor that is asking for some “smart” portfolio allocation over a one-year horizon that does not have any unique or special requests.  Here are a few allocations with very interesting characteristics (note that UCITS are liquid alternative investment strategies that adhere to UCITS regulations):

January 2008 – February 2016

Average Return

Standard Deviation

Maximum Drawdown

60% World Equity, 40% Global Bond




50% World Equity, 40% Global Bond, 10% UCITS Equity Long Short




50% World Equity, 40% Global Bond, 10% UCITS Fixed Income




50% World Equity, 40% Global Bond, 10% UCITS Volatility




The main point in showing these data is not to find the best combination of risk and return, as these are time period specific, but instead to point out that even retail investors can access interesting combinations of traditional and alternative investment choices.If I were a retail investor, I’d be very interested in an asset allocation that goes beyond traditional investment choices.

So now let’s consider the institutional investor.  Given the maximum flexibility enjoyed by accredited investors, the choices available are quite diverse, potentially complex, and in some cases very attractive.  I offer as one example the significant change in the investment landscape of university endowments that have embraced the private equity asset class and have achieved (in some cases) terrific results over many years’ time.  The same can be said for other illiquid asset classes, such as commercial real estate and infrastructure.

What are the common characteristics you have seen over the years in a successful investor?  Are the qualities in-built or can they be learned?

This is a great question and one that I have rather strong personal views.  If I may digress for a moment, I’m a believer in the “10,000 hour” rule made popular by Malcolm Gladwell in his book “Outliers”, where the key to achieving success using any type of skill, whether it’s playing piano, hitting a baseball, or finding alpha in investment arenas, comes with a prerequisite of 10,000 hours of practice.  And so I’m skeptical in the idea that good asset managers were born with these skills.

More to the point, given the sums of money at stake, it is generally the case that large numbers of people are looking for a piece of the action, creating what economists refer to as “efficient markets” which makes the task of long term success even more difficult.

The other part of your question asks whether these skills can be learned.  I believe that the foundation of knowledge necessary for success can indeed be learned.  This would be the “necessary” condition, and is the very genesis of the CAIA Association.  The founders of CAIA held the belief that there exists a knowledge gap in the area of alternative investments, and our main mission is to fill that gap.  In a nutshell, this is what CAIA does in its charter program.

But to fully answer your question, I would state that while knowledge is necessary, is it not sufficient.  Personal characteristics such as perseverance and drive, communication, examination, evaluation, and intuition all combine with knowledge in ways that cannot be described in a textbook. And so I believe I can list these characteristics, but cannot describe or explain how they come together to create the successful investor.

I’d like to end by saying that the Indian market, while having developed quite strongly in particular areas, has great capacity in other areas such as alternative investments.  CAIA has always believed this to be true, and has made a commitment to expand its resources in India to do what we can to help these new markets gain acceptance.  I thank you for the opportunity to help advance CAIA’s role at this important time.

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