A few years later, Dr Wadhwani was a postgraduate student working on a thesis examining why P/E ratios were so low. Influenced by the work of Nobel Prize-winning economist Franco Modigliani, who was exploring the same issue, he published some empirical work linking the low P/E ratios with inflation. This caught the attention of Gavyn Davies at Goldman Sachs, who offered Dr Wadhwani a position as a consultant. “Prior to that I thought I would remain an academic,” he says. “But I started doing some research for Goldman, including creating quantitative models, and I found I rather enjoyed it. One day they asked me if I would join them full time and soon after that I took up the position of director of global equity strategy. Obviously, I was delighted.”
Dr Wadhwani has been involved in quantitative modelling for more than 25 years now, successfully combining academic research with practical application. Between 1999 and 2002, he was a full-time member of the Bank of England’s Monetary Policy Committee, where he gained exposure to a range of different approaches to modelling. “It was fascinating to see how people on the inside did their modelling and witness the multiplicity of models they used,” he says. However, he admits that this ‘multiplicity’ frequently led to conflict. “Those meetings used to get very fraught – it certainly wasn’t a tea party. People were very passionate about what they did, and it’s then inevitable that people will disagree because they all believe that their own views are the correct ones.”
In 2003 he established Wadhwani Asset Management, a London-based asset management company that specialises in systematic macro investing. The company’s approach fuses Dr Wadhwani’s two chief passions – quantitative modelling and Keynesian economics. And it is an approach that has borne considerable fruit: since the models began trading over 5 years ago, the US dollar class of the company’s offshore strategy  has achieved annualised compound growth of 11.7% , with an annualised standard deviation of 13.6% . Over the same period, the MSCI World index gained 3.1% per annum with a standard deviation of 17.3%.
In partnership with Dr Wadhwani, GAM launched a UCITS III product on April 6. The strategy aims to produce attractive net absolute returns using trading strategies to invest in equity and fixed income markets globally. Although it will be run as a separate entity to Dr Wadhwani’s offshore strategy, it will incorporate the same combination of Keynesian economics and quantitative modelling.
The influence of Keynes stems from Dr Wadhwani’s days as a student and remains core to his investment philosophy. He cites Keynes’ rejection of the idea of perfectly efficient markets as being particularly influential. “Keynes recognised a long time ago that most of the decisions we have to make are made in situations which almost resemble pure uncertainty – and I mean uncertainty in a Knightian  sense, not a measurable risk sense,” he says. “There are so many things we know so little about that it’s very difficult to form a probabilistic view.”
“Once you have that as a starting point, a lot of the stuff that efficient markets hypothesis is based on starts falling away. The efficient markets hypothesis tends to get coupled with the rational expectations hypothesis, whereby you assume that people have a common model that they all agree on and that they can form a common view of where market prices should be. But if you’re operating in an atmosphere of pure uncertainty, that’s actually impossible – and therefore the whole edifice begins to crumble. Keynes recognised a long time ago that market behaviour is not necessarily about the markets converging to a true fair value, but rather a beauty contest in which conventions arise, consensus views emerge and people gravitate towards the consensus.”
This, of course, is Keynes’ famous ‘animal spirits’ theory – his belief that many investors’ decisions have more to do with spontaneous feelings of optimism than a rational weighing up of probabilities. The strong influence of human emotion on investor behaviour – so the theory runs – leads to mispricings and, ultimately, investment opportunities. “Keynes argued that when momentum takes prices to some crazy level, you should then turn to your other indicators, such as valuation and sentiment,” explains Dr Wadhwani. “He said that for a while there would be a cosy consensus which people would converge around, but that at some point there would be a major event that would lead to a massive shift in sentiment – that’s the animal spirits at work. And when that happens, there is a sea change in the markets, which creates big opportunities.”
Keynes also famously suggested that central banks should “lean against the wind” and tighten policy in good times to ward off asset bubbles – a piece of advice that, if the events of the past few years are anything to go by, has been systematically and comprehensively ignored by most of the major Western central banks. Dr Wadhwani describes the performance of central banks in recent times as “depressing”, and claims that the lingering influence of the efficient markets hypothesis is partly to blame. “In 1999 Ben Bernanke wrote a famous paper arguing that you shouldn’t lean against the wind,” he explains. “A group of other academics – Steve Cechetti, John Lipsky and Hans Genberg – and myself argued that Bernanke was wrong and that it was vitally important for central banks to lean against the wind. However, we were ultimately defeated because Alan Greenspan was an advocate of the efficient market hypothesis though he has modified his views since thefinancial crisis.’’ Even now, in spite of all the evidence to the contrary, there are still those who believe in efficient markets, Dr Wadhwani says. “I was at a meeting a few weeks ago and this consultant said to me, ‘what you do is impossible because efficient markets theory holds’. It was difficult for us to have a meaningful conversation after that.”
When it comes to the putting theory into practice, Dr Wadhwani insists that although his models themselves can become complex, the principles underlying them are very straightforward. “We only believe in simple things because if you over-complicate your approach, it will eventually let you down,” he says. “We look at things like momentum, sentiment and the business cycle, and we put it all together in a time-varying fashion – it has to be time-varying because we know that there are periods in which people pay no regard to a certain factor, and other periods in which they focus purely on that factor. The ideas themselves are simple – but because we live in a non-stationary world, the statistical modelling inevitably gets a little complicated.”
Wadhwani Asset Management employs analysts from a wide range of backgrounds in order to ensure that the models the company use are as robust as possible. One of the company’s key philosophies – perhaps echoing Dr Wadhwani’s time at the MPC – is that a variety of views are necessary for genuine debate, and that genuine debate makes for better models. “If you just have people of one type, you can get very blinkered and cosy,” Dr Wadhwani says. “So we have people with backgrounds in economics and econometrics, and we have people from the informational sciences, and somebody from mathematical biology. We try – in a friendly way – to encourage dialogue.”
The company seeks to incorporate both price and non-price information into its models. The latter is notoriously difficult to achieve, and is something that Dr Wadhwani admits has not been easy.
“Capturing non-price information is an area where we’ve made a lot of progress over the past few years,” he says. “It’s something I’ve been trying for a painfully long time to get right. If I think about the kinds of models I was looking at in the early 1990s, they seem very old-fashioned and inadequate compared to what we have now. But it has been a multi-year journey to learn how to use non-price information in a sensible fashion – and hopefully we’ve got better over time.”
The launch of a UCITS III product will make the techniques and experience of Dr Wadhwani and his team available to a much wider range of investors. And although they will have to modify their approach in certain respects to conform to UCITS III rules, Wadhwani insists that the new UCITS product will be not be a diluted version of the offshore strategy, but rather a complementary product that will aim to match it in terms of performance and volatility. He says that the UCITS product will be less leveraged than the offshore strategy because it will exclude some of the latter’s leverage-hungry relative value strategies. This would usually imply less diversity – and a lower Sharpe Ratio – but Dr Wadhwani says that this will be mitigated by having a greater exposure to higher alpha strategies in the UCITS product. “Our models show that the Sharpe Ratio of the UCITS product will actually be very similar to that of offshore strategy.”
He says that the UCITS product is already attracting interest from potential investors who would have been difficult to attract to the offshore strategy. “I’ve already spoken to representatives of a pension fund who say they like our approach and would find it much easier to gain approval from their trustees for investment in the UCITS product than the offshore strategy. What they like is that under UCITS our VaR would be monitored, and that gives them a level of reassurance they wouldn’t get from an opaque offshore fund they didn’t understand. In mainland Europe toothey seem to be much more comfortable with the prospect of a UCITS product than they would be with a hedge fund.”
While the process of attracting investors goes on, Dr Wadhwani and his team face a very challenging period ahead given the high degree of uncertainty still facing the global economy. “In terms of economic growth, our models have been predicting that growth would surprise on the upside, and so far they’ve been proved correct,” Dr Wadhwani says. “However, there is a big elephant in the room, and that is sovereign risk. Our models are implying that the markets have been underestimating default probabilities, and we have taken account of that in our positioning. We’ve been more cautious than the momentum players, but I think that has been the most sensible and prudent thing to do.”
It’s clear despite the challenging times ahead, this teenage enthusiast turned academic and professional investor has lost none of his appetite for the financial markets.
Dr Sushil Wadhwani, CBE, is the CEO of Wadhwani Asset Management LLP, a systematic macro specialist. Prior to this he was on the Bank of England’s Monetary Policy Committee and held senior roles at the Tudor Group and Goldman Sachs. His began his career as an academic at the London School of Economics and holds a PhD in Economics.
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 USD ‘B’ class return from 31 December 2004 to April 2010. ‘A’ class returns adjusted for ‘B’ class fee structure prior to July 2009. January to August 2005 strategy returns were earned within the Keynes Leveraged Fund.
 After University of Chicago economist, Frank Knight.