Is modern portfolio theory right for your client?

“Psst! Wanna buy an uncorrelated asset—with factor exposures unavailable in public markets, in an undervalued sub-sector with above-average dividend-growth potential and a substantial illiquidity premium?”

If your answer is, “Do I!” you may be a modern portfolio theory (MPT) junkie. Whether the approach is best for most investors is a matter of debate.

Despite serious questions, MPT and its goal of maximizing risk-adjusted returns pervades investment thinking: from institutional to retail, endowment to mutual fund, full-service broker to robo-advisor. But few professionals ask whether it’s the best strategy for their client. The questionnaire below may help.

If all the answers were “yes,” your client is truly wealthy and MPT could be right for them. MPT was designed with the truly wealthy in mind—specifically institutions, pensions and trusts with long or perpetual investing time horizons. The investment objective is to preserve and grow capital with a focus on getting the strategic asset mix right and rebalancing to it, controlling risk through diversification.

Even one “no,” however, and your client falls into the “other” category. That includes most of us who present a contingent liability problem because we don’t have the money to meet our goals. Planning, saving and investing are required. MPT can’t handle contingent liabilities.

A brief history of MPT

Based on Daniel Bernoulli’s 18th-century idea that rational people making decisions under uncertainty choose the highest expected benefit, Harry Markowitz proposed in 1952 that portfolios seek to optimize expected returns relative to expected volatility by selecting a combination of assets on an “efficient frontier.”

Before the idea picked up support in the mid-1960s, portfolio managers focused on individual security selection. For equities, they sought stocks that maximized the present value of future dividends (using the dividend discount model); for bonds, they sought the highest yield to maturity commensurate with coupon, credit rating, sector and balance-sheet strength, subject to any call date and price, sinking fund and other embedded option.

William Sharpe, Eugene Fama and others expanded on Markowitz’s foundation, and MPT’s mathematical framework armed a new class of analysts—the quants—who, with their passive-strategy cousins, have come to dominate today’s markets.

MPT under attack

Fama’s efficient market hypothesis (EMH) has been attacked because, in its strongest form, it declares that all public and non-public information is reflected in stock prices; long-term outperformance (or underperformance) is therefore impossible. But some portfolio managers appear to under- or outperform more consistently than others, suggesting that beating the market is possible.

Behavioural economics, led by Daniel Kahneman, Amos Tversky and Richard Thaler, challenged classical thinking about rational decision-making with ideas about overconfidence, loss aversion and projection theory.

The most definitive nail in MPT’s coffin came with Nardin Baker and Robert Haugen’s observation that low-risk assets, measured by standard deviation, outperformed high-risk assets—the opposite of what is expected.

MPT relies upon estimated returns, estimated risk and estimated relationships between asset classes (co-variance). Small estimation errors can lead to huge mistakes.

To summarize MPT’s shortcomings:

• higher risk does not necessarily mean higher return;
• investors don’t always act rationally;
• some managers appear to outperform;
• reliance on estimates is unstable.

More important to investors and their advisors is whether the approach addresses their needs and can be implemented easily.

The table below shows various investment characteristics and requirements for the truly wealthy compared with everyone else.

Wealthy clients have long time horizons because they have all the money they need and can wait out bad markets; everyone else must balance the liability represented by their goals with assets and future savings within a finite time period (such as college in seven years).

Wealthy clients establish a strategic asset mix and rebalance to it while most clients must control the volatility of the distance they are from their planned path. And while the wealthy can primarily control risk with diversification, everyone else must target risk.

MPT works for the wealthy but other clients need liability-driven investing (LDI). MPT can’t solve for contingent liabilities, nor does it have a mechanism to consider time the way most clients must.

MPT casts a long shadow over the investing landscape. But is it the best approach for your clients? Maybe not.

Mark Yamada is president of PÜR Investing Inc., a software development firm

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.