Modern Portfolio Theory – the intellectual framework that underlies the methods by which the vast majority of investment managers and advisors execute decisions on behalf of their investing clients – is approaching its 40th anniversary. In a world where anybody with $1000 and an online trading account can buy once-exotic commodities futures, and where US government securities stand not so far from the precipice of a potential downgrade, how well-suited are the assumptions and tools of MPT – fashioned over the last forty years of thought and practice – to the investment challenges of today and tomorrow? MVCM President Masood Vojdani shares his insights gained from thirty years (and counting!) in the investment industry.
I started working in the investment industry in 1981, a year when both inflation and interest rates were stuck in double digits and the conventional wisdom about the equities market was that it was dead. In an age of unappetizing choices for where to put one’s money I learned an early and valuable lesson: portfolio diversification is the smartest way to ensure that when bad things happen in the market you at least have some cushion to limit the downside. Now, diversification may sound like something sensible people have always done since time immemorial, but in fact the building blocks that underlie what today’s professional portfolio managers do for a living were set in place just a handful of decades ago. The cornerstone was a Journal of Finance article called “Portfolio Selection” written by Harry Markowitz in 1952. Markowitz established the basic principles of mean-variance analysis and with that set in motion a fruitful couple decades of advancement in financial theory and practice. This rich period included contributions from William Sharpe (Capital Asset Pricing Model, early 1960s), Eugene Fama and Kenneth French (Fama-French Three Factor Model in the 1970s) and a number of other leading-edge thinkers. The burgeoning discipline that they crafted came to be known as Modern Portfolio Theory.
From Theory to Practice
MPT, as it is known in the trade, had thus already been around in some form for nearly 30 years when I first hung out my shingle as an investment professional. But it seemed to really come into its own as the Great Bull Market of 1982-2000 gathered steam, so to a certain extent I feel like I came of age alongside the movement of MPT from academia’s ivory towers into the cut and thrust of real investment markets. The practical mechanism that effected this movement was asset allocation, which in turn is a somewhat fancy way of saying diversification. Asset allocation is rooted in the two critical measures of Markowitz’s mean-variance analysis: (a) the risk-return characteristics of different types of assets relative to each other, and (b) the level of correlation between different assets in the same portfolio. A whole industry sprang up around the business of making efficient allocation decisions, perhaps best illustrated by the so-called Morningstar “style boxes”. These nine boxes divided the world of stocks into nine flavors from large-cap growth to small-cap value. Pick judiciously among the style boxes for your risk assets, leaven these allocations with whatever percentage of bonds was appropriate for the risk tolerance of a given portfolio style, and you were good to go.
Challenges of the Post-Modern Era
Modern Portfolio Theory has for the most part served the investment industry well; but for two reasons I feel that we may be entering a new – call it “post-modern” – era. The two reasons are: the rapid growth of liquidity-providing financial instruments in an ever-wider spectrum of asset classes; and the increasingly dubious notion that there is a good proxy for a risk-free rate of interest in the market. Let’s look at each of these in turn.
On its face the rise of liquidity-providing instruments would seem like a good thing. Take commodities futures. Back in the 1970s, when MPT was still mostly confined to the halls of academia, it would take a considerable amount of money, sophistication and hard-to-obtain access to a trading platform for an individual to take positions in exotica such as crude oil, soybeans or pork belly futures (remember the movie “Trading Places”, anyone? Randolph and Mortimer Duke were not your typical middle class family with a savings account and retirement plan). Now, for those larger investors (like the Dukes) able to trade in these rarefied markets there were distinct benefits: commodities futures would tend to trade with very low correlation to movements in the stock market. In the late 1970s, for example, equities investors fared quite poorly, while investors in commodities like gold and oil did really well. That changed in the mid-1980s when the stock market rallied strongly while metals and oil prices plummeted. The point is, having the ability to diversify a portfolio across both equities and commodities was a source of value to portfolios of risk assets.
So isn’t it good news that this source of value is now accessible by typical retail investors who live far from the opulent world of Wall Street barons? Yes, to a point. Mutual funds and more recently Exchange Traded Funds (ETFs) have democratized finance. But they have also been at least partly responsible for a noticeable trend in recent years: those low correlation benefits that historical trading patterns produced are disappearing. Commodities futures are now just another so-called risk asset. What markets exhibit now is a tendency to move in and out of risk broadly – not in and out of equities, or in and out of commodities – but in and out of risk. So commodities and equities tend to move in a more correlated pattern than they used to – and the same goes for other risk assets like real estate trusts. This challenges that one important plank of MPT that selecting among different risk asset classes can add value through low correlation.
The Disappearing Risk-Free Rate
While that is concerning enough, I find the second “post-modern” trend even more unsettling. At the heart of practically every valuation technique that has flowed from Modern Portfolio Theory is the notion of the “risk-free” rate of interest. Think of the risk-free rate as a starting point: as you identify and categorize risks that apply to specific assets the investor’s required rate of return moves upwards in increments from the risk-free rate. Investment valuation models usually include some mathematical formula that reflects the idea of “risk-free plus risk market premium”.
For the entire time that MPT has been around the proxy for the risk-free rate has been the US Treasury bond (or note, or bill). The US had established itself as the world’s reigning economy and financial center long before Markowitz’s 1952 paper – that transition really happened when the world went off the Bank of England-centric gold standard in the years following the First World War and never went back. Now US government debt is teetering on the edge of losing its longstanding preeminence, and in the current climate there is even a plausible case to make that the government will at some point in the not too distant future default on certain existing obligations. Whether or not this happens – and I for one believe that ultimately cooler heads will prevail – the fact is fairly indisputable that Treasury debt today substantially lacks the robust “risk-free” nomenclature. It may still be less risky than just about anything else in the market, but that just means that the whole risk curve has shifted upwards and everything in effect is a risk asset. And those time-honored valuation models are rendered much less useful.
Into the Future
At MVCM these problems have been occupying our attention on a constant basis since the market meltdown in 2008. We will by no means claim to have all the answers at our fingertips. But we strongly believe that the investment assets we will be evaluating for portfolio decisions in the months and years to come require different tools than the ones we have become comfortable using over the last thirty years. Post-modern does not have to mean, as it often does in various arts and humanities usages, jarringly chaotic, confusing or depressing. The challenge is to incubate, develop and deploy tools that work within the practical contours of post-modern markets.