Moving Beyond Modern Portfolio Theory

Investing That Matters

Jon Lukomnik, James P. Hawley

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000376159
• Edition: 1
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

Moving Beyond Modern Portfolio Theory: Investing That Matters tells the story of how Modern Portfolio Theory (MPT) revolutionized the investing world and the real economy, but is now showing its age. MPT has no mechanism to understand its impacts on the environmental, social and financial systems, nor any tools for investors to mitigate the havoc that systemic risks can wreck on their portfolios. It's time for MPT to evolve.

The authors propose a new imperative to improve finance's ability to fulfil its twin main purposes: providing adequate returns to individuals and directing capital to where it is needed in the economy. They show how some of the largest investors in the world focus not on picking stocks, but on mitigating systemic risks, such as climate change and a lack of gender diversity, so as to improve the risk/return of the market as a whole, despite current theory saying that should be impossible. "Moving beyond MPT" recognizes the complex relations between investing and the systems on which capital markets rely, "Investing that matters" embraces MPT's focus on diversification and risk adjusted return, but understands them in the context of the real economy and the total return needs of investors.

Whether an investor, an MBA student, a Finance Professor or a sustainability professional, Moving Beyond Modern Portfolio Theory: Investing That Matters is thought-provoking and relevant. Its bold critique shows how the real world already is moving beyond investing orthodoxy.

1 The MPT Revolution Devours Its Children

The MPT Revolution Devours Its Children

Modern Portfolio Theory (MPT) changed the investing world and financial markets. It changed the world’s economy. It was nothing less than a revolution. But, as French journalist Jacques Mallet du Pan observed at the time of the French Revolution, “Like Saturn, the revolution devours its children.”

Du Pan’s analogy fits. In the Greek myth to which he refers, Saturn – or Cronus in the original Greek – was the Titan who ruled the Earth for eons. Warned by prophecy that one of his six children will supplant him, Cronus attempted to swallow them all. However, Zeus survived and fulfilled the prophecy, defeating Cronus and the Titans, ushering in the golden age of the Olympian Gods.

MPT is the financial markets’ Cronus, a powerful theoretical framing of how investing should work. It has been successful for generations. It has reassured investors who want certainty about complex market behavior, just as Cronus reassured the ancients about the workings of the complex world. But MPT has become old. It faces not just one threat to its dominance but three. First, it is a victim of its own success, much the way that Cronus’s own fertility sowed the seeds of his downfall. Second, capital markets have changed in ways that Harry Markowitz, the father of MPT, could not have foreseen when he wrote his seminal paper in 1952. Capital markets have matured, as Zeus did, into a force that overwhelms some of the assumptions upon which MPT was built. Finally, just as Cronus was the ruler of a world built around the Titans but could not escape from his prophesied fate, so, too, MPT cannot escape from its origin as a way to diversify idiosyncratic risk and its inability to provide a framework for mitigating systematic risks. Indeed, MPT does not even try. That is a fateful error of omission. It laid the groundwork for multiple generations to view investing as somehow separate and apart from – and having no role in – mitigating risks to the financial, social, and environmental systems on which the capital markets rely. Thus, the MPT tradition fails doubly from errors of omission: first by ignoring that systematic risk can be influenced and mitigated; and second by ignoring the link between systematic risk and systemic (system) risk. (NB: Throughout this book, we use systematic risk to denote risks that originate from the same source and affect a broad swath of securities. We use systemic risk for risks to the economic, social and financial systems on which the capital markets depend, and which affect those systems, such as the 2020 Covid-19 pandemic or the 2008 financial crisis.)

Whether the issue is 2020’s coronavirus pandemic, 2008’s financial crisis, or the ongoing risks of climate change and income inequality, capital markets and society alike increasingly recognize that MPT’s essential revolutionary development – the ability to diversify idiosyncratic risk – is limited when faced with non-diversifiable systematic risks. MPT’s ability to produce desirable risk-adjusted returns and to efficiently allocate capital when non-diversifiable risks affect markets, economies, and society is puny. Even in non-crisis times, idiosyncratic risk is only a marginal contributor to the overall risk/return profile of any investor’s portfolio and is becoming increasingly more marginal as computing power and research define more and more systematic risk factors. This is due to the insight and practice of MPT itself: to the degree that idiosyncratic risk is diversified away, idiosyncratic risk can in theory be reduced to zero. However, systematic and systemic risks matter more − much more, than idiosyncratic risks, but MPT provides no tool to mitigate them, either for investors or for society. Indeed, Markowitz and the MPT tradition which build upon his ideas were not and are not focused on this; some even deny that it can or should be done. In effect, MPT focuses on that which matters least − a phenomenon that we call the MPT paradox. That is a key focus of chapter two. But before exploring MPT’s original sin, we should understand how revolutionary MPT has been, critiques of the assumptions behind the theory, and the theories which build on MPT, and why it has become a victim of its own success. That is the focus of this chapter.

Before Markowitz and MPT

Before the second half of the twentieth century, investment risk analysis (and therefore risk measurement and management) focused on the individual security. For example, central government bonds were (and still are) considered “safe”, initial public offerings of small company stocks relying on an unproven business model were (and still should be) considered “risky”, and more established companies’ issues were analyzed on their own individual merits. And that was pretty much it.

Although the investing universe was smaller and the focus was on asset by asset risk analysis, there was significant (and long-lasting) debate between those who, like Graham and Dodd, focused on value and fundamental investing vis–à-vis individual stocks but had no coherent theory about how to create a portfolio and those who, like John Maynard Keynes, focused on the more psychological element of the stock market (the madness, or depending on one’s view, wisdom of crowds). Graham and Dodd even made the pre-MPT case that the average institutional manager could not obtain better results than an index¹, (even though practical index funds were not yet available). What was missing for the adherents of both schools of thought was a coherent theory of how to invest. Followers of Graham and Dodd analyzed and picked securities but lacked a plan for their investments as a whole. Followers of Keynes focused on business cycles and market dynamics, but not how to translate those observations into a portfolio of securities.

Enter Harry Markowitz, a brilliant mathematician who also showed an intuitive understanding of what investors wanted and needed. Markowitz wrote in the very first paragraph of his 1952 paper: “…the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing.”² Two key elements are captured in this sentence. The first is that Markowitz’s perspective is purposively normative (“should”), rather than objectively descriptive (“does”) of how markets actually work. Second, MPT distills the impact of all the causes of risk to a single metric: Volatility. As far as MPT is concerned, all risks – no matter the root cause − are reduced to their ability to create uncertainty around the future price of an asset. The root causes of any risk are largely irrelevant, except to the extent that the specifics cause the variance to correlate, which would cause directional co-movement and increase volatility in a portfolio of assets, or if not correlated, reduce volatility.

MPT’s great leap forward was to define an investor’s purpose as creating a “least mean variance” portfolio. That is, creating a portfolio designed to shrink the “wrongness” of an investor’s guess as to future expected returns. MPT codified the job of an investor as maximizing return per unit of risk (or, conversely, reducing the risk per unit of return) by providing both a theory and the math to do so.

While diversification is not new – Miguel de Cervantes wrote “don’t put all your eggs in one basket” in his masterpiece Don Quixhote in 1615³ − what Markowitz midwifed into the world in 1952 was ground-breaking all the same. The mathematics of his theory enabled investors to take individual assets that they might have shunned previously as “too risky” and reengineer those assets into something where the whole was more than the sum of its parts. MPT argues that the aggregate risk of the portfolio – not of the individual securities − is what matters, and that risk will inevitably be lower than that of the individual assets (as the returns on some of them will zig, while others zag, thereby dampening the price volatility of the portfolio overall).

These ideas, and their mathematical proofs, turned out to be exciting thoughts for an investor. If you were an investor previously limited to securities with a certain risk profile, you could now invest in riskier assets which provide higher expected returns. If you could blend them into a portfolio, with the price movement of the components imperfectly correlated, you could be fairly confident that the overall portfolio would return more than your previous allocation to less volatile investments, even while having the same or lower risk. Markowitz provided the theory and the proofs of how diversification enabled extra return without an investor “paying” for it by accepting extra risk.

One key result of MPT’s wholesale adoption was that investors, newly freed from the constraints of buying only “safer” investments, focused on understanding the risk and return patterns of individual securities and other assets. Blending them into less volatile portfolio return patterns became the holy grail. Soon everyone was, and to a large extent still is, drinking from the MPT trough to create efficient portfolios.

The reaction of investors – even massive institutional investors – to MPT was tectonic. Let’s look at just one example, although admittedly a trillion-dollar-plus example. In the US, public pension plans provide defined benefit pensions to literally tens of millions of public sector retirees and have trillions of dollars in aggregate asset. (There are also public sector defined contribution plans, and some sponsoring jurisdictions offer both.) For the history of these funds, until MPT, state legislatures restricted the types of securities that could be owned. For example, stocks were considered risky and often prohibited. Instead, pension funds typically were required to invest in fixed income investments, and often bonds which carried the full faith and credit or the United States, or which met certain credit tests. That depressed returns, but it was the primary form of risk control. Only in 1996 in the US did the states of Indiana, West Virginia, and South Carolina, the last states to have such restrictions, end the prohibition against their pension funds investing in stocks.⁴ It took almost a half-century, but MPT finally conquered even the most conservative of state legislatures, as they saw their states’ pension funds falling behind their peers and the low returns becoming a burden on their taxpayers. With the rise of MPT’s more holistic portfolio theory, all states now have adopted some form of diversification as the law, theoretically anchored in MPT. Even the states that still have some type of restrictions by security type have raised the limits on the amount of “riskier” securities allowed, by creating “basket clauses” to which the legal limits do not apply, thereby creating de facto MPT investment regimes (e.g. New York State).⁵

That same sort of evolution, from looking at risk on a security by security basis to looking at portfolio risk, took place around the world. Indeed, the US public pension plan example is notable precisely because the political environment that governs those plans slowed the MPT investing revolution compared to most everywhere else. By the time of the last states’ adoption in 1996, MPT was the justification for just about every regulation about allowable securities in collective investment plans around the world. The fact that MPT could change not just market participants’ ideas of how to manage risk, but also lawmakers (at least some of whom are skeptical of financial innovation), demonstrates just how omnipresent MPT has become.

What was needed to unlock diversification’s power was numbers, computational power, and resulting analytics. If an investor knows the expected return, expected volatility, and expected correlation of the assets in his or her portfolio, he or she can create the least mean variance portfolio for a desired level of return or, to put it another way, the highest-returning portfolio for a specified level of risk. (We are frequently amazed that the tautology implied in the theory is not more frequently remarked upon: In order to predict the future, an investor needs to have a prediction of what elements of the future will look like. Of course, if an investor could predict the future of risk-free rates, that investor would be foolish to have a diversified portfolio. He or she would be better off picking the single asset or a few assets with the actual best return(s) for the desired period of investment.)

It is worth noting that MPT’s math is somewhat sealed away from the real world. MPT constrains investors to the role of observers of the portfolio companies in which they invested. MPT’s focus on price variability in the financial markets − and not on value creation in the real economy − was a step along the path that separated markets from the real economy, as it creates barriers between capital and active ownership.⁶ Even what we call investors – “analysts” and “portfolio managers” – reflects the divide between MPT’s view of the real economy and the capital markets. Investors analyze real-world companies but manage portfolios of financial assets. This divide relegates the purposes of finance – such as intermediation (allocation of capital) and the creation of a risk-adjusted return where risk is measured relative to the real-world liabilities − to far corners of conversation and study, where it has remained until after the 2008 financial crisis.⁷

To be a good in...

Table of contents

• Cover
• Endorsements
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of figures
• List of contributors
• Acknowledgments
• Introduction
• 1. The MPT Revolution Devours Its Children
• 2. The MPT Paradox
• 3. Short-termism
• 4. Everything Old Is New Again
• 5. From Dividends in Nutmeg to Creating $5 Trillion: Welcome to the Third Stage of Corporate Governance
• Conclusion
• Bibliography
• Index