Modern Portfolio Theory - It doesn't work anymore

Craig Taggart

Feb 9,2016

As we begin 2016 a bear market and recession seem to be upon us. The financial crisis of 2008 has torn up the investment rule book—received wisdoms have been found wanting if not plain wrong. Is history about to repeat itself and why a tactical asset allocation strategy is the wise decision

Investors are being forced to decide whether the theoretical foundations upon which their portfolios are constructed need to be repaired or abandoned. Some are questioning the wisdom of investing in public markets at all.

Many professional investors have traditionally used a technique known as modern portfolio theory to help decide which assets they should put money in. This approach examines the past returns and volatility of various asset classes and also looks at their correlation—how they perform in relation to each other. From these numbers wealth managers calculate the optimum percentage of a portfolio that should be invested in each asset class to achieve an expected rate of return for a given level of risk.

It is a relatively neat construct. But it has its problems. One is that past figures for risk, return and correlation are not always a good guide to the future. In fact, they may be downright misleading. several heads of investment strategy have said "These aren't natural sciences we're dealing with, "It's very difficult to establish underlying models and correlations. And even if you can establish those, it's extremely difficult to treat them with any confidence on a forward-looking basis."

Most money managers are in consensus with the following mentality, including myself, that you only have to look at the historical relationship between the S&P 500 and the U.S. Treasury market to see the problems with this approach. "Investors were once conditioned into thinking that bond and equity prices were positively correlated," he says. "Then, following the Asian crisis and the resulting deflationary shock in 1998, the relationship reversed, and for the next 12 years, until recently, the relationship has been negative."

Another related problem is that modern portfolio theory assumes that diversification always reduces risk—and because of this, diversification is often described as the only free lunch in finance. A well known professor of finance at a well known business school said "Modern portfolio theory focuses on diversifying your risk away," he says. "But the crisis has shown the limits of the approach. The concept of risk diversification is okay in normal times, but not during times of extreme market moves."

Wealth investors are beginning to question the usefulness of an approach that doesn't always work, especially if they can't tell when it is going to give up the ghost. So what are the alternatives? On what new foundations should investors be looking to construct their portfolios?

Tactical Portfolio Management

There are two schools of thought and, unhelpfully, they are diametrically opposed. On the one hand, there are those that suggest investors need to accept the limits of mathematical models and should adopt a more intuitive, less scientific approach. On the other hand, there are those who say that there is nothing wrong with mathematical models per se. It is just that they need to be refined and improved.

From my experience and research, there is no underlying model or structure that defines the way financial markets and economics works. There is no stability out there. All you can hope to do is establish one or two rules of thumb that perhaps work most of the time.

The first principle is known as liability-driven investment. With this approach, investors make asset allocations that give the best chance of meeting their own unique future financial commitments, rather than simply trying to maximize risk-adjusted returns.

Modern portfolio theory is founded on the premise that cash is a risk-free asset. But if the investor knows, say, that he or she wants to buy a property in five years' time, then an asset would have to be correlated with real-estate prices to reduce risk for them.

The second principle is called life-cycle investing. This takes account of the investor's specific time horizons, something which modern portfolio theory doesn't cater for. The final part of the puzzle involves controlling the overall risk of the client's investments to make sure it is in line with their risk appetite—this is called risk-controlled investing.

There is also a third option to choosing a more discretionary approach to investment or looking to improve investment models: to shun the markets altogether. Edward Bonham Carter, chief executive of Jupiter Investment Management Group, believes that, rather than a bull or bear market, we are currently experiencing a "hippo" market.

Hippos spend long periods almost motionless in rivers and lakes. But when disturbed, they can lash out, maiming anything in reach. Nervous of this beast, wealthy investors are starting to back away from publicly quoted instruments whose prices are thrashing around wildly.

Those investors who are not ploughing money back into their own businesses are buying residential property, passion investments like art or are investigating angel investment opportunities.

Private bankers are doing their best to persuade investors to back absolute return strategies, which regularly change their exposure to different markets.

It seems that, for the time being at least, private clients feel safest basing their portfolios on private investments.