Portfolio management theory all wrong, claims economist

Focus on optimal portfolios – rather than optimal investment strategies – a big mistake, says Muralidhar; death to CAPM

May 18, 2011 @ 3:45 pm

By Andrew Osterland

The capital asset pricing model may not be dead, but Arun Muralidhar is digging its grave.

“If I can't kill it today, I'm going to stab it enough times that it stumbles out of the room,” Mr. Muralidhar told financial advisers at the Investment Management Consultants Association annual meeting yesterday.

Mr. Muralidhar has the cred to make you take notice of such a statement. He's the former head of investment research for the World Bank, a former managing director at J.P. Morgan Investment Management and the head of AlphaEngine Global Investment Solutions LLC, a company he started. An economist trained at the Sloan School of Management at the Massachusetts Institute of Technology, Mr. Muralidhar argues that the foundation of modern investment portfolio theory is doing a disservice to investors.

One big problem with the CAPM is that does not take into account the principal-agent dynamic very often involved in investment management. Most investors with substantial assets hire an adviser to manage their money. The incentives those managers have and decisions they make can be dramatically different from the individuals'.

“The decisions I make when I manage my own money can be very different from other people's,” Mr. Muralidhar said.

What's more, investors usually don't leave their advisers to do whatever they think best with their assets. “People don't trust their advisers because they can never be sure if they're smart or lucky,” Mr. Muralidhar said. Consequently, they put restrictions on what their advisers can do with their portfolios and ultimately can undermine investment objectives.

The foundation of the CAPM investing model is to construct an optimal desired portfolio based on the investor's objectives. As the market moves, the portfolio allocations are re-balanced to get it back to its optimal state. For example, if stock prices go up, a portfolio with 60% stocks and 40% bonds will become over-weighted in stocks. To prevent drift in the portfolio, the adviser re-balances by selling stocks and investing the proceeds in more bonds.

The benefit of this process is that it's simple, transparent and easy to execute. However, a static re-balancing process does not work well in falling markets, Mr. Muralidhar said. The biggest risks faced by investors are large draw-downs in asset values, as it requires more substantial gains to recover the lost value. The re-balancing does nothing to prevent further losses when asset values plummet — as they did in the financial crisis.

“It's like tieing the rudder on your ship in place and ignoring the winds and currents that you experience,” Mr. Muralidhar said.

The solution is for advisers to focus on using optimal investment strategies rather than maintaining optimal portfolios, he said. These strategies involve managing allocations more actively, based on market conditions. Mr. Muralidhar suggested advisers employ a “systematic management of assets using a rules-based technique” — “smart” investing.

Essentially, that involves an informed re-balancing of the portfolio toward the more-attractive assets and away from the less-attractive ones. The key is monitoring market and economic factors such as seasonality, momentum and market sentiment to inform your decisions.

“People say this sounds like market timing. But the fact is that doing nothing is market timing and being in cash is market timing,” Mr. Muralidhar said. “You have two choices — either be intelligent about market timing, or don't be.”

And don't expect the principles of the CAPM to save you.

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