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.

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

RIA Data Center

Use InvestmentNews' RIA Data Center to filter and find key information on over 1,400 fee-only registered investment advisory firms.

Rank RIAs by

Upcoming Event

Mar 13

Conference

WOMEN to WATCH

InvestmentNews is honoring female financial advisers and industry executives who are distinguished leaders at their firms. These women have advanced the business of providing advice through their passion, creativity, inclusive approach and... Learn more

Featured video

Events

The power of data

Your clients have financial news and data at their fingertips, but donít know how to interpret it. Katy Gibson of Envestnet|Yodlee and Blake Kannady of Envestnet discuss the power of leveraging aggregated data.

Recommended Video

Path to growth

Latest news & opinion

Tax reform: 7 essential strategies for financial advisers

While advisers face the difficult task of analyzing the law's impact, they will also have a significant opportunity to prove their value by implementing money-saving strategies for clients as well as their own businesses.

Tax law: Everything advisers need to know about the pass-through provision

The provision is tricky, but could provide advisers and business-owner clients with sizable tax savings.

Bill requiring fiduciary disclosure reintroduced in New Jersey

Measures would obligate financial advisers to tell clients they do not have to act in their best interests.

Merrill Lynch to let advisers text with clients

Texting has been a popular mode of communication for years, but in the past the firm's regulations have prevented advisers from using it.

Bear market for bonds has arrived, Gross says

10-year Treasury rate's move above 2.5% confirms outlook for fixed income, legendary bond manager says.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print