Portfolio management all wrong, claims economist

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’s annual meeting last week.

Mr. Muralidhar is an economist trained at the Massachusetts Institute of Technology. After serving as head of investment research for the World Bank and as a managing director at J.P. Morgan Investment Management, he has opened his own business, AlphaEngine Global Investment Solutions LLC.

Mr. Muralidhar argues that the CAPM does a disservice to investors by not taking into account the principal-agent dynamic so often involved in investment management. Most investors with substantial assets hire an adviser to manage their money. Those managers’ incentives and the decisions they make can differ dramatically from those of their clients.

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, clients restrict what their advisers can do with their portfolios — which can undermine investment objectives.

CAPM’s investing model aims to construct an optimal portfolio based on the investor’s objectives. As the market moves, the portfolio’s 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 overweighted in stocks. To prevent the portfolio’s drift, the adviser re-balances by selling stocks and investing the proceeds in more bonds.

It’s simple, transparent and easy to do. But static re-balancing doesn’t work well in falling markets, Mr. Muralidhar said. Large losses in asset values require more substantial gains to recover the lost value. Re-balancing doesn’t prevent further losses when asset values plummet, as they did in the financial crisis.

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

The solution? Focus on using optimal investment strategies rather than maintaining optimal portfolios by managing allocations more actively, based on market conditions, he said. Mr. Muralidhar suggested advisers use a “systematic management of assets using a rules-based technique” — “smart” investing, which involves re-balancing a portfolio toward more-attractive assets and away from less-attractive ones by monitoring market and economic factors such as seasonality, momentum and market sentiment.

“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.”

Just don’t expect the principles of the CAPM alone to save you.

E-mail Andrew Osterland at [email protected]