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Why Modern Portfolio Theory is frozen in time

MPT can lead RIAs to keep investors locked into investment decisions based on forecasting models that don't adapt to ever-changing market conditions

Aug 19, 2016 @ 9:59 am

By Jeffrey S. Ferraro

Ready for a quick pop quiz?

What do the following five items have in common? The first KFC franchise; the beginning of the diet soda era; Modern Portfolio Theory; the first video recording; and the treadmill's predecessor. To save you a little search engine wear-and-tear, these trend-setting events all debuted in 1952.

Now, which of the above trend-setters remains frozen in time, operating in the same way, shape and form as it was back in 1952? The answer: Modern Portfolio Theory, which 64 years later, isn't so modern anymore.

When Nobel Prize-winning economist Harry Markowitz introduced MPT, he gave the investment world an academically rigorous understanding, for the first time perhaps, about constructing a portfolio of assets in which the expected return is maximized for a given level of risk.

Today, MPT is so engrained in the DNA of portfolio construction that it's the go-to model for the majority of financial advisers and, more recently, their robo doppelgängers. Yet instead of simply accepting the status quo, the question registered investment advisers should be asking themselves is, “does an MPT-based portfolio best serve the investment needs of my clients?”

Criticism of MPT, both good and bad, has been the subject of academic research for decades. Not to put too fine a point on it, but one of the major problems MPT creates, it seems, is that it leads RIAs to keep investors locked into investment decisions based on forecasting models that don't adapt to ever-changing market conditions.

Advisers aren't taking the right risks with their clients' assets to help them achieve their long-term investment goals whether we're talking about time horizons, or global and sector diversification, or the balance of equities to fixed income in a given portfolio. Here we are, almost 10 U.S. presidents and a great deal of research later, and we're finally understanding that we've been going about allocations all wrong.

That brings me to rebalancing. MPT says that once a plan is in place, if you keep allocations at a constant for a given time period — using 60% equities and 40% bonds for five years just as an example — an investor should achieve the desired results. What MPT doesn't account for is changing risk in the market and with that doesn't say when and how that portfolio should be rebalanced. Why plan on a five-to-seven-year timeline and make changes then? Why not every 30 days? If the market is raging, wouldn't you want a higher allocation to equities? And, if it's risky to be in equities, why stay pegged to 60%?

It behooves RIAs to have a systematic rebalancing plan, and it must be conducted based on market risk. Counterintuitive though it may be, there are many RIAs who only see the world from a capital allocation standpoint; risk doesn't enter the conversation. These advisers need to see the world through a different lens or they're doing their clients a great disservice.

That disservice continues when we talk about the pool of active investment strategies from which wealth managers have to choose. Most of these strategies fail to best the returns of passive index funds, particularly over longer time horizons. Whether or not you subscribe to this notion, the inescapable observation is that money has been pouring into passive strategies (i.e. ETFs) almost quicker than it can put it to work. Driven largely by underperformance in active management, passive strategies in the last decade have attracted some $2.2 trillion, reports show, while Vanguard Group alone attracted some $224 billion in the last 12 months.

Permit the obviousness of the following statement: just because you're using passive investment products, it's not a guarantee that you'll experience more meaningful returns. If an investor blindly puts all or even most of their sheckles into low cost liquid strategies, they're taking an enormous risk that they've bet on the winning horse. What happens when the investor has to exit positions because of a pending retirement when the index is down 35% at exactly that time?

Moreover, assuming this investor has holdings in a number of passive strategies, do they or their adviser truly understand the relationship of these products to one another? At any point in time, they could be positively correlated — when the markets go up, they all go up. Yet when the markets fall, they all drop together. We can say that this is not being diversified from a risk perspective, but the real risk ultimately is relying on an antiquated approach in world that commands advisers to employ much more modern thinking.

Jeffrey S. Ferraro is managing partner at Paritas Capital Management

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