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Understanding Modern Portfolio Theory

It is not at all uncommon to encounter an advertising banner relating to a mutual fund manager or financial advisor that proudly proclaims adherence to the tenets of Modern Portfolio Theory (MPT), or to extensions of the pioneering work achieved by Nobel Prize winning Harry Markowitz.  But what lies beneath the hyperbolic, marketing-driven, vague references to “scientific method” and the technical jargon in which the theory is often wrapped or, rather, shrouded?  Just what is MPT and, just as importantly, what is it not?

What it is:

A body of theoretical work, and extensions to that work that suggest a systematic and quantitative approach to evaluating risk and diversification in investment portfolio construction.  Application of the theory suggests that, at the portfolio level, risk (a.k.a. volatility of returns) can be reduced by combining assets having similar expected returns but less than perfect correlation in returns.

What it is not:

A portfolio construction “How to …Manual”, a recipe book, or a silver bullet lying on the shelf, just waiting for the elite, financial engineering literate to put to work.
In his landmark 1952 paper, Portfolio Selection, published in the Journal of Finance Markowitz embarked on a mission to quantitatively define risk as security-specific and portfolio-level volatility of investment returns.  He further sought to quantify the impact of combining dissimilar assets on portfolio-level volatility of investment returns.

The practical outcome of this work was an improved level of clarity regarding the benefits of asset diversification and the reduction of volatility in portfolio returns gained through combining assets having less than fully correlated returns.  Markowitz showed, conceptually and within a mathematical framework, that combining such uncorrelated assets could give rise to a portfolio having a lower level of risk (i.e., volatility) for a given level of expected return.  He further demonstrated that specific combinations of less-than-perfectly-correlated assets could enable the minimization of portfolio risk across a range of expected returns … generating an “efficient frontier,” or  risk vs. returns curve representing optimal asset combinations that would maximize expected returns for each incremental unit of risk (volatility).

Markowitz’ work provided a useful theoretical and mathematical foundation and framework leading to more than fifty years of academic and applied research related to finance and investment practices.  Extensions of MPT include the Capital Asset Pricing Model and the Black-Scholes option pricing model – products of other Nobel Prize winners.
Where investors, at both the Main Street and institutional levels, have gotten into trouble is in the application of MPT and its extensions as a literal recipe book for investing and risk management.  Key assumptions underlying models associated with the theory must be relaxed when describing the real and dynamic world.  Among these are assumptions regarding perfect information flows in markets, consistently rational investor behavior, normal (bell-shaped) distribution of returns, independence and random nature of price moves relative to prior price moves, and, quite importantly, stability in volatilities and cross-security correlations over time.

Modern Portfolio Theory provides a simple, clear and common sense framework for understanding the benefits of portfolio diversification.  However, a proper understanding of MPT’s underlying assumptions and an appreciation of their limitations is critical to any and all practical applications of MPT in the investment world.  The streets, now and historically, are littered with the financial corpses of those failing to take good measure of the limitations associated with MPT’s underlying assumptions and related, real-world applications.

How Did Madoff Happen?

A lot of people are wondering how, in this age of Sarbanes Oxley, someone catering to sophisticated investors could pull off a $50 billion Ponzi scheme.  Didn’t the internet bubble, Enron and WorldCom teach investors and regulators anything?

The answer is complex, and has a lot to do with the lack of transparency and regulation in the hedge fund world (both to change soon).  More broadly, it has a lot to do with human psychology.  This isn’t the first major financial scandal to come undone during a financial crisis and it certainly won’t be the last. This is conveyed perfectly in this passage from John Galbraith’s book “The Great Crash of 1929” – – I found the quote at Andy McSmith’s blog.

“To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the Bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.”

ETFs Still Talking Market Share

While we still have unpredictable swings in the market each day, and the implications of the government’s rescue package are uncertain, there is one trend that has become reliable – – the continued growth of ETF market share gains against mutual funds.  The latest industry statistics are out from the Investment Company Institute, and as the graph below shows, the share of all ETFs as a percentage of non-money market mutual fund assets is up to 7.4%:

Perhaps even more ominous for the mutual fund industry is that net redemptions from mutual funds accelerated while there was actually net growth in ETF originations.

A Good Holiday Read: Crash Proof

Anyone looking for a well-written, concise description of the economic underpinnings of the financial crisis would should spend some time over the holidays reading Peter Shiff’s “Crash Proof: How to Profit from the Coming Economic Collapse” [link to Amazon].  Shiff’s book was published not very long ago – in 2007 – but before this year he had often jokingly been referred to as ‘Dr. Doom’ or Chicken Little.  Nobody is joking anymore.

In a straightforward writing style that any non-finance person can understand, Shiff walks through how the policies of the Federal Reserve, trade deficit, lack of savings, and other factors lead to an economic bubble that started to unravel this year.

Shiff warns of very tough times ahead, with a decline in the dollar and stagflation contributing to a painful period of sacrifice as our economy is rebuilt.  He gives his views on the best ways to invest during this period – foreign currency, developed international markets and commodities; all of which are intended to profit from what he believes will be a long-term decline in the US dollar.

Shiff’s writing style isn’t for everyone – he is blunt and pretty cynical.  He also doesn’t give you a warm fuzzy about our economic future and he pimps his own firm a little too much.  But if you want to understand some the macroeconomic reasons the markets have tanked this year so you can protect yourself and improve your odds at success in the future, it’s required reading.

A Cruel Joke – Mutual Fund Fees Going Up!?

As if 2008 wasn’t bad enough, now comes word from Investment News that mutual fund expense ratios might actually be going UP next year.

According to the article, as mutual fund assets have gone down due to both market declines and redemptions, there are fewer revenues to help cover fixed costs, such as accounting and legal fees, call centers, insurance premiums, real estate costs, as well as fewer shareholders left to shoulder those expenses.

I’m not sure the mutual fund companies won’t go ahead and accept lower profitability. The growth of ETFs and their lower cost structure will continue to put pressure on the industry to reduce expenses.  As the article quotes one investment advisor, “If a fund (expense ratio) goes up to 1.9% from 1.4%, after they lost more than that in the market, I’ll look at ETFs.”