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Modern Portfolio Theory – captivating the unwary

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The financial crash has certainly shaken to the foundations many of the fundamental ideas that have underpinned the global financial system. One of the most important lessons for everyone is that economics is not a science like physics or chemistry. This is despite attempts by economists to emulate the physical sciences in creating grand theoretical constructs such as Modern Portfolio Theory (MPT), that seek to explain and predict all aspects of investment activity.

The elegance and beauty of the efficient market theories that lie behind MPT mirror those of the physical sciences and, like many beauties, can captivate the unwary to create an almost axiomatic belief that markets must be efficient. The TMT bubble and even the financial crash, are arguably still consistent with the Efficient Market Theory despite the obvious nonsense it looks like with hindsight. More technically, what is increasingly accepted by academics is that any test that securities are always fairly priced and hence that markets are efficient, also relies on a model of market prices that describes normal security returns.

If a test of the hypothesis that markets are efficient is rejected, it could either be because the market is truly inefficient, or else because the model of the distribution of stock market returns is incorrect. There are therefore always two factors that are being tested that cannot be separated. As a result, market efficiency can neither be shown to be false, nor proved to be right. In that sense, efficient market theory fails the scientific test of any theory, namely, that it should give rise to behaviour that is predictable and testable.

Once you get to the real world outside the MBA courses, you discover that, if anything, markets are becoming less efficient as time goes on. The financial crash was, of course, a prime example of that, with panic spreading from the fixed income markets to the global equity markets, to produce losses of upwards of 50%, only to have them bounce back in a spectacular rally.

At the stock level, for share prices to accurately reflect true and fundamental values, there need to be a very large number of investors who are trying to value them in absolute terms and also relative to each other.

The last couple of decades have seen a huge growth of indexation that has driven many passive funds to buy shares, irrespective of price, and driven up valuations of companies entering narrow but popular indices to levels not necessarily justified on fundamentals.

More recent years have seen large mergers between fund management firms, reducing the number of fund managers making investment decisions whilst increasing the funds available to them and hence their influence on share prices, i.e. the number of influential players in the market has been reduced significantly. Those that survive the mergers have seen their erstwhile colleagues ignominiously depart. Many, seeking to minimise their career risk, dare not stray too far from an index position even if they claim to be active stock pickers. For them, the downside risk of underperforming means losing a job, whilst the upside means getting what, in utility terms, is a marginal (although in absolute terms, a very large) increase in remuneration.

It is in perhaps asset allocation that the flaws in both academic theory and the marketplace are most significant. “You can only manage what you can measure” is a much quoted phrase that lies behind the assessment of fund manager performance through quarterly measurements of relative performance against an agreed equity or bond index. The corollary to this however, is that what cannot be measured easily is often not managed at all even if it is much more important. This applies to asset allocation, which suffers from a lack of a universally accepted methodology for assessing performance.

MPT has often been applied to the area, but one key element of any optimized portfolio of assets, is to have robust and reliable forecasts for future returns of different asset classes, along with their volatilities. Unfortunately, whilst MPT can be used to analyse historical statistics, it has nothing to say about future returns of different asset classes. As a result of both the difficulties and the lack of business models that incentivises those with the expertise to offer unbiased advice, relatively few resources are devoted to asset allocation.

Yet asset allocation is of far more significance to a pension fund than whether a manager outperforms or underperforms an index by amounts in a year that are a fraction of the daily market movements that were experienced during the financial crash. “A skilful financial economist can make a sound case for investing pension assets in either equities, bonds or any asset class in between based on corporate finance theory…” according to Moshe Milevsky and Mike Orszag, co-editors of Journal of Pension Economics and Finance.

Understanding the philosophical approach behind asset allocation is a critical issue and ties in closely with measurement of performance and ultimately on what is a fair and effective means of remuneration. Pension fund trustees are left facing a plethora of conflicting advice and themes. Terms such as “Liability Driven Investment” can mean many different things and imply very contradictory strategies. - At one extreme, it can mean hedging a snap shot view of the pension fund liabilities with a portfolio of nominal and index linked bonds and swaps, which is a very expensive proposition, particularly when assumptions on the liability side change leaving the so called matching asset portfolio with unhedged risks.

At the other extreme, it could be argued that approximate matching using inflation hedging assets are all that is required. But this can lead to large weightings in equities, which may not be very different from a portfolio devised by a person who had never head of the term LDI.

Economics is ultimately based on human behaviour, which as recent years have shown, can be irrational, riddled with contradictions and impossible to predict. Pragmatism and scepticism are better guides to investment choices than any doctrinaire theory and the actions of the central banks in propping up their failing banking systems is evidence of that. The greatest challenge in asset allocation, may be to actually have an open and informed debate as to what are the alternative philosophical approaches that pension funds can choose from, without elevating the academic theories of economics such as MPT to the status of those in the physical sciences.

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