This year marks the 30th anniversary of the 1990 Nobel prize in Economics given to Harry Markowitz, William Sharpe and Merton Miller. IPE is marking this in several ways. The first event took place at the IPE annual conference in Copenhagen in December 2019, with a panel discussion following on from the showing of a delightful video. The video was based on a few days that TOBAM CEO Yves Choueifaty and I spent with Markowitz in his office in San Diego in June of that year and showed Markowitz’s charm and humility despite his great achievements.
I count myself privileged to have known Markowitz since setting up a joint venture with him in the mid-1990s to launch a suite of quantitative fund management strategies in the UK, managed by a group he was then leading at Daiwa Securities.
While the strategies were successful in terms of their objectives, the marketing was not. Perhaps our timing was premature, with one head of a leading investment consultant telling me then: “Joseph, you must realise no UK pension fund would ever invest in a quant fund.” Clearly, much has changed since then.
Markowitz is referred to, quite rightly, as the father of modern portfolio theory (MPT). MPT provides the structural framework for today’s whole investment market. It has led to, at one extreme, the drive towards so-called passive investment through indexation which has swept the mar-ket and, at the other extreme, to the most sophisticated risk-controlled approaches to active management.
Thirty years after the Nobel and almost 70 years after Markowitz first came out with the ideas behind MPT, there have been enormous applica-tions and developments in financial economics that have arisen and underlie many of the products such as index funds that are dominating today’s investment marketplace.
The topic that Markowitz was asked to explore for his doctoral the-sis was how best to structure a portfolio of equities. His revolutionary approach was to recognise that while equities may offer dividend streams in the future like bond coupons, equities also have risks in the form of volatile share prices, which should also be taken into account in a systematic manner. The way to do this, he postulated, was by defining risk as the standard deviation of the total equity returns and recognising that the standard deviation of the returns of a portfolio of equities, or assets in general, will be reduced by the extent that the securities are uncorrelated with each other.
Combining stocks which tend to move in opposite directions will reduce the overall port-folio standard deviation to levels below that of individual stocks. It is then possible to produce an ‘efficient frontier’ of portfolios, each of which maximises future return expectations for a given level of overall portfolio risk. That insight, which seems so obvious today, was a revelation when it was first put forward.
The mathematical problem that Markowitz solved was that, given a set of stocks with expected returns, standard deviations and correlations with each other, how the set of efficient portfolios that maximises the expected return for a given level of risk can be determined. He devised an algorithm in 1956 known as the ‘critical line algorithm’ which produced a set of efficient portfolios that maximised returns for a given level of risk, tracing the now famous ‘efficient frontier’.
Today, there is another thread in investment thinking that is increasingly seen as a critical factor in invest-ment decision-making alongside returns and risks and that is the idea of sustainability. Investors are increasingly coming to the view that what matters when it comes to analysing any potential investment are not only returns and risks, but also the impacts that an investment in a company will make on the world in which it operates. Developing a coherent theoretical framework for a sustainable portfolio theory (SPT) is a challenge that, when solved, may even provide the opportunity for a future group of Nobel laureates.
There are some clues as to what SPT could look like. It is possible to measure in an objective quantitative manner the impact that every company within an investment universe makes on the world it operates in. Such impact figures can be expressed in monetary terms. Dividing the total monetary impact on the external world of a company’s activities by the company’s market capitalisation would give a figure for the impact per million dollars invested in that company – an ‘impact intensity’. There will be one stock with the maximum positive impact intensity).
It is possible to create an efficient frontier of portfolios with the maximum positive impact intensity for a given level of portfolio risk, just as Markowitz had created with portfolio returns. In this case, the stock with the maximum positive (or minimum negative) impact intensity would form one end of the efficient frontier. Adding more stocks to the portfolio would reduce portfolio impact intensity but also reduce the risks through the extra diversification produced. Producing an efficient frontier of portfolios with the maximum positive impact intensity for a given level of risk can be easily undertaken using Markowitz’s critical line algorithm as before but replacing return forecasts with impact intensities.
The challenge is to produce an efficient frontier that covers impact intensities as well as the returns and risk for-mulation of MPT. As there are now three variables, the solution would not be a straight line, but a three-dimensional surface. What is the mathematical formulation that could produce such a surface? We know that solutions exist for returns and risks and also for impact intensities and risks. But to create a solution that covers returns, impact intensities and risks requires a model for the relationship between returns and impact intensities. That is, do companies with better impacts on the world produce higher returns or, indeed, is there any correlation at all, positive or negative, between returns and impact intensities? If there was no correlation at all that is, returns and impact intensities are random, then the efficient frontier would presumably be a smooth curved surface connecting both two dimensional frontiers of returns and risk and impact intensi-ties and risks. But what if there is evi-dence that long-term returns are positively correlated with impact intensities? Would the surface be different?
Incorporating sustainability in a theoretically rigorous manner within portfolios is a challenge that still lies unsolved. Perhaps the most amazing thing about Markowitz is that at the age of 92, he is still working hard in his office near the beach in San Diego. He is writing another book, and as he told me, he intends to continue work-ing till he is 105. Perhaps there may still be an opportunity for him to help move modern portfolio theory towards sustainable portfolio theory.
Joseph Mariathasan is a contributing editor of IPE and a director of GIST Advisory