Is Modern Portfolio Theory Still Modern?

A reprinted article from July/August 2020

By Anthony B. Davidow, CIMA®

Is Modern Portfolio Theory Still Modern?

By Anthony B. Davidow, CIMA®

odern portfolio theory (MPT) This article addresses some of the identifies a few of the more popular assumes that investors are limitations of MPT and evaluates alter- approaches and the corresponding Mrisk averse, meaning that native techniques for allocating capital. limitations. For MPT and PMPT (post- given two portfolios that offer the same Specifically, it will delve into the follow- modern portfolio theory), the biggest expected return, investors will prefer ing issues: limitation is with respect to the robust- the less risky portfolio. The implication ness and accuracy of the data used to is that a rational investor will not invest A What are the various asset allocation optimize. Using only long-term histori- in a portfolio if a second portfolio exists approaches? cal averages of the underlying asset with a more favorable profile of risk A What are the limitations of each classes is a flawed approach.Long -term versus expected return.1 approach? data should certainly be considered—but A How should advisors evolve their what if the future isn’t like the past? MPT has a number of inherent limita- approaches? tions. Investors aren’t always rational— A What is the appeal of a goals-based The long-term historical annual return and they don’t always select the right approach? of the S&P 500 has been 10.3 percent portfolio. Investors often chase returns, A How should advisors use third-party (1956–2019). The equity allocation pro- especially during bull markets. Markets models? vided substantial growth, and the fixed aren’t always efficient, and they are prone income allocation provided income through to boom and bust periods. Long-term ASSET ALLOCATION retirement. Equity returns likely will be capital market assumptions (CMAs) are METHODOLOGIES lower than their historical averages, and used in mean-variance optimization Critics will point to the limitations of bond yields are at generationally low models; however, returns, risks, and cor- MPT, but many of the alternative method- levels. In fact, globally there are roughly relations aren’t stable over the long run. ologies have drawbacks as well. Table 1 $12 trillion in negative yielding bonds.

Table ASSET ALLOCATION METHODOLOGIES 1 Methodology Approach Limitations Dependent on robustness and accuracy of capital MPT is the optimal combination of asset classes Modern Portfolio market assumptions (return, risk, and correlations). to maximize the return for a given level of risk or Theory (MPT) MPT assumes that investors select the best portfolios minimize the risk for a given level of return. rather than the highest-returning portfolios. Dependent on robustness and accuracy of capital PMPT builds on MPT, focusing on optimizing the Post-Modern Portfolio market assumptions (return, risk, and correlations). downside risk of a portfolio, rather than the mean Theory (PMPT) PMPT reduces the risk of the overall portfolio but variance of returns. may lag in rising markets. Black-Litterman builds on MPT, focusing on the Larger asset classes will have a disproportional equilibrium assumption that the allocation to a Black-Litterman impact on model results, and smaller asset classes particular market should be proportional to the will have minimal impact on results. underlying market size. Liability-Driven LDI is an approach designed to match future This is typically an institutional approach used for Investing (LDI) flows to future liabilities by size and duration. defined benefit plans with predictable cash-flow needs. Risk parity focuses on allocating equally to risk, Risk parity helps in limiting risk, but this approach Risk Parity as defined by standard deviation, across asset likely will lag in rising markets where investors are (Risk Premia Parity) classes. rewarded for taking on risk. GBI solves for the various goals of individual Investors are prone to chasing returns, and it can Goals-Based Investing investors including accumulating wealth, saving for be challenging to keep them focused on their goals. (GBI) a home, sending a child to college, or generating Goals may change over time, so it is important to income in retirement income, among others. revisit goals periodically.

10 INVESTMENTS & WEALTH MONITOR

According to J.P. Morgan’s recent long- correlations, investors may not achieve especially in light of the financial term capital market assumptions,2 U.S. the desired diversification benefits. media’s fixation on record highs. large-cap equity returns are projected to be 7.2 percent over the next 10–15 years, Although MPT, PMPT, and Black- Nobel laureate Harry Markowitz once with aggregate bonds projected to be Litterman are somewhat similar in claimed that “diversification is the only 2.8 percent and cash 1.6 percent (all well approach, the nuances of each lead to free lunch in investing.” The free lunch below the long-term historical average) different resulting portfolios.Liability - is accomplished by introducing asset (see table 2). The lower assumptions driven investing (LDI) and risk parity are classes that don’t move in lockstep are driven largely by the current global more institutional approaches and may with one another. You could say that economic environment. Note, the not be the best approach for high-net- the correlations among asset classes are CMAs have changed to reflect the recent worth families. Goals-based investing the secret sauce of MPT. Unfortunately, volatility associated with COVID-19. (GBI) has become increasingly popular correlations aren’t static—and, in fact, because it aligns with investors’ goals they have been increasing over the Many of the approaches listed in table 1 and makes intuitive sense. Reporting past several years (see figure ).1 This are influenced by the CMAs used in the and reinforcing progress relative to is due in part to the inter-connectivity models. CMAs also are used in financial- those goals can be challenging, of the various markets and the central planning tools. The inputs need to make sense and not rely upon flawed historical Table SELECT LONG-TERM CAPITAL MARKET ASSUMPTIONS (10–15 YEARS) data. Relying upon flawed CMAs may 2 lead to overestimating returns and Capital Market Capital Market Assumptions Assumptions income—and falling short of investor Asset Class (9/30/2019) (3/31/2020) Change expectations. AC World Equity 6.5% 8.1% 1.6% U.S. Large Cap 5.6% 7.2% 1.6% All of the approaches in table 1 are Emerging Markets Equity 9.2% 10.5% 1.3% impacted by flawed CMAs, producing a “garbage-in, garbage-out” result. U.S. Treasuries (Intermediate) 2.7% 2.2% –0.5% Merely using long-term historical U.S. Aggregate Bonds 3.1% 2.8% –0.3% averages may lead to higher expecta- Private Equity 8.8% 9.8% 1.0% tions for returns and income than may Cash 1.9% 1.6% –0.3% be achievable today. Plus, with elevated Source: LTCMAs, J.P. Morgan Asset Management Multi-Asset Solutions, data as of April 20, 2020

Figure SELECT CORRELATION DATA 1 D D .00 2 .00 2 2 0. .00 2 0.0 .00 0. 0. .00 0. 0. .00 0. 0. 0.2 .00 0. 0. 0. .00 0. 0. 0. 0. .00 0. 0. 0. 0. .00 0. 0. 0.00.0 0.0 .00 0.0 0. 0.0 0.02 0. .00 0.0 0.0 0.22 0.2 0. 0. .00 0. 0. 0.0 0.0 0. 0. .00 0. 0. 0. 0.0 0. 0.22 0.2 .00 0. 0.0 0.2 0. 0. 0. 0. .00 0. 0. 0. 0. 0.0 0.2 0.2 0. .00 0 0.0 0.0 0. 0. 0. 0.0 0.2 0. .00 0 0 0. 0.20 0. 0. 0. 0.02 0. 0.2 0. .00 0 0.2 0. 0. 0. 0. 0. 0. 0. 0.20 .00

C ■ 0..0 ■ 0.0. ■ 0.0. ■ 0.00. ■ 0.0

A C .. arge ap International eveloped arge ap merging arets loal onds RIs 2.. mall ap International eveloped mall ap .. ore onds igh ield onds 0ommodities

Source: Zephyr STYLEAdvisor 2019

INVESTMENTS & WEALTH MONITOR 11

© 2020 Investments & Wealth Institute. Reprinted with permission. All rights reserved. © 2020 Investments & Wealth Institute. Reprinted with permission. All rights reserved. JULY AUGUST FEATURE | Is Modern Portfolio Theory Still Modern? 2020

Figure BEYOND THE 60/40 PORTFOLIO Advisors should consider broader diver- 2 sification across their equity and fixed L M income allocations including international developed, emerging markets, high yield bonds, real estate, commodi- ties, and certain types of alternative iversiied ore onds investments. The broader diversification iversiied onds can assist in increasing the return, ore uit uit reducing the risk, and providing non- ash correlating returns. ash iversiied Alternatives In recent years, many advisors have become enamored with the growth of U.S. large-company growth and some A A C have questioned the merits of allocating ommodities Alternative Investments abroad (see figure ).3 Of course, making rivate uitet loal aro anaged utures onghort uit rivate Real state Alternative redit et. decisions based on short-term results can be short-sighted. Recency bias is a common problem for investors because they extrapolate short-term bank intervention that has led to artifi- results and assume those results will cially low global interest rates, among persist in the future. other issues. It may be prudent to employ some form of tactical How quickly we forget the lessons of the Figure 1 shows that more asset classes first decade of the 21st century, some- exhibited low to negative correlation to approach during turbulent times called “The Lost Decade,” which one another (dark blue and green boxes) times when markets don’t was bookended by stock market crashes. during 1999–2008 than during 2009– act rationally. From January 2000 to December 2009, 2018. Over the past decade, correlations U.S. large-cap equity was the only major have increased dramatically across the asset class that delivered negative annu- board. In fact, during periods of shocks alized returns (see figure ).4 Emerging such as 2008 or the fourth quarter of most of their returns from stock alloca- markets equity and debt performed very 2018, correlations rose among most tions and income coming primarily well during this period. After this period, major asset classes. When we need the from bond allocations. The long-term investors were tempted to dismiss the benefits of correlations the most, they fail historical annual average of the S&P 500 U.S. markets and focus more attention to retain their diversification benefits. has been 10.3 percent, and the long- on the emerging markets. This supports the argument for spreading term annual yield on bonds has been the risk to more and new asset classes. 4–5 percent. Stocks and bonds have In addition to broadening exposure provided some degree of diversification. outside our borders, advisors also It’s worth noting that markets react Therefore, the naïve 60/40 portfolio should consider including alternative very differently over normal periods has provided attractive returns and investments. With the strong U.S. and turbulent periods. Correlations are income, and investors easily could large-cap returns during the bull run, much more stable over market cycles. shift allocations to generate higher advisors have been slow to incorporate However, when we experience shocks to returns or higher income to accommo- alternative investments in a meaningful the market such as the second half of date needs over time. way. Some of it is due to the generally 2008 or the fourth quarter of 2018, lackluster results of many of these correlations rise significantly. It may be But what if equity returns and bond strategies—and some is due to the lack of prudent to employ some form of tactical yields are lower during the next 10–20 education and conformity in describing approach during turbulent times when years? What if the correlations among what these strategies are designed to do markets don’t act rationally. asset classes remain elevated? Does the in a diversified portfolio (Davidow 2018). 60/40 portfolio still work for our clients EVOLVING ASSET ALLOCATION (see figure )?2 In fact, many are ques- Most alternatives are not designed The 60/40 allocation is a popular bench- tioning the merits of the 60/40 portfolio to outperform the S&P 500 in a rising mark portfolio, with investors gaining (Davidow 2017). market. Strategies such as long–short

12 INVESTMENTS & WEALTH MONITOR

and relative value provide hedged Figure SELECT ASSET CLASS RETURNS (2010-2019) 3 2000 2001 2002 2003equity20 0exposure.4 2005 Managed2006 futures2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 and global macro are defensive strate- Emerging Small Cap U.S. Real Small Cap Real Large Small Cap Emerging Cash Large Market Equity Fixed Estate Equity Estate Cap Equity Market Equivalent Cap gies that earn their stripes in difficult Equity Income Equity Equity Equity market conditions, and alternative 78.51% 26.85% 7.84% 27.73% 38.82% 15.02% 1.38% 21.31% 37.28% 1.87% 31.49% High Yield Real High Yield Emerging Large Large U.S. High Yield Dev ex- U.S. Small Cap credit strategies exploit illiquidity and Estate Market Cap Cap Fixed U.S. Fixed Equity the ability to be long and short sectors Equity Equity Equity Income Equity Income 58.21% 19.63% 4.98% 18.23% 32.39% 13.69% 0.55% 17.13% 24.21% 0.01% 25.52% of the credit market. Real Emerging Glbl ex- Dev ex- Dev ex- U.S. Cash Large Large High Yield Dev ex- Estate Market U.S. U.S. U.S. Fixed Equivalent Cap Cap U.S. Equity Fixed Equity Equity Income Equity Equity Equity Private equity, private debt, and private 37.13% 18.88% 4.36% 16.41% 21.02% 5.97% 0.05% 11.96% 21.83% -2.08% 22.49% Dev ex- High Yield Large Small Cap High Yield Small Cap Real Emerging Small Cap Glbl ex- Real real estate are garnering a lot of atten- U.S. Cap Equity Equity Estate Market Equity U.S. Estate tion. These once-elusive asset classes Equity Equity Equity Fixed 33.67% 15.12% 2.11% 16.35% 7.44% 4.89% -0.79% 11.19% 14.65% -2.15% 21.91% are now available to more investors, at Small Cap Large Cash Large Real High Yield Dev ex- Real Glbl ex- Large Emerging lower minimums, with better liquidity Equity Cap Equivalent Cap Estate U.S. Estate U.S. Cap Market Equity Equity Equity Fixed Equity Equity (Davidow 2019). If, in the future, tradi- 27.17% 15.06% 0.10% 16.00% 3.67% 2.45% -3.04% 4.06% 10.51% -4.38% 18.44% tional returns and income are likely to Large Dev ex- Small Cap High Yield Cash Cash Small Cap Dev ex- Real Real High Yield Cap U.S. Equity Equivalent Equivalent Equity U.S. Estate Estate be well below historical averages, advi - Equity Equity Equity 26.47% 8.95% -4.18% 15.81% 0.07% 0.03% -4.41% 2.75% 10.36% -5.63% 14.32% sors will be forced to identify alternative Glbl ex- U.S. Real U.S. U.S. Emerging High Yield U.S. High Yield Small Cap U.S. sources of returns and income for their U.S. Fixed Estate Fixed Fixed Market Fixed Equity Fixed Fixed Income Income Income Equity Income Income clients. They’ll need to evaluate different 7.53% 6.54% -6.46% 4.21% -2.02% -2.19% -4.47% 2.65% 7.50% -11.01% 8.72% strategies and structures to meet clients’ U.S. Glbl ex- Dev ex- Glbl ex- Emerging Glbl ex- Glbl ex- Glbl ex- U.S. Dev ex- Glbl ex- Fixed U.S. U.S. U.S. Market U.S. U.S. U.S. Fixed U.S. U.S. needs and objectives. Income Fixed Equity Fixed Equity Fixed Fixed Fixed Income Equity Fixed 5.93% 4.95% -12.21% 4.09% -2.60% -3.09% -6.02% 1.49% 3.54% -14.09% 5.09% Cash Cash Emerging Cash Glbl ex- Dev ex- Emerging Cash Cash Emerging Cash Figure 5 shows that private equity histor- Equivalent Equivalent Market Equivalent U.S. U.S. Market Equivalent Equivalent Market Equivalent Equity Fixed Equity Equity Equity ically has delivered strong absolute and 0.21% 0.13% -18.42% 0.11% -3.08% -4.32% -14.92% 0.33% 0.86% -14.57% 2.28%

relative returns compared to traditional Source: Callan, 2020 asset classes. Today, there are substan- tially more private companies than Figure THE LOST DECADE public companies—and many will stay 4 private longer. Note, however, private 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Real U.S. Glbl ex- Emerging Real Emerging Real Emerging U.S. Emerging Small Cap U.S. Real Small Cap Real Large Small Cap equity standard deviation is likely under- Estate Fixed U.S. Market Estate Market Estate Market Fixed Market Equity Fixed Estate Equity Estate Cap stated due to the nature and frequency Income Fixed Equity Equity Equity Income Equity Income Equity 13.84% 8.43% 22.37% 55.82% 37.96% 34.00% 42.12% 39.38% 5.24% 78.51% 26.85% 7.84% 27.73% 38.82% 15.02% 1.38% of valuing securities. U.S. High Yield U.S. Small Cap Emerging Real Emerging Dev ex- Glbl ex- High Yield Real High Yield Emerging Large Large U.S. High Yield Fixed Fixed Equity Market Estate Market U.S. U.S. Estate Market Cap Cap Fixed Income Income Equity Equity Equity Fixed Equity Equity Equity Income ASSET ALLOCATION 11.63% 5.28% 10.26% 47.25% 25.55% 15.35% 32.17% 12.44% 4.39% 58.21% 19.63% 4.98% 18.23% 32.39% 13.69% 0.55% CONSIDERATIONS Cash Cash Real Real Dev ex- Dev ex- Dev ex- Glbl ex- Cash Real Emerging Glbl ex- Dev ex- Dev ex- U.S. Cash Equivalent Equivalent Estate Estate U.S. U.S. U.S. U.S. Equivalent Estate Market U.S. U.S. U.S. Fixed Equivalent There are a number of asset allocation Equity Equity Equity Fixed Equity Fixed Equity Equity Income and portfolio construction consider- 6.18% 4.42% 2.82% 40.69% 20.38% 14.47% 25.71% 11.03% 2.06% 37.13% 18.88% 4.36% 16.41% 21.02% 5.97% 0.05% Small Cap Small Cap Cash Dev ex- Small Cap Large Small Cap U.S. High Yield Dev ex- High Yield Large Small Cap High Yield Small Cap Real ations in building better portfolios. The Equity Equity Equivalent U.S. Equity Cap Equity Fixed U.S. Cap Equity Equity Estate Equity Equity Income Equity Equity following represent a few key issues: -3.02% 2.49% 1.78% 39.42% 18.33% 4.91% 18.37% 6.97% -26.16% 33.67% 15.12% 2.11% 16.35% 7.44% 4.89% -0.79% Glbl ex- Emerging High Yield High Yield Glbl ex- Small Cap Large Large Small Cap Small Cap Large Cash Large Real High Yield Dev ex- U.S. Market U.S. Equity Cap Cap Equity Equity Cap Equivalent Cap Estate U.S. A Strategic versus tactical allocation Fixed Equity Fixed Equity Equity Equity Equity Equity A Asset allocation and asset location -3.91% -2.61% -1.37% 28.97% 12.54% 4.55% 15.79% 5.49% -33.79% 27.17% 15.06% 0.10% 16.00% 3.67% 2.45% -3.04% High Yield Glbl ex- Emerging Large High Yield Cash High Yield Cash Large Large Dev ex- Small Cap High Yield Cash Cash Small Cap A Active versus passive investing U.S. Market Cap Equivalent Equivalent Cap Cap U.S. Equity Equivalent Equivalent Equity A The role and use of alternatives Fixed Equity Equity Equity Equity Equity -5.86% -3.75% -6.16% 28.68% 11.13% 3.07% 11.85% 5.00% -37.00% 26.47% 8.95% -4.18% 15.81% 0.07% 0.03% -4.41% A Liquidity and cash-flow needs Large Real Dev ex- Glbl ex- Large High Yield Glbl ex- High Yield Dev ex- Glbl ex- U.S. Real U.S. U.S. Emerging High Yield Cap Estate U.S. U.S. Cap U.S. U.S. U.S. Fixed Estate Fixed Fixed Market Equity Equity Fixed Equity Fixed Equity Fixed Income Income Income Equity Given some of the limitations noted -9.11% -3.81% -15.80% 19.36% 10.88% 2.74% 8.16% 1.87% -43.56% 7.53% 6.54% -6.46% 4.21% -2.02% -2.19% -4.47% Dev ex- Large Small Cap U.S. U.S. U.S. Cash Small Cap Real U.S. Glbl ex- Dev ex- Glbl ex- Emerging Glbl ex- Glbl ex- above, and the dynamic nature of U.S. Cap Equity Fixed Fixed Fixed Equivalent Equity Estate Fixed U.S. U.S. U.S. Market U.S. U.S. today’s market cycle, advisors may Equity Equity Income Income Income Income Fixed Equity Fixed Equity Fixed Fixed -13.37% -11.89% -20.48% 4.10% 4.34% 2.43% 4.85% -1.57% -48.21% 5.93% 4.95% -12.21% 4.09% -2.60% -3.09% -6.02% want to incorporate a tactical overlay Dev ex- Large Cash Cash Glbl ex- U.S. Real Emerging Cash Cash Emerging Cash Glbl ex- Dev ex- Emerging to respond to changing market condi- U.S. Cap Equivalent Equivalent U.S. Fixed Estate Market Equivalent Equivalent Market Equivalent U.S. U.S. Market Equivalent Equity Equity Fixed Income Equity Equity Fixed Equity Equity tions. We don’t recommend making -21.40% -22.10% 1.15% 1.33% -8.65% 4.33% -7.39% -53.33% 0.21% 0.13% -18.42% 0.11% -3.08% -4.32% -14.92% big swings in and out of the market Source: Callan, 2020

INVESTMENTS & WEALTH MONITOR 13

but rather subtle shifts to better posi- want to consider exchange-traded funds implications. What specifically are you tion portfolios given the prevailing (ETFs) to gain broad market exposure. solving for? Does your client meet the market conditions. ETFs typically are more tax-efficient than accreditation standards? Does the separately managed accounts (SMAs) and structure provide adequate liquidity? Advisors often spend a lot of time think- mutual funds. Passive management also Based on the answers to these questions, ing about client asset allocation strategy, has a significantcost -advantage. Active advisors can then determine the most but they spend little time thinking about managers may be best equipped to play appropriate solutions. which investments belong in which type defense and navigate through a challeng- of account (e.g., personal account, indi- ing market environment such as the one ENVIRONMENTAL, SOCIAL, vidual retirement account, trust, etc.). we’re currently experiencing. Active AND GOVERNANCE Asset location is an important consider- managers also may be suitable in less- In recent years, there has been a lot of ation for high-net-worth investors because efficient asset classes and niche strategies. interest in environmental, social, and the tax consequences of bad decisions governance (ESG) investing. Women may erode any benefit gained from asset The role and use of alternatives are and men, young and old, have indicated allocation. Consequently, advisors may important considerations with multiple a desire to align their interests and their portfolios. There has been some confusion about how best to do that and Figure SELECT ASSET CLASS RETURNS (1999-2018) 5 whether all strategies screen securities in the same fashion (see table 3). There’s 2 also a great deal of confusion surround- ing the terminology used (i.e., socially responsible investing [SRI], ESG, sustainable, and impact investing).3 Return In the 1990s, SRI became popular primar- 0 ily with institutions. SRI is negative 0 0 20 2 0 screening, eliminating companies with tandard eviation harmful practices. SRI typically came at U.S. Large-Cap Stocks International Large-Cap Stocks Emerging-Market Stocks a cost. By eliminating certain com panies, U.S. Small-Cap Stocks U.S. Bonds Private Equity or industries, these strategies typically lagged the market. Consequently, many Source: Morningstar Direct, 2019 investors chose to reflect their views and preferences in a different fashion. Table IMPACT INVESTING 3 ← Minimize Negative Impact Target Impact→ Restriction Screening ESG Integration Thematic Exposure Impact Investing Managing exposures Proactively considering Focusing on themes and Allocating to investment by intentionally ESG criteria alongside sectors dedicated to funds focused on private Impact avoiding investments financial analysis to solving sustainability- enterprises structured Priorities generating revenue from identify opportunities and related domestic and to deliver positive social objectionable activities, risks during investment global challenges and/or environmental sectors, or geographies process impacts Differentiated by Differentiated by ESG Differentiated by Differentiated by impact restriction criteria and integration process and macroanalysis, approach, regional focus, degree of shareholder degree of shareholder sustainability, research, liquidity, and impact advocacy advocacy and sector focus reporting Characteristics Not proactively seeking May also include screens May have investor environmental and social restrictions impact Mutual fund that excludes Separately managed Exchange-traded A private equity fund companies from buy account incorporating fund tracking index focused on emerging Investment universe (e.g., tobacco, analysis of ESG of renewable energy consumers or project Examples firearms, coal mining performance into stock companies level renewable energy companies) selection process investment Public and Private Markets Private Markets Source: Morgan Stanley Institute for Sustainable Investing

14 INVESTMENTS & WEALTH MONITOR

Over the past several years, ESG has And it should be reinforced and garnered a lot of attention, and a pro revisited in quarterly reviews. liferation of new products have come Advisors can align clients’ to the market. ESG is a relative screen- values and preferences with As an industry, we need to move inves- ing approach, and based on data from tors away from chasing returns and keep a number of reputable sources, it a broad array of U.S. and them focused on long-term goals and appears to outperform the market. international strategies. objectives—not because managers have Intuitively this makes sense—good There are limitations in a difficult time outperforming, but companies, with sound practices, should because we all have seen the data show- do well over time. certain asset classes, but ing how investors experience substantial the number of strategies underperformance relative to their This topic warrants a more compre and asset classes accessible benchmarks. hensive discussion than we have space for in this article, but let us consider is expanding rapidly. Advisors should start the goals-based a few asset allocation issues. As advi- discussion by identifying why they would sors have begun to embrace ESG, the recommend certain investments (see challenge for many is how to incorpo- Multiple studies have shown that inves- figure ).6 Obviously, much of the growth rate it into diversified portfolios. Does tors want more education about ESG, will come from the equity allocation— it need to be an all or none solution? and they want their advisors to provide U.S. and international, developed, and In other words, do all investments it to them (Dixson 2019). Embracing emerging markets. And depending need to incorporate ESG to validate ESG with clients moves the quarterly on the investor’s wealth, risk appetite, the approach? Are there enough strat review discussion beyond focusing and sophistication, an advisor may want egies across all asset classes? How solely on whether or not the portfolio to consider relative value, long-short, can one distinguish among myriad outperformed the market. or private equity. strategies? GOALS-BASED INVESTING Income will come primarily from fixed The answers to these questions are We’ve highlighted some of the limita- income—corporate, high yield, and evolving. Advisors can align clients’ tions of MPT and the methodologies emerging market debt, among others. values and preferences with a broad that build on MPT. Goals-based invest- Defensive assets include assets such array of U.S. and international strat ing relies on underlying CMAs, but as cash, Treasuries, and gold. Managed egies. There are limitations in certain it moves the discussion from optimizing futures and global macro may be appro- asset classes, but the number of strat portfolios to solving for investor needs. priate for certain investors. egies and asset classes accessible GBI needs to be part of the profiling is expanding rapidly. Advisors need process and incorporated in the invest- The value of framing the discussion in to evaluate the various screening meth- ment policy statement. It should this manner is that an advisor can focus odologies and the corresponding tilts influence the investments used and on how each investment is performing and biases. the amount allocated to each asset class. relative to the client goal. Gold isn’t in

2.2 2.2 .2 2.2 . 2.2

Figure GOALS-BASED FRAMEWORK 6 U.S. International Emerging Long- U.S. Large Small Private Growth Developed Large Relative Market Short Co. Stocks Co. Value Stocks Equity Stocks Co. Stocks Equity

U.S. Investment U.S. Emerging Grade U.S. Corp. Market Bank Loans and Alternative Income High Yield Bonds REITs Securitized Other Floating Rate Corp. Bonds Bonds Credit Bonds Notes

Defensive/ Gold and Non-Correlating Real Global Managed Cash CDs Treasuries Assets Other Macro Futures Precious Metals

INVESTMENTS & WEALTH MONITOR 15

the portfolio to outperform the S&P 500 segments of the markets. The models model per household to solve for client but rather to buffer market volatility in can provide global macro exposure or be needs. An advisor’s value proposition uncertain times. High yield and real used to generate income through retire- shouldn’t be devalued by employing estate investment trusts (REITs) are ment. The models can be geared toward third-party models; rather, it shifts in the portfolio to generate additional maximizing returns in rising markets or the focus to evaluating, selecting, income. damping volatility in choppy markets. and assembling models to achieve Because of the diverse nature of these the desired outcomes. Based on goals and objectives, each models, advisors may choose to utilize client will own different amounts of the multiple models with clients depending The value of the advisor is putting the underlying strategies. A young married upon what they’re trying to solve for. pieces of the puzzle together in the couple may be willing and able to take appropriate fashion. This is more than on more risk due to their time horizon. Advisors now have a multi-faceted asking a series of generic questions and The couple may have a healthy alloca- toolbox leveraging the resources and turning the portfolio over to a robot. tion to growth-oriented strategies and expertise of a broad set of proprietary and It’s understanding your client’s unique more aggressive income strategies third-party partner firms. Consequently, wants, needs, and desires—and assem- such as high yield and REITs. A family the value of the advisor is determining bling the right building blocks to nearing retirement may have a larger how best to use these models to satisfy achieve those goals. Sound asset alloca- allocation to income-generating strate- clients’ goals, dreams, and aspirations. tion advice is both art and science. gies and more defensive assets to protect against big losses. CONCLUSION Anthony B. Davidow, CIMA®, is president and In the age of robos, advisors should founder of T. Davidow Consulting, LLC, an independent consulting firm serving the needs THE RISE OF THE MODELS embrace asset allocation and portfolio of sophisticated advisors, asset managers, and One trend we’re seeing across the mar- construction as a way of demonstrating family offices. He is chair of theInvestments & ketplace is the rise of third-party models. value. Advisors should recognize some Wealth Monitor editorial advisory board. He With the extraordinary growth of ETFs of the inherent limitations with MPT and earned a BBA in finance and investments from providing abundant raw materials to other asset allocation approaches. For Bernard M. Baruch College. Contact him at [email protected]. build portfolios, and the challenges of asset allocation and financial planning asset allocation, a lot of focus has been purposes, advisors should ensure that ENDNOTES on developing and introducing model the CMAs used in the models are cur- 1. This is the technical definition of MPT; portfolios, many of which are manufac- rent and make sense. Otherwise, you’ll however, it uses some flawed assumptions. tured by third-party asset managers. likely fall short of reaching clients’ long- 2. J.P. Morgan Asset Management, “2020 Long-Term Capital Market Assumptions: These models can be total return or term goals and objectives. We may need LTCMA Mark-to-Market: COVID-19—New goals-based, or they can reflect client to adjust clients’ expectations for lower Cycle, New Starting Point” (April 2020), preferences such as ESG. returns and income in their portfolios. https://am.jpmorgan.com/us/en/asset- management/institutional/insights/portfolio- It’s always better to temper expectations insights/ltcma/executive-summary/. How should advisors think about these and overdeliver—rather than set your 3. see Tony Davidow, “Understanding and Embracing ESG” (May 22, 2020), models? Do they lessen the value of the clients up to fail. https://blog.investmentsandwealth.org/ advisor? Does one model solve for all understanding-and-embracing-esg- your client needs, or should you use A goals-based approach keeps investors investing. multiple models? focused on attaining goals rather than chasing performance. Advisors need to REFERENCES The growth of these models is a good consistently reinforce this goals-based Davidow, Anthony. 2017. Revisiting Modern Portfolio Theory and Portfolio Construction. thing—and a natural evolution for the approach to be effective; they cannot Investments & Wealth Monitor 32, no. 1: industry. In fact, we could see a similar focus on performance when it’s strong, 5–12. growth trajectory as in the early days of then refocus on goals when performance ———. 2018. Alternative Investments: A Goals- Based Framework. Investments & Wealth SMAs. SMAs didn’t negate the value lags. Also, it’s important to periodically Monitor 33, no. 1: 54–61. of the advisors but rather shifted the revisit client goals and objectives—they ———. 2019. Private Equity: Innovation and Evolution. Investments & Wealth Monitor 34, value proposition to selecting the right often change over time. no. 6: 38–43. combination of SMAs to meet client Dixson, Keith. 2019. Developing Deeper goals and objectives. Regardless of whether you build the Client Relationships through Sustainable Investing. Investment Insights, New York model or utilize models manufactured Life Investments (December). http:// With robust raw materials and better by a third party, you should understand images.go.newyorklife.com/Web/NewYorkL ifeInsuranceCompany/%7B6c4c259a-514a- technology, the models can provide the underlying methodology. There 4bc6-a66f-e7950985ee19%7D_RIS067- broad diversification to virtually all may be a need to use more than one 19_ESG_Develop_Relationships_final.pdf.

16 INVESTMENTS & WEALTH MONITOR

5619 DTC Parkway, Suite 500 Greenwood Village, CO 80111 Phone: +1 303-770-3377 Fax: +1 303-770-1812 www.investmentsandwealth.org

INVESTMENTS & WEALTH INSTITUTE® is a registered mark of Investment Management Consultants Association Inc. doing business as Investments & Wealth Institute. CIMA®, CERTIFIED INVESTMENT MANAGEMENT ANALYST®, CIMC®, CPWA®, CERTIFIED PRIVATE WEALTH ADVISOR®, RMA®, and RETIREMENT MANAGEMENT ADVISOR® are registered certification marks of Investment Management Consultants Association Inc. doing business as Investments & Wealth Institute.