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Is Modern Portfolio Theory Still Modern?

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Is Modern Portfolio Theory Still Modern? A reprinted article from July/August 2020 Is Modern Portfolio Theory Still Modern? By Anthony B. Davidow, CIMA® © 2020 Investments & Wealth Institute®. Reprinted with permission. All rights reserved. JULY AUGUST FEATURE 2020 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 © 2020 Investments & Wealth Institute. Reprinted with permission. All rights reserved. JULY FEATURE | IS MODERN POrtfOLIO THEORY StiLL MODERN? AUGUST 2020 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 Januar D Januar D 1 1 1 .00 2 1 .00 2 2 0. .00 3 2 0.0 .00 3 3 0. 0. .00 4 3 0. 0. .00 4 4 0. 0. 0.2 .00 5 4 0. 0. 0. .00 5 5 0. 0. 0. 0. .00 6 5 0. 0. 0. 0. .00 6 6 0. 0. 0.00.0 0.0 .00 7 6 0.0 0. 0.0 0.02 0. .00 7 7 0.0 0.0 0.22 0.2 0. 0. .00 8 7 0. 0. 0.0 0.0 0. 0. .00 8 8 0. 0. 0. 0.0 0. 0.22 0.2 .00 9 8 0. 0.0 0.2 0. 0. 0. 0. .00 9 9 0. 0. 0. 0. 0.0 0.2 0.2 0. .00 0 9 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 anges ■ 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 ortf ForwarL M income allocations including interna- tional developed, emerging markets, high yield bonds, real estate, commodi- ties, and certain types of alternative iversiied Core onds investments. The broader diversification iversiied onds can assist in increasing the return, Core uit Euit 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 Pot Alternativ 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.
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