Here are some things to consider about recent market performance and Modern Portfolio Theory, raising some interesting questions.
-There have been no discernible risk-adjusted performance premiums associated with small-capitalization stocks, value stocks or non-U.S. stocks over the past 10 years.
-The current correlation between long-only equity strategies and hedged equity (long/short) is very close to +1, and those hedged equity strategies have been a negative alpha contributor to performance over the past several years, according to recent research produced by Morgan Stanley. In addition, most alternative-investment strategies have struggled mightily over the past three to five years to deliver performance in line with both historical performance and investor expectations.
But “The Fundamental Law of Active Management” (Grinold followed by Clarke, de Silva, & Thorley) suggests that removing investment constraints (e.g., allowing shorting) is one of the primary ways to increase the potential for increasing active management performance, as measured by the information ratio.
-In their provocative 2012 analysis titled “Low Risk Stocks Outperform within All Observable Markets of the World,” Nardin Baker and Robert Haugen suggest that, in direct contradiction to the work of Markowitz and Sharpe, among others, low-volatility stocks consistently outperform high-volatility stocks, that is, investors aren’t rewarded for taking higher risk.
So what is going on? Is MPT (and the Capital Asset Pricing Model, the Three-Factor Model and the Fundamental Law of Active Management, etc.) dead? Or, paraphrasing Mark Twain, are reports of its death greatly exaggerated?
It is important to note and remember that MPT and its offshoots are just that, theories that provide an analytical framework for trying to understand the highly complex and adaptive capital markets. All theories regarding the market will, by definition, make simplifying assumptions that may not hold up at all times or in all markets.
But for most of the past 30 to 40 years, investors who have used these tools as a logical framework for making defensible investment decisions have generally been served well.
Perhaps a simpler explanation, at least since 2008, is that “Don’t fight the Fed” has thoroughly overwhelmed the historical relationships between risk and return. For the most part, global central bank policies have been consistent and convergent: flood the markets with liquidity to fight off deflation and stimulate growth, lower rates to zero (or, increasingly below) to force investors to take risk if they want any hope of return, and generally truncate market volatility at every turn to preserve fragile economic growth and investor sentiment.
What are the market consequences of this global quantitative easing approach? Low volatility and reduced dispersion between the performances of individual securities, two critical ingredients for success in active management.
Fundamental analysis has mattered less than simply being in the market. Historical relationships between risk and return have mattered less than reaction to evolving central bank policies, and a very bad couple of innings for MPT.
One very rational reaction to this turn of events has been a renewed and increased adoption of goals-based investing, where the focus moves away from index comparative performance evaluation and toward progress to plan in meeting personal investment objectives.
A cynic might think, “Well, sure, when you are underperforming, change your benchmark. But since investors are goals-based and only consider index-based performance because the industry trained them to, this may be an unintentional but very positive development for wealth management.
So though it is true that central bank policy has beaten MPT to a pulp over the past seven to eight years, advisers should remember the dangers of extrapolating now into forever. One capital markets concept that hasn’t been seemingly discredited is the notion that markets tend toward mean reversion, which means that the tenets of MPT may start working again, just as investors jettison them in the mistaken belief of their premature demise.
This story is part of a 30-day series on ways to build a better portfolio.
