This year marks the 50th anniversary of what most people call Modern Portfolio Theory, or MPT. The seminal work of Harry Markowitz on efficient portfolio construction was first published in 1952. This work, coupled with that of Graham and Dodd, separated the world of economics from that of finance and formed the foundation for investment decision-making as we know it today. In this article we make the distinction between Mr. Markowitz's work, which we call simply Portfolio Theory, or PT, and extensions of this theory that have evolved during the past half century, which we call Extended Portfolio Technology, or EPT.
Let's begin by examining what we've learned in the past 50 years, with an eye toward identifying how this knowledge has led us to make better investment decisions. PT explains quite clearly that there are risk-return tradeoffs in the market. A few of these tradeoffs are efficient in that they provide the highest expected return for a given level of risk. Almost all individual securities and most combinations, or portfolios, of securities are inefficient. Efficient portfolios are expected to deliver superior risk-adjusted returns over time. Patience is not its own reward; creating efficient portfolios is. PT further advises against putting all of your eggs in one basket because a well-diversified portfolio reduces risk better than stock picking. Good solid basic stuff. In the past 50 years, we've learned many important lessons, most of which derive from these basic tenets.
One lesson is that investment policy, or asset allocation, is by far the most important determinant of investment results. In other words, determining the amount allocated among stocks, bonds, real estate, etc. is undoubtedly the most important decision an investor makes, and it's an unavoidable decision.
PT gives us a framework for making this decision. All one needs to know is how to measure risk and return and how to choose the appropriate risk-return tradeoff. In his 1959 book "Portfolio Selection," Mr. Markowitz chose variance over downside risk, which he called semivariance, because of the "superiority of variance with respect to cost, convenience and familiarity," even though he believed downside risk "produced better portfolios than those based on variance." He called for the investment community to "start with analysis based on variance" and then consider applying downside risk "after experience is gained with simpler measures." We believe 50 years is long enough. It is time to redefine investment risk not as volatility, but as failure to accomplish an investment goal, e.g., to keep what you've got, or to meet a future obligation. Volatility overstates risk because it assumes high returns are just as risky as low returns. In addition, capital markets are not all that efficient, due in part to investor behavior, which was supposed to keep the markets efficient, but instead messes them up.
Another lesson we've learned is that active managers rarely earn their fees, especially after taxes, and that the majority of investors chase the infamous "hot dot," resulting in even worse performance. Studies have shown the average investor in a typical mutual fund earns less than that mutual fund earns over time, because the investor switches in and out at precisely the wrong times. Further exacerbating this problem, the average mutual fund typically underperforms an appropriate passively managed - and cheaper - alternative.
Let's examine how these lessons of the past half century have improved investment practices. First, it took about 20 years for the world to recognize and accept Mr. Markowitz's breakthrough, so not much happened for a while. Then the next 15 years brought a flurry of innovation, and gave rise to the investment consulting profession. This brings us through to the end of the 1980s. Much of what consultants deliver today is essentially the same as it was 15 years ago. Advice and guidance have not evolved much. Importantly, the lessons of the recent past have not made their way into contemporary investment portfolios.
Investment policy innovation
Technology is available today to help consultants deliver on their value-added proposition. However, this technology is grossly underutilized because it appears to be on that same 20-year slow track that Harry Markowitz experienced. It is time we recognize in a formal way that all retirement plans involve liabilities as well as assets. In defined benefit plans, there is an identifiable rate of return that must be earned on the assets to meet the actuarial liabilities. Similarly, 401(k) and other defined contribution plans also have a liability in the form of a desired stream of future payouts that will support the participants' lifestyles in retirement. And like the defined benefit plan, there is a rate of return that must be earned at minimum to provide these desired payouts. We call this required return the minimal acceptable rate of return, or MAR. Returns above the MAR lead to good outcomes, which are the rewards for taking on the risk of falling below the MAR. This approach is sometimes called Post Modern Portfolio Theory. Since it is simply implementing and extending the ideas Mr. Markowitz recommended 50 years ago, we will call this and the other extensions of PT discussed below Extended Portfolio Technology. It's not easy to collect the inputs for this technology, which include capital market forecasts and client assumptions, and it takes time and energy to interpret the results, but, after all, this is the most important decision the client makes.
Similarly, investors can improve the odds of actually finding investment manager talent. Do managers have skill? Do you know who these skillful managers are? Are consultants personally invested with these managers? We've recently discovered that investment style is an important determinant of performance, ranking second only to investment policy, and that skill within a style tends to persist. Good growth equity managers continue to be good growth equity managers. Ditto for value. Unfortunately, we routinely confuse style with skill. Witness the mass firings of value managers just two years ago.
We've also learned that value and growth go in and out of favor, so you can try to call the style turns, or avoid making the wrong call by maintaining style neutrality. Whichever choice you make, you'll want to employ managers with skill or, if you can't find skill, invest passively. The search for skill is enhanced by a new technology that first separates style effects and then identifies the sources of the value added above style, otherwise known as performance attribution. In contrast to the attribution analyses developed 15 years ago and still widely used today, which promote the mistake of confusing style with skill, the new contemporary technology actually helps identify investment manager talent.
Once you've discovered talent, you need to allocate among these skillful managers in a manner that avoids making unintended style or sector bets. You've got to diversify while simultaneously capitalizing on the collective skills of the team you've assembled. The key to success is to invest with winners.
How to allocate
We want to allocate among skillful managers to achieve the greatest upside potential above the MAR relative to the downside risk of falling below MAR. First we want to find managers who have demonstrated an ability to beat their style-customized benchmarks on a risk-adjusted basis. Then we estimate how often each manager might be above MAR and how far above.
In the example shown in the accompanying table, style analysis reveals the Vanguard Windsor II behaves like a portfolio made up of 92% large value index and 8% long-term bonds. So we construct a style benchmark with those percentages to measure the upside potential and downside risk for that fund. The upside potential ratio is 1.67, which means this fund has 67% more upside potential than downside risk. Similarly, a benchmark of 90% large value, 5% long-term bonds and 5% intermediate-term bonds is created for the T. Rowe Price Equity Income fund. The T. Rowe Price fund has about the same upside potential as the Vanguard fund (1.65) because they have very similar styles. The difference is that T. Rowe Price Equity Income earned three percentage points more on average than its style benchmark while Vanguard earned three percentage points less than its style benchmark. T. Rowe has evidenced more skill. This risk-adjusted return above the style-customized benchmark is called an "Omega-excess return." This process would be repeated for all mutual funds or active managers under consideration.
In the second step, the optimizer seeks that combination of active managers and passive indexes that maximizes the overall portfolio's Omega excess return, while preserving the desired style profile, which is normally style neutral. This is accomplished with quantitative methods designed for this purpose that are mathematically sound. This is not a mystical procedure to guarantee success; it is a professional approach for managing uncertainty with respect to specific financial goals.
If we use what we've learned over the past 50 years, with special attention to the recent lessons, the resulting EPT can lead us to success in accomplishing our goals, mainly by managing financial uncertainty in a professional manner, and by avoiding the common mistake of confusing style with skill. The prescription is actually quite simple:
Find talent by identifying those who appear to be winners in their style of management, and by confirming that the reasons for winning are consistent with the manager's people, process and philosophy. The first step finds the winners. The second step, confirmation of consistency, is the window to success.
Allocate to that talent to maximize the probability of achieving objectives while minimizing the likelihood of regret.
These concepts have only been around for a few years now so they are noticeably underutilized in practice. Perhaps these ideas are on the same 20-year slow track that MPT experienced. If so, you may have to wait 15 years before EPT becomes common practice. But you will have missed an opportunity to identify potential winners.