Modern portfolio theory and practice are failing institutional investors at a time when their depressed funding levels and high covenant risks require smarter ways of investing, according to the first paper published by the 300 Club.
In The Death of Common Sense: How elegant theories contributed to the 2008 market collapse, Professor Amin Rajan examines modern portfolio theory’s influence on the thinking of successive generations of investors and policy makers since the 1960s and the role it played in the cataclysmic financial crash of 2008.
Rajan says: “Harry Markowitz, the pioneer of modern investment theory, was the first person to make risk the centerpiece of portfolio management. This view inspired the origin of the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), both of which have since dominated portfolio theory. However, the evolution of these two theories led to the inference that markets are efficient and that active management does not work, which is simply untrue.”
The CAPM argues that by making various assumptions, much of the variation in investment returns comes from market movements, with each investment containing systemic and idiosyncratic risks. Systemic, being all pervasive market risks that cannot be diversified away, affecting investor sentiment directly and market volatility indirectly. Conversely, idiosyncratic risks are specific to the individual stock and can be diversified away as an investor increases the number of stocks in their portfolio. The only reason why an investor should earn more by investing in one stock rather than another is that one is riskier than the other.
The CAPM’s starting point is the risk-free rate, but it goes on to argue that investors in equities also demand an added premium to compensate them for taking the extra risk. This risk premium is derived by calculating the expected return from the market as a whole less the risk-free rate. On this argument, much of the variation in expected return comes from market movements as a whole: idiosyncratic risks are negligible. Therefore, by implication, active management cannot add value, it is just noise.
Subsequent studies have established that CAPM not only ignores investors behaviour biases, but that it omits other factors that have a significant role in influencing future returns, such as: price-earnings ratios; debt-equity ratios that measure leverage and book-to-market equity ratios. However, it is the supposition that active management does not add value that has been disputed the most.
The EMH states it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Hence, it should be impossible to outperform the overall market through expert stock selection or market timing. Therefore, passives are bound to beat actives that seek to exploit mispriced assets relative to a risk-adjusted benchmark, since the invisible hand of the market works faster than any single investor.
This belief has spawned today’s $4 trillion index fund industry and created a belief in the primacy of markets as an article of faith: markets knew how to value resources and allocate them most efficiently through an impartial and robust price mechanism. While the Dow Jones Industrial Average dates back to 1896, this index was simply a market proxy to provide a representative outcome for the stock market as a whole, and not an investment idea to evaluate manager performance.
While a number of ‘anomalies’ have been identified as delivering higher returns that cannot be explained by the EMH, there is no consensus on whether these factors reflect the existence of an inefficient market or the dynamic nature of risks that no model can explain.
Rajan says: “Nevertheless, the anomalies mean that the whole paradigm of rational expectations that reigned supreme for nearly fifty years is no more than an ideological aspiration about how markets ought to work under the tenets of neo-classical economics. The crash-landing of its two cherished idols – CAPM and EMH – in 2008 shows all too well that they were as remote from the complexities of markets as the man on the moon. The EMH cultivated a belief that markets are always right, with their own self-correcting fair-value dynamic, and mean reversion towards fundamental values is the norm.”
Indirectly, the EMH turned the art of investing into a science, from craft to industrialisation, from judgment calls to mechanical formulas. Modern innovations like portable alpha, derivatives, shorting and high frequency trading were justified as the only means to beat the market through clever mouse traps. However, systemic risks, product complexity and higher charges have been the main outcomes.
Rajan continued: “The industrialisation of investing has depersonalised relations between investors and their asset says. Unlike their physical counterparts, investment products do not have a definable shelf life or have predictable outcomes. For good returns, what matters most is timing and market environment – both of which require a far higher degree of engagement between investors and their managers than has been the case over the past 20 years.”
The events of the past four years have hugely discredited modern portfolio theory at an enormous cost to the global economy. While the EMH and the CAPM are no longer tenable, they have played a major part in shaping the psyche of financial investors, policy makers and the investment industry. It is too far-fetched to single them out as the key culprits in the current crisis. They are merely ingredients in a rich stew of financial irresponsibility, political ineptitude, lax regulation and perverse incentives.
Subsequent papers in the 300 Club series will focus on some of the challenges we are facing, including dynamic asset allocation, manager selection, principal-agency relationship and client engagement.