Use and Abuse of Modern Portfolio Theory
“ You don ’ t want to be average ; it ’ s not worth it , does nothing . In fact , it ’ s less than the [ public ] market . The question is ‘ how do you get to first quartile ?’ If you can ’ t , it doesn ’ t matter what the optimizer says about asset allocation .”
— Allan S . Bufferd , treasurer emeritus , MIT ( 2008 )
In 1990 , Harry Markowitz received a Nobel Prize in Economics for his pioneering work on portfolio management . Dubbed Modern Portfolio Theory ( MPT ), Markowitz ’ s research demonstrated how investors could improve risk-adjusted returns by diversifying their portfolios among investments with imperfect return correlations .
Markowitz ’ s Nobel Prize coincided with an era of rapid growth for investment consulting firms . Many firms started by offering only investment performance reporting to institutional plan trustees , while bank asset management departments provided discretionary advisory services . Over time , consultants revealed that banks often produced lackluster performance and charged relatively high fees . Throughout the 1970s and 1980s , consultants convinced trustees to abandon banks and construct multi-manager portfolios with increasingly complex allocations . MPT was the tool that consultants used as a basis for their recommendations .
By the turn of the 21st century , MPT-based models were stretched far beyond their limits . The issue was that the utility of the output depended on the accuracy of return , volatility and correlation assumptions . But these assumptions were and always will be subject to a high degree of imprecision . While MPT models can help trustees visualize risk / return tradeoffs at a high level , they are far too imprecise to provide value in niche asset classes , such as alternative asset classes .
Abuse of MPT has intensified in recent years . Struggling to differentiate from competitors , many consulting firms concoct dozens of asset class assumptions that are highly misleading at best . This is especially problematic with alternative asset classes because expected returns are further distorted by the exceptional returns realized in the early phase of the cycle . Even more importantly , success in alternative asset classes is largely a function of skill , the presence of which is vitally important when an asset class is flooded with capital . Therefore , the most important metric to guide alternative asset allocations is the track record of the firm or person recommending them . But unlike the capital being deployed , such information is usually in short supply . indicating that the opportunity has largely expired . In the late phase of the alternative asset class cycle , sufficient rewards only accrue to a small cohort of highly skilled investors . Trustees considering entry or expansion into these asset classes must ask whether the track record of their advisors is sufficiently robust to warrant such adventures . This raises another formidable challenge . Few consultants bother to calculate their track records , and those who do are unlikely to share them because they justifiably fear it will reveal the absence of skill rather than the presence of it .
Mark Higgins , CFA , CFP ® is a financial historian , experienced institutional investment advisor and frequent contributor to Financial History magazine . His book , Investing in US Financial History ( Greenleaf Book Group , 2024 ), recounts the full financial history of the United States from 1790 to 2023 .
Sources
Burrough , Bryan and John Helyar . Barbarians at the Gate : The Fall of RJR Nabisco . New York : HarperCollins . 2009 .
Higgins , Mark J . Investing in U . S . Financial History : Understanding the Past to Forecast the Future . Austin : Greenleaf Book Group . 2024 .
Hsu , David H . and Martin Kennedy . “ Organizing Venture Capital : The Rise and Demise of American Research & Development Corporation , 1946 – 1973 . Industrial and Corporate Change . June 21 , 2005 .
Kochard , Lawrence and Cathleen Rittereiser . Foundation and Endowment Investing . Hoboken : John C . Wiley & Sons . 2008 . Nicholas , Tom . VC : An American History .
Cambridge : Harvard University Press . 2019 .
“ U . S . Government : Letter to SEC ( Demmler ) re : 17A , March 24 , 1954 .” Harvard Business School Baker Library , Volume 113 , Item 1 .
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