Modern Portfolio Theory (MPT) and supporting research have become the primary principles on which investors and investment advisors base their portfolio construction and business decisions. If you’re counting on Modern Portfolio Theory to mitigate risk and drive returns for an investment portfolio, results will be disappointing.
It is important for investors to understand why the financial services industry insists on using mathematical illusions to create a false sense of security among investors. Prior to 1975, brokerage commissions were fixed by law. This allowed established brokerage firms to generate enormous profits on large transactions. Financial planning and fee-based advice did not exist. On May 1, 1975, the Securities Acts Amendments eliminated fixed commissions, allowing for firms such as Charles Schwab to enter the market and drive down commission rates. This forced brokerage firms to expand their marketing reach to retail investors, whose accounts were not as profitable as the fixed commissions once charged to institutional clients.
The deregulation of commissions became the catalyst for the birth of financial planning and advice. New firms emerged, and with few barriers to entry, the financial services industry experienced an unprecedented influx of untrained financial advisors. The dilution of investment acumen and downward pressure on commission rates forced brokerage firms to rethink their business models. They needed a simple, standardized approach to help their financial advisors gather more assets without having to spend time analyzing investments – enter Modern Portfolio Theory.
The fundamental concept behind MPT is that the relationship between risk and return can be measured using mathematical equations, based on historical information. Moreover, MPT assumes that stock market returns are normally distributed. In probability theory, normal distribution gives the probability that an observation will fall in-between two real numbers. Said another way, a data set will have the same number of observations on the left and right side of a distribution curve. The majority of performance measurement tools used in portfolio management – beta, alpha, sharpe ratio, standard deviation – assume market returns and are normally distributed.
During the 1980s and into the 1990s, the simplicity of MPT allowed financial advisors to garner a larger percentage of their investors’ assets. The industry dogma of diversification and asset allocation convinced both investor and advisor alike, that it was impossible to beat the market. Under this paradigm, everyone wins except the end-investor.
In turned out that MPT’s assertions about risk control and investment returns did not work in the “real world.” Although not a Ponzi scheme, per se, it become a quasi-truth touted for the benefit of Wall Street at the expense of the retail investor. The economic crises experienced in 2002 and 2008 provide a great opportunity to revaluate the purpose of investing and the role of the investment advisor.
The reliance on traditional theories and styles of investing must be replaced by new strategies that have a real world application. Forecasting future returns based on what happened twenty years ago is a recipe for disaster. And that is exactly what the financial services industry has been doing for the past 30 years. The investment world is ready for major changes to take place.
Currently, 73% of trading activity on the NYSE is performed by computers, each programmed with similar algorithms. Stock prices no longer correlate with earnings because most of the trades that enter the market are programmed for short-term profit. Yet, investors still hold a majority of their assets in stocks, bonds and cash – based on the advice of their investment advisor.
The need for investors to find alternative investment prospects (alternative to stocks and bonds) has never been greater. It may be, perhaps, the only chance investors have to experience substantial returns in their portfolios.
The theoretical foundation of alternative investing is based on rewarding investment professionals who generate absolute returns, regardless of market conditions. Alternative investment managers are given greater freedom to operate in their area of expertise than traditional investment managers, whose decisions are constrained based on prospectus. Said another way, alternative investment management is to guerrilla warfare as traditional investment management is to trench warfare.
There is still a lot of mythology with respect to alternative investments. Although alternative investments are often branded as a separate asset class, an argument can be made that alternative investment managers are simply utilizing other strategies and a wider range of investment and risk management tools than those used by relative-return, long-only managers.
Additionally, there is a widely held perception that alternative investment strategies are somehow a new idea. Investors have used farmland, real estate, commodities, and private equity strategies for hundreds of years before a group of traders and speculators gathered under the Buttonwood Tree at the foot of Wall Street. Yes, alternative investments provide unique risk and return opportunities not generally available through stock and bond investments; however, this does not translate to alternatives being more “risky” than stocks and bonds.
Most investors are surprised when they discover how easy it is to invest in alternative return strategies. Direct ownership in real assets such as farmland may be a good place to start for investors new to the alternative investment arena. The rational for such investment is as follows:
As a real, tangible asset that is linked to food and energy production, farmland is expected to be a hedge against inflation. Its supply is inelastic, and increasing valuations will lead to relatively marginal increases in supply, further reinforcing its value as an inflation hedge.
Economic and demographic growth is likely to create increasing demand for agricultural products, especially in niche markets such as organic food. Increased demand may lead to the development of new farmland, new methods of cultivating the land and price appreciation of existing farmland assets.
As a private market investment, farmland has its own dynamics apart from that which exists in the traditional stock and bond markets. Farmland is generally a relatively unlevered asset, further disassociating its returns from traditional financial markets (CAIA Level II Advanced Topics in Alternative Investments).
Nearly every investment advisor, institutional investor and retail investor will agree that the financial services industry is much different today than it was at the turn of the century. The 2008 financial crisis has added more question marks about the role of model risk mitigation tools created in academic laboratories. To believe that a government, bond-heavy portfolio is investment panacea is to ignore nearly all economic systems and socio-economic experiments that have failed (see AIMA’s Roadmap to Hedge Funds, 2012). Holding onto the investment dogma and ideas that worked well in the past, might be the biggest risk investors face today. Maybe the greatest attribute an investor can possess is to be receptive to different perspectives and ideas; with the courage to act.
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