Modern Portfolio Theory: Break Free, Dude!

by: AllAboutAlpha

There were a series of government-sponsored television commercials in Canada in the mid-1980s that in simple yet effective terms sought to encourage young people to “break free” from smoking tobacco.

Showing teenagers at school playgrounds, on the streets and in other social settings shouting “break free!” (“Fumer, c’est fini!” en Francais) the ads (click here for a humorous glimpse at one of them on YouTube [Ed: Yikes. Holy 80's hair!]) quickly caught on as a catchphrase among the Canuck young, with the at-the-time-prerequisite “dude” tossed in at the end for good measure.

State Street might easily have drawn more attention to its recent report on re-thinking asset allocation by using the slogan as its title, given its message of encouraging institutions to “break free” from the more traditional and in their view somewhat outdated confines of modern portfolio theory, or MPT.

While noting both its usefulness and its ability to mitigate damage during market extremes, particularly during the 2007-2009 financial crisis, the report (click here to download) indeed makes the case that perhaps it’s time institutional investors wean themselves away from relying solely on MPT and at least consider applying it in conjunction with other more modern and effective variables.

As most in the allocation business know, MPT is a theory of investment which tries to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.

More recently, however, the effectiveness of MPT, which as the report notes dates back to the 1950s, has been challenged by fields such as behavioral economics, particularly in the wake of the financial crisis and the multitude of black swans that flocked to Wall Street and every other financial center.

State Street makes the case that there are now better and more effective tools centered on market volatility, portfolio construction and trading liquidity that in combination with MPT can help asset allocators much more effectively than straight MPT alone. What’s more, the emergence of quantitative approaches aimed specifically at tackling turbulent market activity and ensuing “non-normal” investment returns that can be harnessed to help construct more robust risk models.

The chart below from the report illustrates the distribution of differences between hedged and unhedged on a five-year rolling basis.

“Investors should think about whether two basic assumptions of MPT apply to their circumstances,” the report says. “Are their returns normally distributed, and is there a smooth trade-off between wealth and satisfaction (i.e. quadratic utility?) If these assumptions do not apply, they should consider an alternative optimization methodology called full-scale optimization.”

In other words, augment the traditional MPT route by throwing some cash at hedge funds and other types of alternative strategies that can diversify the portfolio, help keep returns decent, mitigate risk in the event hell freezes over again and all assets correlate to one, and at the same time ensure there’s an option to pull the chute, if absolutely necessary, according to State Street.

Case in point: According to the report, when US and non-US equity markets produce returns greater than one standard deviation above the mean, the correlation stands at 17%. However, when the return drops to more than one standard deviation below the mean, correlation sharply rises to 76%, meaning investments are likely to suffer with the market.

Indeed, the report notes that one of the greatest failures of risk management in recent years was using average risk numbers rather than regime-specific risk analysis to gauge risk – something MPT doesn’t incorporate or address in the new era of extremes, in State Street’s view (see chart below).

The bottom line, according to State Street, is that MPT still remains deeply relevant in terms of portfolio construction, diversification and risk management. But given new and updated techniques in contemporary financial markets that take advantage of computational and information aggregation capabilities, it makes more sense to cut back a little rather than kick the MPT habit outright.