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Former analyst for Connecticut General and current serial entrepreneur with over 40 years experience building companies. Background includes a masters degree in economics from the University of Connecticut and experience taking several companies public. Educational and professional experience... More
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  • Proof that the Modern Portfolio Theory Should be Declared Dead  3 comments
    Apr 27, 2010 10:44 AM

    For the past sixteen years, Dalbar, Inc. has published its Quantitative Analysis of Investor Behavior (QAIB), which is the company's official survey of actual investor returns from mutual funds. The QAIB is developed based on an analysis of data received from the Investment Company Institute, and reports the actual average returns an investor realizes from mutual funds (which are significantly different than those advertised by mutual funds). In its 2010 report, Dalbar blames investor behavior, not the mutual fund industry, for 20 years of shockingly low returns, but surprisingly declares that the Modern Portfolio Theory is dead. Dalbar's latest report can be found here.

    In our opinion, Dalbar has been functioning as an apologist for the mutual fund industry - the company reports accurate data (i.e. the low returns that investors actual receive from investing in mutual funds) but then bends over backwards to make tortured arguments, which try and rationalize the mutual fund industry's failure to add value. While the low returns reported in the 2010 QAIB are no surprise, Dalbar's admission that Modern Portfolio Theory is dead is long overdue and shocking to say the least.

    Mutual Fund Investors' Low Returns

    The quantitative analysis part of the report shows improvement of returns for investors as compared to the numbers reported in 2009, but the numbers will shock most investors. For the 20 years ending December 31, 2009, investors' annualized returns by fund type were:  equity 3.17%, fixed income 1.02%, and asset allocation 2.34%.  All returns are before an inflation correction of 2.80%, which leaves investors with 20 years real equity annualized return of 0.37% and negative annualized returns for fixed income of -0.78% and asset allocation -0.46%. 

    For the 20 years the S&P 500 annualized return was 8.20%.  Mutual fund investors that invested in S&P 500 Index funds beat actively managed funds by 5.03 percentage points of annualized average return.  Why?  Dalbar's 2010 QAIB report blames investors for the poor returns: "The problem is, investors aren't rational and they don't buy and hold.  They jump in and out of the market."  To support this assertion, data is presented that shows the typical mutual fund investor has a holding period of three to four years. However, Dalbar doesn't mention that the S&P 500 outperforms a changing universe of active money managers 70% of the time, which makes the recommended buy-and-hold strategy for actively managed mutual funds a loser.

    Modern Portfolio Theory is Dead

    Modern Portfolio Theory is the foundation of the mutual fund industry. It's widely advertised as the way investors should allocate capital to be in tune with the best money management practices.  Modern Portfolio Theory says investor returns are determined by the level of risk the investor assumes.  So, like selecting a radio station, dial in the level of risk and get the expected return.  Simple! 

    We quote from QAIB 2010:

    "In spite of catastrophic losses in 2008, the belief in Modern Portfolio Theory ("MPT") has remained inexplicably strong.  MPT is grounded in the observation that asset classes are predictably uncorrelated.  Based on the theory risk can be mitigated by diversifying into uncorrelated asset classes.  However, unless the correlations of the various classes are predictable, the mitigation of risk is lost.

    Investors expect to be rewarded for the level of risk they are taking in a particular market.  Investments results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning.  This brings into question the very basis of MPT and its ability to forecast an efficient frontier.

    The Achilles' heel of MPT is that it simply cannot be reduced to a mathematical model or relied upon as the sole basis for the management of investment decisions..."

    It's a tough case for actively managed mutual funds using the Modern Portfolio Theory when you have at the table 20 years of S&P 500 Index Fund averaging annualized real returns of 5.40% and mutual funds achieving a real equity annualized return of 0.37% and negative annualized returns for fixed income  and asset allocation of -0.78% and -0.46% respectively.  To sell the investor that by allocating capital to each of these asset classes the investor can, based on the risk of each asset class, forecast an "efficient frontier" (optimal portfolio) to achieve a target rate of return is not a likely outcome. The dial on the radio is broken!  But before it broke, Modern Portfolio Theory caused investors to lose trillions of dollars.

    Disclosure: No positions
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Comments (3)
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  • thebziteam
    , contributor
    Comment (1) | Send Message
    We couldn't agree more.
    29 Apr 2010, 03:12 PM Reply Like
  • bmullen
    , contributor
    Comments (5) | Send Message
    When you start with an incorrect premise, the conclusion will rarely be correct. Stating that the basis of the MF industry is MPT is absurd. I do not know of any one MF that adheres to MPT with respect to diversification and rebalance. There is little to any diversification in an individual MF. Even the S&P 500 is not diversified. It represents the largest 500 stocks in the US. The Dalbar QAIB does compare the average investor against a true MPT based portfolio. The average MF has a turnover ratio of 100+%. That is stock picking and market timing. MPT has never stated that MPT guarantees a positive return. The business model of the MF industry does not put the investor's best interest first. It puts the MF company first.
    6 Dec 2010, 05:37 PM Reply Like
  • inlineskater
    , contributor
    Comment (1) | Send Message
    Though I agree with bmullen in concept I should clarify that actually the S&P 500 is a constructed index, not the largest 500 stocks in the US.
    29 Sep 2011, 07:34 PM Reply Like
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