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Active Management Is Killing Modern Portfolio Theory

It is truly amazing how poorly understood Modern Portfolio Theory "MPT" is among industry "professionals". What is even more puzzling is the hackneyed means with which MPT has been applied by the financial industry which promotes this work as the "secret sauce" that makes the food they feed the dogs so much more palatable. Investment managers love to dazzle unsophisticated investors with MPT models and statistical references that create an aura of "science" intended to supplant the thought that these investment guys/gals are simply winging it. This article is not solely focused on the battle between active vs. passive management, but the fact that MPT is being used and applied incorrectly exactly because it is being implemented by active managers, not to mention implemented poorly.

How well does the average investment manager really understand MPT and how correctly do they actually end up applying its principles? If we have time enough, we might even explore why it is that investors still pay a premium to investment mangers wielding MPT as the primary tool in their bag when MPT seems to be the antithesis of active management (the fact that most active managers don't beat passive benchmarks backs this up). The performance comparisons suggest that active managers are not adding value. And, since the preponderance of investment management services utilize MPT methodology, they must be guilty of not getting it purely because they are not implementing it well. If they did get it they would realize that correlations are developed over long periods and while these measures may flex over the short-term, wisely allowing these periods to pass allows managers to avoid falling prey to errors they are being paid to help investors not to succumb to.

If this sounds like I am promoting a more passive style of investing you're right, and MPT gives me all the support I need to defend that position. I realize that while flapping gums around the street love to proclaim buy-and-hold dead along with attempting to include its cousin concept of MPT. If you are talking about a limited individual stock/bond portfolio I would suggest that buy-and-hold may be a more risky approach than active management. However, again this is the street misunderstanding and misapplying the principles of MPT. I submit that if you truly compose a balanced portfolio of broadly diversified, non-correlated investment components it will require very little management and perform as well as the market itself with considerably less volatility (see Harry Browne's Permanent Portfolio).

But would it be it wise to simply create a properly diversified, balanced, broad portfolio of uncorrelated investment types, set it and forget it? Of course few managers would have any vested interest in proposing such a portfolio but that doesn't make it a bad idea. The question becomes, how well would it perform, how consistently, and does Modern Portfolio Theory support and even provide all the tools necessary for this approach?

At its core there is but no doubt that the diversification generically described by MPT does what it is advertised to do, which, I suggest, has also been misrepresented by the investment industry in general. Sans agenda, MPT simply provide investors with a set of options for managing the risk of a portfolio. Risk, as the industry prefers to define it, is measured by what I like to refer to as "up-and-down-ness" or volatility, i.e., the range of potential gains or losses over a given period of time (we will leave "black swans" to another discussion). In this effort the "big hammer" use to mold the theory of MPT is correlation, and the lack thereof between and among investment options.

Simple right? Put your money on the nose of one pony and you end up with a binary result with a range of outcomes that are not suitable for most "investors" (as opposed to gamblers). Spread your bets among mounts and your odds of both winning and improving your average result increase. Taking one further step to determine how correlated these nags are, e.g., age, number of prior races and results, jockey experience and record, abilities in varying weather conditions, etc., then allows you to make bets that are not assured, rather, simply provide better odds of a higher average outcome.

The truth is as well that this horse-racing application of MPT will provide one additional obvious result, the better you apply it the smaller the range of dollars you ultimately leave the track with in your pocket. That is, you will obtain greater predictability of result which again, as I suggest, is the most important product of MPT. Investors give up getting their picture in the paper as the lucky person who hit the trifecta, but they also avoid having to bum money for bus fare to get home. Most investors are as Will Rogers suggested, i.e., concerned about the return of their money rather than the return on their money. Moreover, if the average investor is like those I've personally worked for, they are less impressed when they make an additional million bucks than they are upset when they lose a million bucks.

After spending 30 years in the "biz" I found that investment firms have altered the simple concept of Modern Portfolio Theory from that which I just laid out into some magical tool that they use to actively manage portfolios. Truth be told, MPT begs for these same managers to stay out of the kitchen while Chef MPT has dinner cooking just fine, thank you very much. The numbers bear this out each and every year and for any period that you care to study (hundreds of them but you can start here). I suggest that the numbers also bear out that those who beat their benchmarks do so inconsistently and produce long term results below their benchmarks no better than benchmark minus fees, and in most cases worse yet. Sadly though not unpredictably, we are also coming to see the light of day shone on those managers who have been able to consistently beat the benchmarks. By applying the same principals of "wow them with the B.S." as generic investment pros apply, these former geniuses have been exposed as either the guys who can still sell people bridges, or as in the case of Lynch, Miller and so many others who used to walk on water, those whose genius was confused with the greatest bull market in our country's history. Lynch was lucky he left the party when he did. Emperor Millers' clothes evaporated coincident with the end of the 20 year raging bull market.

The fact that MPT is so simple should cause you to wonder how the average manager continues to screw it up and therefore underperform. The fact is many are closet-benchmark-huggers and are simply hoping to wash back and forth with the tide, hovering within a reasonable range of their target giving the impression that they are somehow adding value. The truth is most investment managers are guessing when they decide to get involved in the portfolio by making investment changes, either because they are attempting to determine the future of a new investment that they recommend, or because they are exiting another investment and again attempting to guess which of the others is the best place going forward, hoping that it will do better than the alternatives. As we all know, hope ends up being a terrible investment strategy.

That, Dear Reader, is ultimately the point. There is no value being added, i.e., as measured by consistency of performance or even absolute performance improvement (alpha). Investors can do what most managers do and avoid the fees. Heck, Asset Allocation is so omnipresent in today's world it might even be on the drive-in menu at McDonald's. What seems to happen is that the more active-managers "act" the worse they eventually perform. I'm not talking about isolated arbitrage opportunities that arise from significant market mispricing's. Most investor portfolios are not intended to be focused on such investing nuances or that of HFT, complex option strategies, Fx, etc. The average investor with a few hundred thousand to a million or so dollars that he/she needs to generate a retirement income from is currently being invested at 99% of all investment firms the very same way. A quick explanation of MPT including the concept of Asset Allocation followed by a questionnaire represented as the key to determining the risk-based mix appropriate for each investor, ending with a highly standardized final, relatively generic portfolio composition contained in a pre-defined and limited set of models. From there specific investments are chosen, but the bulk of the MPT heavy-lifting has already been done. Somebody explain to me where the genius was in that exercise, spelled: v a l u e -a d d e d?

It always amazes me to read articles about Modern Portfolio Theory, particularly by folks with impressive credentials. One such SA article reminds me of what most novice investors believe constitutes a "diversified" portfolio. Referencing my earlier statement, at the core of MPT is broad, balanced diversification and non-correlated components. This is proper investing. Everything else is simply either speculation at best, or at worst, pure gambling. Most investors are just that, investors. They need to be schooled to build proper portfolios and by definition, being properly constructed, allowed to do what it will do with only minor tweaking. After all, while there are short bursts of time when correlation among assets moves closer to 1, I submit that a properly diversified portfolio will be much less affected by such occasions. Unfortunately, even learned folks in the industry seem to believe that diversification is a 75/25 portfolio. This is scary stuff but par for the course, making my point very effectively. The wild swings that accompany this portfolio would drive even the most steady-handed gray-bearded pro to micro-manage the portfolio during times of high volatility, or to heavy drinking, or both. And this is exactly what screws it up!

The fact is, a properly built portfolio creates less need for the tinkering that comes when lesser-effective portfolio compositions express an uncomfortable level of the prior-mentioned "up-an-down-ness". Even the pros are not immune to the gut-wrenching anxiety that accompanies market swings, making them feel as though they simply need to do something to earn their keep, in addition to avoiding being viewed as a do-nothing manager while all hell breaks loose. Investors and managers alike fall into the same trap and sadly this again bolsters the case for professionals generally not adding value to the investment equation.

CONCLUSION: The investment management industry is not a value-added proposition for the average investor looking to manage an income producing, asset preservation portfolio. In fact, the work that active managers do in the name of Modern Portfolio Theory is exactly why they underperform. While MPT doesn't suggest that professionals should not employ its principles, it does make the case that after the initial work is done all that anyone can do in "managing" such a portfolio will likely screw it up. Volumes of proof back this up. However, if there be an investment manager who wants to provide AIMR-compliant proof to the contrary we invite and encourage you to produce such evidence. But please don't bother commenting that Asset Allocation, infrequent hand-holding and 2 @ 30 minute meetings per year are worth 1-2.5%/year...NOT!

Disclosures: Permanent Wealth Management manages portfolios based upon Harry Browne's Permanent Portfolio utilizing broad-based, passively managed ETF's. Consistent performance speaks for itself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.