A very short history of modern portfolio theory

How to design a secure, income-producing portfolio – by Andreas Calianos

 
Several years ago, a small experiment led to a terrifying discovery. I was helping a family investment office do some long-range planning and I was not shy about sharing with them the fundamental ideas from my earlier articles: namely, that liquidity bias is leading many investors awry and that there is important investment opportunity beyond the standard mix of stocks and bonds.

To drive these points home, I recommended that my client conduct an experiment. I suggested she visit three of the largest global private banks and ask each of them for the same thing: a proposal for how they would manage $5m of her money. I recommended that she request detailed information not only about the portfolio allocation they would suggest, but also the management philosophy and applicable fees. My client must have recognised the potential for this experiment to yield some interesting results, because she agreed to give it a shot – neither of us anticipated how stunning the results would be.

When the first bank had readied its proposal, they asked her to come back to the office, where she was greeted by her prospective advisor. He walked her outside to a leafy courtyard and proffered a leather-bound folder. The proposal was beautifully done, on fine stock paper, and it spelled out just how the bank would allocate her money: what percentage to US large caps, what share to small caps, how much to emerging markets, how much to tech, how much in fixed income. Toward the back there was also a special section called ‘Proprietary Investments’.

“You won’t find this anywhere else,” the advisor told her, dropping his voice. He went on to say that his institution had access to certain unique assets. “We’re talking about multi-factor exchange-traded funds,” he said, conspiratorially, as if the two of them were in on a secret. Multi-factor ETFs are funds that include an array of securities that are supposed to demonstrate diverse characteristics.

Then she went to the next bank. Their proposal wasn’t leather bound, but it didn’t matter, because it contained exactly the same thing. This second proposal had allocations that were nearly identical to the first, from large caps to small caps, to tech and emerging markets – and it even had the very same ‘secret’ sauce – the multi-factor ETFs.

Maybe you can guess what happened next. She went to the third bank and their proposal looked just like the first two. She had gone to three of the largest, most respected financial institutions, asked for a customised proposal for how they would invest $5m and they all told her the same thing.

This homogeneity across investment portfolios is a big deal. Whether you’re someone who has $5m or more invested with a name-brand bank, or if you’re simply the owner of a 401(k) or IRA, you can be certain that there are millions upon millions of other portfolios out there that look exactly like your own. This matters because, when everyone is diversified in the same way, no one is diversified. And when no one is diversified, it creates instability deep in our financial system.

So, how on earth did we get here? And what can we do to make our portfolios more stable, rather than exacerbate the risk? To begin to answer those questions, we must briefly step back in time.

Back in the 1950s, an economist named Harry Markowitz had a simple insight: that different types of securities tend to perform differently over time. From this insight he theorised that you could construct a portfolio by intentionally selecting securities that counter-correlate. That is, that move in opposing ways. In its simplest form, such a portfolio might contain two securities with a correlation between them of negative one: if one stock is up 10%, the other’s down 10%. From there Markowitz had a more complex insight.

He realised that he could construct a very large variance/covariance matrix, which would contain data on the performance of hundreds of different securities and benchmarks over time and would compare them to hundreds of other securities and benchmarks over the same period. Markowitz saw that, once he had constructed this vast matrix, he could then optimise and select from all the available options the best match for a given criteria. In this case Markowitz was seeking an optimally diverse portfolio for a given level of risk. Such a portfolio would then produce the best risk-adjusted return. Note that he wasn’t trying to produce the best possible return: he acknowledged that it was impossible to beat the market and therefore the best he could do was seek the greatest return given the inherent risk. That’s what his matrix and the optimally diverse portfolio were designed to do.

It was a powerful insight. Not only was Markowitz right, but his diversification idea worked better and more reliably than any other strategy that had preceded it. His approach became known as Modern Portfolio Theory, or MPT. The first investors who applied the wisdom of MPT did very well. They did so well that other investors followed suit. The MPT approach was eventually replicated in investment offices, well, everywhere. And this was an important feature of Markowitz’s idea: it was easy to copy.

Back in the 1950s, investing in small caps was unusual. Thanks to Markowitz’s insight about diversification and to the growing use of MPT, many other investors now realised that moving into small caps was a great way to diversify. Small caps, they saw, were an overlooked area of the market. And so more people started buying into smaller companies and then vast numbers of people did. Investment advisors began to recommend it. Eventually diversification into small caps became an agreed-upon best practice. Then, in 1984, the Frank Russell Company created the Russell 2000 index of small cap equities. An index allows investors and their analysts to construct an efficient portfolio that’s supposed to capture the long-term performance history of an entire security class. With the advent of the Russell 2000, anyone could own small caps by buying the whole index.

MPT, and small caps along with it, has long since become the accepted dogma for how to construct a portfolio. In the decades since Markowitz made his discovery, MPT has changed the entire landscape of investment practice. And it has created a new kind of risk. How, exactly, has it produced new risk? By increasing volatility.