Modern portfolio theory (MPT) has become the whipping boy in recent years, and rightly so. Too many investors and financial advisors put it on a pedestal and assumed it had powers it could never achieve. Couple that with a global financial crisis and you have the groundwork for disappointment.
Like every theory, MPT is flawed and makes simplifying assumptions about the real world. That’s the nature of theories. But while it’s easy to pick apart MPT, assumption by assumption, at its core is a simple but effective foundation for investing. The fact that the historical record offers support for MPT-inspired real-world portfolios sweetens the deal. That’s not always obvious in a world that favors looking at one market at a time, or emphasizing the short term. But a careful look at how MPT performs over time suggests there’s value here.
Don’t misunderstand: we shouldn’t dismiss the limitations that come with MPT’s simplifying assumptions. We need to understand the glitches and make plans for dealing with them. But neither should we dismiss MPT’s reasonable suggestions for portfolio design. Nonetheless, some MPT critics are quick to draw lines in the sand. A recent example comes via Green River Asset Management’s Scott Vincent, who recently put MPT in the crosshairs in an extended critique: “Is Portfolio Theory Harming Your Portfolio?” Yes, he effectively responds. As he explains,
It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes. However, this important fact has been lost because we allow MPT to define the debate in its own misleading terms, tilting the field in its favor and hiding the reality about active manager performance in a complex game of circular arguments.
I can’t speak for “quantitatively-driven index-like strategies,” which can include virtually any type of strategy. But when it comes to using index funds and their ETF equivalents for asset allocation, the record as well as the theory is worth studying. Sure, you can do a lot better than an MPT-inspired index-based portfolio, but you can also do a lot worse. The fact that many suffer the latter is one reason for using MPT as a tool for building better portfolios. This isn’t some blind faith on my part. Rather, by meticulously creating MPT-inspired portfolio benchmarks, including a real-world version built with ETFs, I monitor return and risk and compare it with the actively managed universe. Each month on these pages, I update the results (you can find the latest review here).
The bottom-line result is that an MPT-inspired portfolio performs roughly in line with what theory predicts, delivering average to moderately above-average return with something comparable in terms of risk over time. In fact, there are fairly compelling reasons to expect that these results will prevail, for reasons I explain in detail in my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.
Does this mean that we should become strict MPT investors, following theory to the nth degree? Of course not. For one thing, there are lots of capital market anomalies to consider for tweaking the passive asset allocation inspired by MPT. And as Vincent correctly points out, there’s also a growing body of literature that says there’s evidence in support of identifying talented active managers in advance after all. This is encouraging, and it’s worthy of careful review, although it’s no silver bullet. I dive into the finer points of why the new generation of research on active management is intriguing but problematic in an upcoming article in Financial Advisor magazine (I’ll post a link once it’s published—stay tuned).
Meantime, it’s reasonable to start with the facts. Building a multi-asset class portfolio and weighting all the pieces by market value, a la MPT, performs competitively over time. For example, as I discussed earlier this year, my MPT-inspired benchmark, the Global Market Index (GMI), fared quite well over the last decade vs. 1,000-plus mutual funds invested in several asset classes using various types of active strategies. Yes, a handful of funds delivered stellar outperformance, and a few suffered dismal results. The majority, however, posted middling returns. GMI’s results were average, of course, but it was a high average, settling in at roughly the 80th percentile.
Not bad for a forecast-free, know-nothing portfolio that accepts Mr. Market’s asset allocation and runs with it. MPT is hardly a short cut to easy riches, but it provides a default strategy that comes with a high-degree of confidence for expecting that it will capture the general risk premium embedded in the capital and commodity markets at minimal cost. But that’s just a beginning.
There are many possibilities for adjusting Mr. Market’s asset allocation, and some of these adjustments are worthwhile. Simply rebalancing the mix, for instance, has a history of boosting performance by 50 to 100 basis points a year with little or no additional risk. Finance theory also tells us that if we overweight small cap and value stocks, the portfolio’s expected return rises. We can also change Mr. Market’s portfolio weights, perhaps radically so, depending on our expectations and skill set. And, yes, it may even be reasonable to use actively managed funds instead of, or perhaps to compliment index funds when filling out the asset allocation.
And on and on. There are countless things we can do to customize the market’s asset allocation. But as a first step, we should begin with the default portfolio, which is available to everyone and has a moderate level of expected return and risk. It requires no skills or forecasting prowess and it can be implemented with ETFs for as little as 50 basis points. It’s a no-brainer investment strategy that’s competitive with a broad sampling of the various efforts intent on beating it. At the very least, we should understand it, monitor it, and look for opportunities for rebalancing it.
That’s hardly the last word on money management, but neither is it chopped liver. A strict interpretation of MPT is probably going too far. The theory’s not perfect—nothing is. But it’s equally radical to argue that there’s no value here. At the very least, MPT is a useful guideline for building portfolios, managing risk, and putting the various choices in perspective. Theory tells us so, as does the historical record. That’s a powerful combination, even if some analysts are eager to suggest otherwise.