The following blog by HMI Senior Fellow Jon Lukomnik and Jim Hawley, the Head of Applied Research at Truvalue Labs, is a modified version of an article requested by the Principles for Responsible Investment. It is a “preview” of the book the two are researching and writing for Routledge. The anticipated publication date is late 2020 or early 2021.
Modern portfolio theory (MPT) – the dominant investment paradigm across the world – is in major need of a refresh. Simply put, MPT is not up to the challenges that confront today’s investors. Although this widely-accepted Nobel Prize-winning financial theory enriched the world in the 20th century, its narrow focus, and the consequences of this, look to diminish wealth and well-being in the 21st.
Finance has two main purposes: to provide adequate risk-adjusted returns to individuals and to direct capital to where it is needed in the economy. In our opinion, there is a new way forward that will help finance fulfill this. We call it “better beta” – a focus on improving the systematic risk and opportunity of the market as a whole.
MPT regards non-diversifiable market risk (or “beta”) as entirely unaffected by and exogenous to the actions of investors. But we know that beta is unintentionally affected by such investor actions as psychology (risk on/risk off markets) and the rise of passive investing (index effects), to name just two. We also know that alpha (commonly thought of as incremental risk/return due to security selection and portfolio construction) and beta are not distinct and permanent, but inextricably linked. For example, idiosyncratic factors that investors might consider in their pursuit of alpha become systemic risk exposures as increasing numbers of market participants identify characteristics such as size, style, quality, ESG and other intangible factors, etc. Disaggregating individual security return into these and other “exposures” has led to the rise of “smart beta.” The very terms are illustrative of the links between alpha and beta.
Despite this, MPT states, quite correctly in our view, that you can diversify many risks through creating a portfolio of stocks rather than just holding a few and choosing them only on their individual risk profile, as was typically the case prior to MPT. But MPT also argues that you cannot escape the impact of systematic risk on your investments. Rather, you just have to accept market risk, or beta. Whether caused by economic distress or climate change, MPT claims that beta will impact your portfolio, but that you cannot affect beta.
The MPT paradox
That claim goes to the very heart of what we argue is “the MPT paradox.” However, innumerable studies (notably Brinson, Hood and Beerbower, Financial Analysts Journal, 1986) prove that beta affects investment returns by a far greater amount than an investor’s skill in picking securities or constructing diversified portfolios (commonly thought of as “alpha”). Thus the paradox: MPT tells us that what you can affect is what matters least. In so doing, it self-neuters the abilities of investor to create better risk-adjusted returns, since it washes its hands of a major investment risk.
MPT is wrong about systematic risk. As mentioned above, the risks and returns of “the market” are affected by investors’ decisions and what is considered an idiosyncratic source of alpha by one generation of investors may be considered “smart beta” by the next. The borders between the actions of investors and systematic risk (and the feedback loops between them) are becoming ever more porous and provide examples of how financial value and socio-ethical values have become more tightly interlinked. Secondly, the nature of institutional ownership of assets has fundamentally changed; in 1952, at MPT’s birth, only 8% of the US equity market was owned by institutions, a ratio that has almost completely inverted. The institutionalization of the financial markets provides a powerful, ready-made conduit for affecting how markets are structured and function, something for which MPT in its various forms does not account.
Of course, beta, or non-diversifiable risk, still exists. But that does not mean you can’t take intentional actions to mitigate beta, starting with the real-world issues which cause beta, such as climate change, income inequality and gender discrimination. Some of the largest investors in the world mitigate market risk directly, an action not considered possible by traditional MPT, whose signature – diversification – only deals with diversifying idiosyncratic risk. These investors take actions, individually and sometimes coordinated with others, which broaden the traditional definition of investing from security selection and portfolio construction to market-wide engagement around issues such as corporate governance, country risk, gender diversity, economic inequality and climate change. These initiatives have often been at least partially successful. Nonetheless, despite the proven power of these actions, MPT continues to restrain more consistent and effective focus on such “beta activism.” But these new forms of investment understanding and activity have the potential to transform financial markets, more closely integrating them into the broader socio-economy.
That, in turn, suggests that deliberately adding a systems focus to MPT can mitigate many of the causes of systematic risk that, in turn, are inputs into beta. Preventable surprises should be fewer and result from a lack of understanding or a failure of will, not from an inability to prevent, or at least mitigate, them. The largest investors in the world are trying to mitigate systematic risks, from climate change to lack of gender diversity to political risk. Their actions speak more loudly than the MPT traditionalists denying the ability to affect beta. Because each of these sources of risk is also a major socio-political issue, they are often viewed through that lens as a sequential series of “one-off” actions. But viewed through an MPT lens, rather than being a series of isolated incidents, these real-world actions form a coherent challenge to MPT’s central tenet that investors lack the ability to affect beta. They are attempts to overcome the MPT paradox and affect more forms of risk than are addressable simply through diversification.
Recognizing the ability to mitigate systematic risk changes almost everything. It means both that improving the marketplace overall is more powerful than beating the market through security selection (a zero-sum game) and that it is possible to do so. A corollary is that much of today’s focus on relative performance (“benchmarking”) is myopic, because focusing on system health (which cannot be benchmarked on a relative basis) over the long term will have greater impact on financial returns. And it foreshadows a powerful new force in the fight against global warming, income inequality, gender discrimination and other systematic risks that threaten to depress returns.
For more on these issues, please listen to a podcast of PRI’s Head of Academic Research, Katherine Ng, interviewing HMI Senior Fellow Jon Lukomnik and co-author Jim Hawley. https://pripodcasts.libsyn.com/breathing-new-life-into-modern-portfolio-theory-0