Has Modern Portfolio Theory (MPT) outlived its’ usefullness?

In the early 1950s, Dr. Harry Markowitz was awarded the Nobel Prize in Economics for his work in defining the relative relationship between risk and reward when analysing investments. Considering that he did all of this work without the benefit of modern computers, this was truely ground-breaking research – and up until recently, has stood the test of time. MPT evolved into a resulting concept of plotting investment portfolios along an “Efficient Frontier” based on Harry’s formulae. The theory is that each point on the curve of the Efficient Frontier represents the greatest potential return for a given level of risk acceptance.

However, is it still valid today? I am not going to go all mathematical on everyone – I assure you – but the relationships charted and modeled by Dr. Harry were from the late 1940s and early 1950s. I think we can all agree that the economic environment today is vastly different in size, scope, volume of transactions, new products, regulation, more exchanges and other factors such as the use of arbitrage to name but one.

While I still believe there is a correlation between risk and reward, I am having increasing doubts that this relationship can be accurately modeled any longer.

Again, to avoid going into crazy formulas few would even try to follow, I decided to examine how some very large portfolios are being managed – such as the Canada Pension Plan, the Ontario Municipal Employees Retirement System (OMERS) and the Harvard University Endowment Funds. All of the data for these funds is publicly available – very easily too – and all make very interesting reading.

To quote from the OMERS website: Investing Globally
“Our goal is to diversify OMERS assets on a global basis to capture investment returns from economies that move on a different cycle than the Canadian economy and to reduce the home market bias of “too many eggs in one basket” (recognizing that Canada is less than 3% of world investment markets).” http://www.omers.ca/investments/about_OMERS_worldwide.aspx

Their investment report goes on to say “In order to satisfy its obligations and secure the pension promise, OMERS has implemented prudent and evidence-based investment strategies in public and private markets that target positive absolute returns.”

The CPP Investment Board (CPPIB) 2014 Report states: “Our distinctive investment strategy, known as the Total Portfolio Approach, ensures that we can maintain – or deliberately change – targeted risk exposures across the entire portfolio….” http://viewer.zmags.com/publication/37dab3ed#/37dab3ed/2

The Harvard Management Company (HMC) report for 2014 includes the statement: “The Policy Portfolio differs from a traditional stock/bond portfolio, including allocations to less-traditional and less-liquid asset categories, such as private equity, real estate, and absolute return strategies.” http://www.hmc.harvard.edu/investment-management/policy_portfolio.html All of HMC’s investment decisions also follow the United Nations Principles for Responsible Investment (Socially Responsible Investing in other words).

None of the reports mention a single thing about MPT. So, I decided to take their portfolios and plug them into an Efficient Frontier calculator – guess what? None of the portfolios from these well-known, and arguably leading, investment management teams fit anywhere close to the EF curve! The largest distance, interestingly, was HMC.

This is a blog – not a research paper to be sure – so I won’t bother including the graphs and numbers. To really understand this you need to do your own research and analysis – don’t take anyone’s word for it – you need to take personal responsibility in the management of your investments. But don’t let an advisor push a bunch of graphs and numbers under your nose and quote MPT and the Efficient Frontier – they are both more than 60-years old and they do not take into account the realities of markets in 2014 and beyond!

Ian Whiting

Ian R. Whiting CD, CFP, CLU, CH.F.C., FLMI (FS), ACS, AIAA, AALU With more than 40-years of experience in the industry, Ian has qualified 3 times for MDRT, completed LUATC in 1979, the LUAC Financial Planning Skills Course and attended numerous Schools in Agency Management and Sales Management through LIMRA. He obtained his CLU in 1987 while also completed his IFIC qualification and completed his Fellowship in the Life Management Institute with a specialty in Financial Services in 1988. In 1989, he completed qualifications for his Chartered Financial Consultant designation. In 1992, he qualified as an Associate of the Academy of Life Underwriters (Head Office underwriter qualification) and in 1993 he completed his Associate, Customer Service designation program through LOMA. In 1997, he qualified as a CFP and also completed his courses and exams to obtain the Associate, Insurance Agency Administration designation. In 1999, he completed the study and examinations to qualify as a Trading Officer, Partner and Director for Mutual Funds with the BC Securities Commission. As a result, he is also qualified as both a Branch Compliance Manager and Head Office/Provincial Compliance Officer. He served for nearly 18 years with the Canadian Forces (Air) Reserve (reaching the rank of Captain) primarily working with Air Cadets and was award the Canadian Forces Decoration (CD) in 1982. Long known as a maverick and forward thinker in the financial services world, Ian enjoys the challenge of learning new material and planning for the future evolution of his chosen profession.