Modern portfolio theory still has a place in portfolio construction, but fund managers have been taking the wrong approach, according to Pinnacle Advisory head of research Michael Kitces.
Addressing the PortfolioConstruction Forum, he referred to the traditional method of a strategic asset allocation approach as 'portfolio construction 1.0', an approach that "worked all well and good until we got to the global financial crisis [GFC]".
"A lot of us started to talk about the GFC as whether it was even a failure in diversification overall because we've struggled with the fact that we're not making a lot of progress with investing," Kitces said.
He said fund managers essentially construct portfolios on two theoretical pillars – Modern Portfolio Theory (MPT) and Efficient Markets Hypothesis (EMH).
MPT works on the framework that a manager needs to strike the balance between risk and return and incorporate low correlation assets into a portfolio in order to bring down volatility.
Layered on top of the MPT is EMH, which implies that markets are relatively efficient, that you cannot necessarily predict anything about markets in advance and are better off using passive strategic asset allocation because "there is no useful [market] information to adjustments accordingly", Kitces said.
According to Kitces, MPT is still a valid theory, but the problem is that the industry has largely been taking "giant shortcuts" and straying away from the essence of Harry Markowitz's theory.
"What Markowitz was saying is constructing a portfolio requires two stages – stage one is figure out what you think all the individual assets are going to do," he said.
"Step two – mix them together in the portfolio."
Kitces said the financial industry did not spend enough time addressing the first step in the decade or so leading up to the GFC, but rather, used the longest stretch of historical data at hand and engaged in asset allocation based on the average of those results.
He said valuations and price-earnings ratios are more important than ever in today's volatile markets and this has given rise to a new theory – Adaptive Markets Hypothesis.
"MPT still seems rather valid but EMH is breaking down, and as we shift from a view that markets are efficient to a view that markets are adaptive, we end up with a portfolio construction framework that's still built around balancing risk and return, but recognises that because markets aren't stable and these inputs fluctuate, so too should the construction of your portfolio," he said.
