Modern portfolio theory: the death of common sense
Amundi’s CIO has written a thought-provoking book which argues that both wealth managers and their clients need a dose of reality when it comes to managing expectations of future returns
Book review: Essays in Positive Investment Management, by Pascal Blanqué
The 2000s will be long remembered as a ‘lost decade’. At the end of it, investors discovered the buy-and-hold strategy was not working, as equities were outperformed by bonds over a long period; nor was the bar-belling approach, as actual returns diverged markedly from expected returns for most asset classes; nor was diversification, as excessive leverage ramped up the correlation between historically lowly-correlated asset classes. Now we know why.
Pascal Blanqué, CIO of Amundi Asset Management, has written a thought-provoking book for an incumbent senior investment professional. He blames the entire edifice of the modern portfolio theory, which continues to plague today’s investing with its near hypnotic appeal. Its various tenets have done no more than provide a dangerous comfort blanket to successive generations of investors.
Prominent among the tenets are: there are risk-free assets, government bonds are risk-free, diversification adds returns, concentration adds risk, there is a hierarchy in risk premia, asset classes are not highly correlated, asset allocation boils down to a trade-off between risk and return, equities outperform all other asset classes in the long term, and, finally, the higher the liquidity risk, the greater the risk premium.
For example, he shows that asset-based diversification, as implemented over the last 30 years, has rarely been consistent with the objective of adding value. Good returns were often a matter of luck than judgement.
The notion of risk-free assets does not match the evidence, either. By definition, such assets are meant to exhibit three features: the lowest returns in the investment pecking order, zero correlation with risky assets and zero difference between expected and actual returns.
Whether you agree or not, Mr Blanqué’s central contention is hard to fault: investors live in a world of dynamic risk, so any formulaic approach will end in tears
In practice, from 1999 to 2009, the US 10-year Treasury Bonds not only outperformed risky assets such as equities, their actual returns were also well above the expected ones. In fact, government bonds have violated every tenet of conventional investment wisdom over the past thirty years.
Mr Blanqué’s forensic analysis leaves such tenets floundering on a sea of irrelevance. His remedies enjoin us to look at risk in a different light. For example, diversification is not dead. The issue is what should be diversified. Diversification across risk or macro factors is more effective than the one based on classic asset allocation. High conviction investing is not a bad idea, so long as there is a single factor risk exposure.
DOOMED TO FAIL
Whether you agree or not, his central contention is hard to fault: investors live in a world of dynamic risk, so any formulaic approach will end in tears. Risk is at its highest when it is close to certainty, as the subprime debacle showed all too clearly in 2008.
Since then, events have only confirmed the key insight of this book: risk premia are driven far more by monetary action than economic fundamentals and have been for a long time.
The new regime ushered by the QE programmes on both sides of the Atlantic mark the end of the Volcker Revolution, named after former Fed chairman Paul Volker, under which the primary aim of monetary policy was to contain inflation. Now, in marked contrast, asset prices are both the result of monetary action and a factor influencing it.
The implied circularity is great when markets are doing well, but disastrous when they reverse. While markets have been flirting artificially with their all time highs, such words of wisdom cannot go unheeded.
Clearly, central bank action has forced investors into uncharted waters. Notions of “fair value” and “equilibrium price” remain shrouded in mystery during this journey into the unknown. In hindsight, investors have learnt that they were not managing risk, they were managing uncertainty. One relies on known probabilities of expected returns, the second on pure guesswork.
Hence, it is time to get real, the author cautions. That means an open honest dialogue between investors and their wealth managers on what can and can’t be delivered when valuations are so distorted and big macro risks lurk in the background. As part of expectations management, wealth managers must avoid making exaggerated claims about future returns. On their part, investors must avoid aggressive return targets that only set their managers up to fail.
These require a far higher degree of engagement between investors and their managers than has been the case over the past 30 years where disintermediation has become ever more pronounced in all client segments.
This is common sense. But common sense is not common practice currently in the world of investing. The book is a brave attempt at rectifying it. It addresses uncomfortable issues that most other texts have shied away from. It deserves to be read widely. The investment community needs an open debate about life after modern portfolio theory.
Amin Rajan is CEO of Create-Research
