Asset Allocation: Is Modern Portfolio Theory Dead? (1/2)


This is a summary of a session of the Money Management Institute’s 2012 Fall Solution Conference.

Moderator:
Michael Jones, Chairman and Chief Investment Officer, Riverfront Investment Group
Panelists:
Colin Moore, Chief Investment Officer, Columbia Management, $339 billion AUM
Howard Present, President and Chief Executive Officer, F-Squared Investments
Steve Murray, Director of Asset Allocation Strategies, Russell Investment Group

This was an interesting discussion since each of the panelists approach asset allocation from a different perspective.  Jones believes that modern portfolio theory (MPT) is dead and that asset allocation should be more fluid and dynamic so they shift the pie chart around.  Riverfront has a simple methodology, which states that the price you pay is the number one determinate of the upside potential and downside risk of an investment.  They feed the price into a proprietary optimization process to create a portfolio that tries to make money in a worst case scenario while still maximizing the upside potential.

Moore agrees that the standard process is deeply flawed and feels you shouldn’t maximize return for a given level of risk.  Instead you should figure out what is the maximum level of return that the client can accept.

F-Squared believes that downside risk management has a disproportionate impact on clients, according to Present, so they factor it into their portfolios at a higher level.  Standard deviation is used to represent investment risk and maximum drawdown to represent the client’s perception of portfolio risk, he said.

Murray disagrees with Jones and believes there is some value in modern portfolio theory but that it is just one data point.  It’s not enough to rely on by itself.  At Russell, they know that different asset classes follow different pattens in the market so they use using different asset classes to offset each other in a portfolio by combining long and short term market processes, he stressed.

Assuming modern portfolio theory doesn’t work, how do you deal with style box dilemma, that we are forced into. Because of the 20 year dominance of MPT, how do we break the culture of asset allocation using narrow pie slices?

The world isn’t normal, particularly in the short-term, Murray described, so we need to recognize the factors that are driving market returns in the long run.  we need to recognize the fat tails, the event risk we experience.   They use short-term information to work around long-term trends, but don’t feel constrained by style boxes.  Russell is a manager of managers for most products and they allow the underlying managers to change their bets in order to be opportunistic, he added.

The macro allocation typically assumes a pure beta solution underneath it, then you assign an active manager to the sleeve but risk budget for that manager is so narrow that they have minimal ability to engage.  how much dynamic capacity you can engage, they don’t think that MPT is broken because the math works.  The problem is that the horizon is typically too long to make it work for the needs of a client.

It’s important to have the flexibility to adjust the allocations to provide more dynamic responses during significant down years.  It’s less about which asset classes you have and more about how structured are they?  Do they have tight correlations to benchmarks?  This was the problem during 2008 when you consider that the maximum drawdowns for equity asset class were all between 48% – 52%.  So this level of diversification didn’t help anyone very much, he concluded.

Over the past five years, the yield on the Lehman Aggregate has dropped from 5.5% down to 1.5%.  How has that impacted your asset allocation strategies?Screen Shot 2012-10-22 at 10.31.13 PM

This reduction in yields has had a tremendous impact on fixed income and equity investments over the past thirty years, Moore asserted.  He doubts that this scenario is likely to re-occur any time soon given that we had such an enormous tailwind that drove the returns of so many asset classes. The MPT allocation slices have been strongly influenced by the drop in yield, so they can’t be trusted going forward.

It’s critical to discover the driving factor behind the alpha (non-beta) return for each asset class, he advised.  It appears that there’s more diversification around the alpha factors since they aren’t as heavily correlated.  You will have more success if you capture the alpha factors and leverage them to replace beta factors, he said.

Have you changed your allocation to fixed income due to large drop in yields?

The big change was in how Treasuries are represented, Murray admitted, since it changed their view of the spreads.  Columbia had an internal discussion about how the drop in yields would affect high yield spreads.  They determined that High yield spreads are below average but investment grade spreads are about average.  Total yields are very low because of what happened to the Treasuries.  Intermediate Treasuries have a twelve month return of a 13.5% loss… not many people factored in a 13.5% loss for their mean variance optimization.It drove them out of Treasuries and into spread products, he said.

It is impossible to remove bonds entirely from asset allocations since they have been single most important risk management tool for the last 20 years, Present observed.  They’re the only stopgap for risk-averse clients that is out there.  An interesting secondary problem is that for standard asset allocation solutions the level of risk strictly controls the investment mix, Present pointed out.  These restrictions trap managers into a tight allocation range where they aren’t allowed to make any drastic changes.  You have to take it down to the second level and determine how much embedded downside risk is in the portfolio, he said.

The fiduciary guidelines are there to prevent managers from taking on too much risk, Jones noted.  For conservative clients we can’t back off bonds weights, especially when paying the highest prices ever for bonds, he said, since your risk is off the charts.

The Investment Policy Statement often locks the allocation down to a tight range for east asset class, Present reminded us.  A manager changing the fixed income allocation from 77% down to 75% is too small a change to have any real impact on the portfolio.

Moore suggested that we change the way we control client risk from from asset allocation ranges to ranges of downside tolerance instead.  Can the client tolerate a 20% drawdown?

Related Content
Fixed Income Investing in a New Yield Environment – Russell Investments
Diversifying a Fixed-Income Portfolio in Today’s Low-Yield Environment – Pyramis Global Advisors
Fixed Income Redefined for a 2% World – RBC Global Asset Management

This was part 1 of a 2 part series.  Look for part 2 coming soon!

Check Out Our Summaries from the MMI Spring 2012 Conference:
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