How can past innovators inform portfolio construction today?
2020 Investment Innovation Conference
BY Kelsey Rolfe | November 30, 2020
Trying to define the perfect portfolio is as complicated as asking what it takes to be healthy — with a number of factors at play and no singular answer.
Even modern finance pioneers don’t agree on what the perfect portfolio looks like, noted Stephen Foerster, professor of finance at Western University’s Ivey Business School, when speaking at the Canadian Investment Review’s Investment Innovation Conference in November. But looking at their works, some broadly applicable takeaways for institutional investors emerge.
At the conference, Foerster previewed his new book, In Pursuit of the Perfect Portfolio, co-authored with Andrew Lo, finance professor at the Massachusetts Institute of Technology’s Sloan School of Management, which profiles 10 modern finance luminaries who played leading roles in major investment innovations since the 1950s.
One key theme that emerges from the luminaries’ stories is that investors should think about their fund’s investment philosophy and put it down in writing to guide decision-making, Foerster said.
Further, they need to understand their fund’s tolerance for risk, something Foerster noted was strongly emphasized by Martin Leibowitz, whose research on fixed income securities has changed the market’s understanding of bonds.
“You want to know what your risk comfort zone is, and that’s not easy to do in a pension fund,” he said. “This comfort zone for risk should really determine the kind of assets that you will invest [in] or the kind of assets that you will choose not to invest [in].”
Foerster highlighted William F. Sharpe, who received the Nobel Prize in economics for his capital asset pricing model, noting his idea of the “market portfolio” offers diversification lessons for investors. “So many funds have this home bias where we over-invest in Canadian assets, which are only a fraction less than five per cent of equities worldwide. So do what you can to avoid that home bias.”
Another luminary, Eugene Fama, whose work centres around portfolio theory, asset pricing and the hypothesis of an efficient market, urges long-term thinking when it comes to manager selection. In particular, the last three to five years of investment manager performance data is just noise, Foerster said, highlighting it’s not enough to base hiring and firing decisions on. “You’re not doing yourself a good service [if you’re doing that] and should be much broader when you think about hiring and firing.”
Foerster also discussed Myron Scholes’ Black-Scholes model, one of the inputs for what eventually became CBOE volatility index for measuring the market’s expectations for volatility. “Scholes’ key message is to pay attention to the derivatives market because there’s a lot of important information [there]. And I think we have seen that recently, both during the pandemic as well as around the U.S. election.”
Overall, the stories of these luminaries demonstrate the necessity of adaptation. “We have to adapt to evolving situations. Fama started out supporting the capital asset pricing model, and then he killed it. [Robert] Shiller’s dissertation was actually on rational expectations and then subsequent work turned that around. Jack Bogle started out as an active investor and then turned into a passive investor. We’ve got to evolve.”