The Death of Modern Portfolio Theory

Thomas Schneeweis talks to Scot Blythe about the alternatives...

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down marketsAs a speaker at this fall’s Investment Innovation Conference in Bermuda (November 16 – 18), Thomas Schneeweis, a long-time observer of alternative assets, will be sharing his views on post-modern asset allocation. He is the Michael and Cheryl Philipp Professor of Finance and Director of the Center for International Securities and Derivatives Markets at the Isenberg School of Management. In advance of the conference, we asked him a few questions about the necessity of evolving beyond the long-dominant paradigm of Modern Portfolio Theory. To find out more about Tom’s presentation and the Investment Innovation Conference, click here.

Q: What is post-modern portfolio allocation?

A: It’s a phrase that we use to describe a change in emphasis in the science of asset allocation. Sometimes we need a small change in terminology to force individuals to rethink their approach to asset management. Post-modern portfolio allocation  focuses on the changing asset and risk management toolkit (especially the concentration on rules-based dynamic risk management) of asset portfolios, that academics and the practitioner are using  to come to grips with the modern world of asset management. While current engrained approaches to risk and return management will continue to dominate (e.g., creation of efficient frontiers, correlation-based risk reduction), dynamic forms of risk management (including rules-based approaches to track volatility benchmarks) will increasingly be used to manage portfolio risk. This change will fundamentally redirect investment management to a “New Normal” with investment managers whose focus is risk management and, in part, away from traditional security selection (alpha) or manager selection. Much of the emphasis away from manager-based security selection and traditional correlation-based risk management is due to changes in regulation, changes in technology, and changes in market conditions which have, in many ways,  fundamentally altered views as to the benefits of the traditional “correlation-based” asset allocation.

One must remember that the traditional view of portfolio theory, what we called modern portfolio theory, is now 40 to 60 years old. When MPT was first described, it concentrated primarily on describing the trade-off between risk and return with risk based primarily on the underlying correlations that existed within stocks or within bonds and between stocks and bonds. Even today, if you go to a typical investment textbook, it really starts out saying the fundamental basis of asset allocation remains the so-called means-variance optimization modelling approach based on the expected correlations existing between and among stocks and bonds.

Q: What’s changed to require this new “rules-based” dynamic risk approach to asset allocation?

A:  Perhaps an evolutionary approach rather than new approach is a better terminology but in the last decade changes in market economics have resulted in a greater linkage between global asset values and a higher degree of correlation between markets. In addition, there’s been an unbelievable increase in the set of investible asset classes that are now available to the individual and institutional investor. Today there exists not only a wider range of liquid traditional assets but a number of liquid alternative investments including tracker funds which capture the return pattern of illiquid investment vehicles.

For instance, for much of the past 40 years, real estate and private equity have been regarded as illiquid and not tradable and though a fixed part of an overall portfolio they were not part of the so-called dynamic asset management between stocks and bonds. In the last 10 years, a couple of things have happened. First of all, many previously illiquid forms have become much more liquid through the use of structured products or exchange traded equity forms. For instance, today  there’s private equity firms that are investible directly through the equity markets. Moreover, there’s been an increase in new asset vehicles in the marketplace called hedge funds and managed futures as well as ETFs which offer a liquid equity-based means to access these traditional “off-exchange” alternative investment classes.  In short, today “Post Modern Asset Allocation” calls for investing across a wide range of investment classes and a risk-based portfolio management process based in part on the development of liquid investible alternatives assets as substitutes, in part, to traditionally illiquid investment vehicle.

Q: How did these new vehicles change the risk-management landscape?

A: Starting around 2000, there was a huge increase in the number of asset classes, as well as a fuller understanding of the factors that were driving those particular returns. We started to talk about absolute returns – trying to find asset classes that, by their very nature had a low exposure to market risk. We looked at the investment vehicles themselves as a way to manage risk, or defined investment strategies that by themselves had low risk. What has happened in the last five years is called post- modern portfolio theory, or modern portfolio theory with a twist. The twist was that some additional asset vehicles including investible trackers that capture the return of illiquid assets but in a liquid form could be fit with other investment vehicles to offer an expanded investment set. As important with the development of new liquid “alternative” investment vehicles, there is an increased emphasis on the development of new risk-based investment management approaches which permit a more flexible approach to return/risk management as well as the ability to manage operational and market risk  through dynamic changes in the risk characteristics of the portfolio itself (e.g., a fixed alpha section and a dynamically managed liquid section with market betas similar to the fixed alpha section).

Q: But there were unpleasant results with the expanded investment set.

A:  Coping with change is often unpleasant. Many practitioners and academics found it difficult to adjust to the idea that some of the fundamental assumptions that we were using in the initial MPT model required change, including a change in the belief that asset classes never change or that strategies didn’t change. For example, the S&P 500 of 1990 isn’t the S&P 500 of today (there’s more financials and more global stocks) such that assumptions of an asset’s past relationship with the S&P 500 may not reflect the current relationship In addition, trading conditions have changed, with increased informational efficiency and lower trading costs we now find in many market conditions that markets around the globe have a tendency to move up and down together. In many market conditions, the benefit of correlation-based diversification is reduced as correlations go to one but the importance of overall risk management is increased. So we now realize that there’s a changing dynamic of risk out there. There are periods where we have low risk, there’s periods where we have high risk, periods where the risk is predominately interest rate risk, other periods where it’s primarily earnings risk, maybe other periods where it’s predominantly regulatory risk. But whatever that period’s risk is, it needs to be managed.

Q: How do you manage through the changing risk structure?

A: As discussed previously, we now have a larger set of asset vehicles and  new risk toolkits that permit a more flexible approach to traditional asset risk management than there ever was before. But more importantly, because of the new liquid assets and asset forms that are out there — the ETFs, active and passive, tracker funds – the benefits of more operational market-risk-based management exist. Remember, if risk cannot be managed via correlation assumptions, it still requires management. Today, risk management approaches exist which can offer a more dynamic approach to the risk characteristics of a portfolio that don’t depend primarily on assumed historical correlation relationships, but look directly at managing the overall risk of the portfolio. Some of these techniques we are familiar with. The original one was called Value at Risk, which was an attempt to manage the tail risk of the portfolio. it. Then after a while we understood its shortcomings (its principal shortcoming was that risk changes so fast that our measurement of VaR is quite often poor). The issue then is how to manage that changing risk. From simple portfolio volatility assumptions we have moved to more direct ways of managing expected volatility risk (Risk Parity, Stable Risk) to even more dynamic risk adjustment models based on assumptions of the pattern of asset volatility and resultant risk modification of the existing portfolio.

Q: How can risk management techniques be improved?

A: Certainly we have had techniques to manage risk at a very basic level: For example, we’ve seen option collars, but still that was primarily static. We now realize that risk is changing constantly and one’s exposures to different risks are changing. Fortunately there’s now a broader range of liquid vehicles to move around in those market conditions. Risk has to be constantly adjusted through time. You simply can’t have a static or an historical view of risk. You can’t even take an illiquid portion of your portfolio and hide it for a while. You have to constantly manage it in the portfolio in a way in which the risk relates to the underlying market, regulatory and, let’s call it, the technology risk of the day. In periods of high risk, you have to lower your overall exposure; in periods of low risk you do have a chance to move the risk perhaps a little bit higher. For example, when the VIX has gone from 20 to 40, what quite often happened was that your portfolio lost a major portion of its value. When people bought these portfolios, I don’t think they ever bought into the game of having a 40% volatility. They bought into the game of having a 20% volatility asset with a commensurate expected rate of return.

So in the post-MPT world we have to have a fuller understanding of the underlying risks of the portfolio and how those particular risks have to be managed including using some of these new approaches to leveraging and deleveraging overall portfolio risk commensurate with current market volatility. For example, the ability to create liquid versions of previously illiquid assets permits one to adjust risk continuously. It even allows you to manage that risk at a constant level across a range of economic conditions.

Q: We have to get over fighting the last war?

A: Everything is in evolution and I think that is the hardest thing for most people to realize. I think it’s difficult for a host of reasons (cultural reasons, behavioural reasons). We have a tendency to do things that worked 10 years ago. In some ways, since tools are generally created to solve past problems, you’re always fighting the last war.

When things go bad, the first thing you want to say is make sure that this never happens again. For example, let’s make sure we pass regulation that forces investment managers to track indices so we don’t let managers go off and do things on their own. So when indices fall dramatically as volatility increases, investors fall with it. We have a tendency, as you said, to put in rules and regulations to fight last year’s war, without realizing that with the new technology, the new regulations and the new market conditions we should be thinking of what tools we have that are out there. What mechanisms do we now have that allow us to manage the risks that may not have been there even 10 years ago? We may not need managers to find alpha opportunities but we do need managers to insure that we do not create situations where we fail to obtain returns consistent with their risk. Or if we do need managers to find alpha opportunities how do we protect them from forced liquidation of those investments? Even worse do the solutions we have come up with to reduce the risks of the past financial crisis simply increase the risks of the next crisis?

To learn more about the Investment Innovation Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Garth Thomas to be considered, as limited space available.

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