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Is Modern Portfolio Theory Dead?

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Diversified Fate

The last 18 months have been an unmitigated disaster. Financial planners have seen their income melt away like global warming on steroids. The stock market has fallen to 12-year lows. Unemployment has risen to 25-year highs. Even traditionally conservative investments like municipal bonds fell roughly 15 percent in 2008. Every asset class has lost value except two: U.S. Treasury bonds and gold. “I’ve spent a lot of my time in the past six months talking clients off the ledge,” says Bob Kargenian, president and principal of TABR Capital Management in Orange, Calif.

In industry circles, one question we hear more and more: Is Modern Portfolio Theory dead? Financial planners have been preaching the sacred truth of diversification to their clients for years. Elaborate asset allocation strategies have been carefully crafted. Financial goals discovered, articulated and codified. Risk tolerance measured and incorporated. Calculations, estimates and scenarios have been run. Fancy colorful financial plans were printed, presented and kept. And in the end, it just didn’t matter. Most portfolios have lost 20 percent to 50 percent in value, and for advisors whose compensation is based on AUM, 2008 was a painful year.

“The prime imperative of wealth management is if you take care of the money, everything else will take care of itself,” Kargenian says. So riddle me this: Is Modern Portfolio Theory (MPT) a best practice or folly? Once an advisor carefully diversifies a client’s portfolio, is putting it on autopilot the right thing to do?

Not according to Harold Evensky, CFP, AIF, president of Evensky & Katz Wealth Management in Coral Gables, Fla. The classic definition of MPT boils down to diversifying investments among different types of investments, each of which have unique characteristics, hence reducing the probability of sustaining a large loss. Unfortunately, the last 18 months have challenged the theory. Disparate asset classes, with distinct risk profiles, all went down together. What went so terribly wrong? Evensky concludes: “It’s not that MPT is invalid, it’s that the application has been faulty.”

According to Evensky: “The MPT model alone will not necessarily work in bear markets, or at least not using historical averages alone as inputs without other adjustments to forecast the return, volatility and especially correlation.” Evensky advocates a “core and satellite” approach, where the core allocation of a client’s portfolio is used to capture market returns, and a satellite allocation, namely a portion that is allocated 100 percent of the risk budget, provides the alpha.

John E. Rice, CFA, CFP, notes that MPT originally started with a paper by Harry Markowitz in 1952 that basically quantified mathematically the idea that diversification across different asset classes that are not well correlated reduces risk. “I do believe that diversification is appropriate and that it should be used in portfolios,” says Rice, formerly chief investment officer at Phoenix wealth-management firm Keats, Connelly and Associates. “However, I think that advisors have had a tendency to overuse the idea of standard deviations and correlations when making decisions about portfolio diversification.”

Based on Markowitz’s groundbreaking research, financial planners have been selling MPT for years as one of the tenets of prudent investing. Are they misguided? Not so says investment advisor Richard A. Ferri, CFA, founder and CEO of Portfolio Solutions in Troy, Mich.: “I fall on the side of it does work. It just doesn’t work well all the time because in finance, models are not like those in the natural sciences, where water freezes to ice at 32 degrees Fahrenheit at sea level. No matter where you go in the world, if it’s 32 degrees Fahrenheit and you’re at sea level, water will freeze…it will happen every time. But in finance, that’s not the way it happens. Theories are approximations, good generalities. They are guides. Investing is like throwing horseshoes; you get points for being close. You don’t have to get a ringer.”

Ferri believes that over the long term, generally, MPT works, but if you’re looking at it over any short-term specific period, it may not work. He comforts investors by saying: “My belief is that investors shouldn’t abandon MPT. They should continue with it because even though it did not work among risky asset classes in the last 18 months, evidence is that it will work again in the future.”

Not So Random

Markets aren’t truly random. Human panic, fear or greed can overwhelm what true standard deviation would show for markets. Diversification is absolutely essential for building a good portfolio, but advisors need to take it a step further and make sure that they have a commonsense approach and some qualitative analysis as well.

Ferri is a fan of ETF investments that, very efficiently and at low cost, give advisors the means to create portfolio diversification across different asset classes. Advisors, he says, “should not rely on the hard, past fixed numbers to come up with their asset allocations; rather they should use common sense and say, ‘Europe is different than the Pacific Rim, although sometimes everything goes down together, but there are unique risks there so maybe we should have a little bit in one and a little bit in the other.’”

Harold Evensky supports this idea with his core and satellite approach, which puts him somewhat at odds with Rick Ferri about the method of implementation. Evensky believes advisors should try to add value in the satellite part of the portfolio by making active management bets. Ferri disagrees, saying: “The fact is, no one can predict the future.

To try part-time to become a global, top-down macro-economist and make decisions better than the highly paid global, top-down macro-economists whose investment decisions are neutral, at best, is just foolish. I question whether the advisors that are doing this are actually doing it because they think they can do it, or are they doing it as some justification for charging the client higher fees.”

He feels a better approach is to keep expenses down to a rock-bottom minimum and trust in MPT. He puts his low-fee philosophy at the center of his business. Portfolio Solutions has $700 million under management and charges a modest 0.25 percent investment advisory annual fee.

“Just because virtually all asset classes went down together and therefore are highly correlated at the moment, is not surprising given the scope of the current financial meltdown and the interconnectedness of the global economy,” Ferri says. “It has happened in the past and it will happen in the future. It does not mean that Modern Portfolio Theory is dead.”

And according to these three keynote panelists at the 9th Annual U.S. World Series of ETFs conference, in Miami, it does not mean that active management strategies should be used. They fear that an activist approach will lead to more portfolio losses in the future.

Deena B. Katz, CFP, associate professor of personal financial planning at Texas Tech University, in Lubbock, Texas, and a partner of Evensky & Katz, e-mails a similar view: “I am interested to hear if MPT is dead. I wouldn’t be so quick to hold a wake.”

Marie Swift is the president of Impact Communications, a marketing and communications firm for independent advisors; see