Finding Your Client’s Place on the Efficient Frontier

Modern Portfolio Theory plays a role in academic finance, but for Dave Basten, CEO of API Funds, MPT plays a unique role in investment practice.

The founder of the billion-dollar boutique fund company believes API Funds is the only fund company that “conquers” the efficient frontier with six funds that lie on key points of Harry Markowitz’ famous upward-sloping curve linking the highest expected return for any given level of risk.

So on the low-risk, low-return bottom left corner of the axis investors can find API’s Core Income Fund, then follow the curve upward toward its Income Fund, then Capital Income Fund, Master Allocation Fund, Value Fund and Growth Fund.

And as MPT theory might suggest, at least in steadily rising markets, each of these funds have progressively generated increasingly higher annualized returns compared to their lower-risk siblings over the past five years through Dec. 31, from 2.73% to 11.60%. (The past 10 years, which saw dizzying highs and lows, reshuffled the performance deck, however.)

“Our funds are what Markowitz called ‘the balanced whole,’” Basten tells ThinkAdvisor in an interview. “You can adjust your risk by overweighting or underweighting our five funds.” (Note that a sixth fund, API’s Master Allocation Fund, builds a balanced allocation using the other five core funds.)

So how is that different from an investor in any other broadly diversified fund — say, an investor in a broad-market-based passively managed index fund?

Answers Basten:

“Someone who is extremely conservative could come in and buy 60% Core Income and 20% Income fund and put the remainder in three equity funds, and their risk exposure would be inclusive of emerging markets all the way down to short-term Treasury markets,” he says.

Widows and orphans, in conventional investment industry thinking, don’t go long emerging markets, but correctly implementing efficient markets theory, according to Basten, means that “even our most conservative investor earns a piece of the far end of the efficient frontier.”

The essential argument of Markowitz and efficient markets theorists is that investors can minimize risk and maximize return by not owning too much of anything nor too little of anything.

It’s easy to see how this approach differs from active fund management. As Basten puts it, “most active managers [inherently] exclude large swaths of the market.”

But how again, besides giving Grandma some emerging markets exposure, does API differ from a passively managed index fund? “We’re very much like a passive index fund except we’re actively managed,” Basten explains. “If you look at the individual holdings, you would see as much diversification or more than the most diverse passive index funds.”

“The difference is that active managers for the most part are trying to beat the market,” he continues. “What we are trying to do is to try to get as much of the market into your portfolio as we can to diversify risk down to zero while expanding opportunities, because more is a lot better [than less from an MPT point of view].”

That’s straightforward enough. But Basten’s key insight goes to why an investor might want an actively managed broad-market fund rather than an index fund.

“All passively managed funds are actively managed to some extent,” Basten says. “They delete funds that get bought out or [otherwise no longer meet their index standards]; passive is always updating their portfolios; we supercharge that update one [security] at a time, as best we can. We would be always open to that next best idea that comes into our research.”