In the early 18th century, Daniel Bernoulli proposed that individuals maximize expected utility when they make decisions under uncertainty. This reasoning launched the rationality model of human behavior that underpins many of today’s theories in economics and finance, including modern portfolio theory (MPT). The mathematical models that sprang from these theories provide a veneer of orderliness while obscuring the behavioral messiness of real-world financial markets.
The Rise of MPT
In 1952, Harry Markowitz published his article on portfolio selection, arguing that portfolios should optimize expected return relative to volatility, with volatility measured as the variance of return. He proposed the now ubiquitous efficient frontier. By the mid-1960s, this mean-variance model had become a mainstay within academic finance departments.
Combining Markowitz’s model with restrictive assumptions regarding investor rationality, information availability and market trading structure, Bill Sharpe (and others) derived a model of capital market equilibrium in the mid-1960s. Soon the capital asset pricing model (CAPM) became a central tenet of MPT.
Eugene Fama erected the final MPT pillar in the mid-1960s, in perhaps the most famous finance doctoral dissertation of our generation. Extending the concept of rational investors to its logical conclusion, Fama proposed the efficient market hypothesis (EMH), that financial market prices reflect all relevant information and thus generating excess returns through active management is impossible.
MPT quickly became the ascendant paradigm. For the quantitative-based analysts who dominated the investment industry, a simple theory like MPT that explained messy financial markets was very attractive. Now they had a rigorous theory of markets and a rational approach to building investment portfolios.
Their conception could not have been further from the truth.
The Fall of MPT
The first shots were fired across MPT’s bow in the late 1970s.
The initial CAPM empirical tests uncovered a negative return to beta relationship, the opposite of what was predicted. Rather than reject CAPM, however, the discipline responded by searching for statistical problems in these tests.
As EMH came under attack, Sanjay Basu’s research demonstrated that low P/E stocks outperformed high P/E stocks. In the early 1980s, Rolf Banz showed small-cap stocks outperformed large-cap stocks. The problem, of course, is that both P/E and firm size are public information and should not allow investors to earn excess returns.
In response, EMH proponents integrated these anomalies into a new “factor model,” though they admitted they did not know if the model captured either risk or opportunity. Ironically, these anomalies were then used by financial industry adjuncts — investment consultants, for example — to create that classic active management handcuff, the style box. In turn, the style box unintentionally led to additional active management restraints, such as style drift and tracking error.
These same proponents also argued that the EMH remained viable as long as active equity managers could not use anomalies to earn excess returns. But for the last 20 years, multiple studies have shown that many active equity managers are superior stock pickers and do indeed earn excess returns on these holdings. Russ Wermers demonstrated that the average stock held by active equity mutual funds earns a 1.3% alpha, and Randolph B. Cohen, Christopher Polk, and Bernhard Silli found that ex-ante best idea stocks earn a 6% alpha.