Why Asset-Allocators Are Anxious And Balanced-Funds Are Baloney

Tyler Durden's picture

Modern Portfolio Theory (MPT) is broken. That is how we interpret Niels Jensen's (Absolute Return Partners) latest missive as he draws a concerning line between the number of managers who rely sheep-like on the diversifying 'artifacts' of MPT in a new normal world of undiversifiable systemic risks. The shifts in intra- and inter-asset class correlations (both long- and short-term) have been incredible both in terms of direction change and magnitude - for example (as Nielsen notes) - In the 2000-03 bear market commodities were an excellent diversifier against equity market risk with the two asset classes being virtually uncorrelated (+0.05). Nowadays, the two are highly correlated (+0.69). This shift to a risk-on / risk-off world, fed by central bankers, makes the empirical Sharpe ratios of olde and track records of your favorite balanced-fund manager entirely useless for any investor seeking protection from not just volatility risk but ultimate risk - the permanent loss of capital.


The massive volatility in the dynamics of correlations between individual names in the equity and credit markets is a colossal drain on any MPT-based diversification effort:






Via Jens Nielsen of Absolute Return Partners:

Why MPT Doesn't Work

Let’s begin with a quick recap of what the credit crisis has done to Modern Portfolio Theory (MPT). If you google “MPT”, Wikipedia will tell you that it is “a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset.”


That’s all very well, provided asset classes behave the way Harry Markowitz assumed they would, when he produced his first paper on MPT back in 1952. The reality, however, has been very different in the post crisis environment. I have run a simple correlation analysis to illustrate the problem (see chart 1).





The 2000-03 bear market was massive. It followed an 18 year bull market which gave us valuations this world has never seen before. When the bubble finally burst, stock prices around the world fell like a stone. MPT followers still did relatively well, though, as other asset classes offered investors at least partial protection.


In chart 1 above I have compared correlations during the 2000-03 period (bright blue) with correlations in the current environment (dark blue). As you can see, with one or two exceptions, correlations are generally much higher now.


Now, you could quite reasonably confine this observation to the ‘academically interesting but why should I care?’ category, if it wasn’t for the fact that most investors around the world continue to manage money in a way that is deeply rooted in the MPT school of thought even when facts suggest that a different approach to asset allocation and portfolio construction is warranted.


Nowadays, only a handful of sovereign bonds are considered safe haven assets. Pretty much all other asset classes are now deemed risk assets and they move more or less in tandem. Even gold looks and smells like a risk asset these days.


Take another look at chart 1. In the 2000-03 bear market commodities were an excellent diversifier against equity market risk with the two asset classes being virtually uncorrelated (+0.05). Nowadays, the two are highly correlated (+0.69). It follows that we are not only in a low return environment at present, as evidenced by the paltry return on equities since the end of the secular bull market in early 2000, but we can’t rely on the ability to diversify risk either.


Now, perhaps I should define risk. In traditional investment management parlour, risk is usually synonymous with volatility risk. One could make the argument that volatility risk is a risk that most investors could and should ignore (provided no leverage is used) and that only one element of risk really matters – that of the permanent loss of capital.


Whilst theoretically correct, the reason you cannot ignore volatility risk is that it profoundly influences investor behaviour. Few investors have the nerve to stay put when a financial storm gathers momentum.

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Precious's picture

What?  The Fight Club is too chicken shit to talk about the most important event of the past 24 hours?



LawsofPhysics's picture

So Romney will stop the socialization of private losses, reduce the deficit, VETO a vote to raise the debt ceiling?  LMFAO!!!!

A non-event, not worth discussing and trading upon.

Precious's picture

Well then I guess you have no fucking idea how the executive branch allocates billions of dollars marked by congress.

The federal government is the biggest single purchasing machine in the nation.

LawsofPhysics's picture

So you are saying Romney will stop "allocating billions of dollars marked by congress"?


Bah hah ha ha ha ha ha!!!!

Stop it, you are killing me.

Precious's picture

I would say you should stop typing.

LawsofPhysics's picture

Truth hurts, I know.  Now if you actually have some information on how those billions will be allocated, that would useful.

In case you missed it, this is a trading site douchebag.

Precious's picture

"Truth hurts !"  

Profound !  

High school rules !

LawsofPhysics's picture

As profound as any information you provide, troll harder.

LawsofPhysics's picture

been buying all kinds of energy on the dips, so thanks.

What, not what you meant dipshit?

The Alarmist's picture

MPT is broken? Why the F*ck am I spending so much money on Mean-Variance Analysis to structure our portoflios when i could simply throw darts?  Oh, yeah ... regulations.

Creepy Lurker's picture

Even better than Obama getting his ass kicked (since I don't really give a shit about the sham that is our politics) is watching the lefties turn on each other and become cannibals. Now that's entertainment.

Silver Bug's picture

Put your wealth in gold and silver. You'll be much better off.



machineh's picture

The point of this post is that gold and equities have a low correlation. Therefore, you want to diversify with both.

'All gold and silver, all the time' is for the crowd who don't even know what MPT means.

aerojet's picture

Why be so sure?  Commodities are artificially inflated due to government liquidity pumping, so can you rely on any correlation statistics?  The article is telling you that asset allocation doesn't work anymore--which is correct, it hasn't worked since at least 2008.  But this whole "buy gold" mantra--doesn't it seem just a little too obvious a play to you?  Like perhaps you're being led to the metal gates like just another cow to the bolt gun at head of the line?

akak's picture


Commodities are artificially inflated due to government liquidity pumping

If by that you mean "due to government debasement of the currency", then I would agree with you.

But what chance is there that that debasement is going to be reversed?  When has ANY fiat currency debasement ever been reversed?

Yes, buying gold in the attempt to protect one's savings from government-created fiat currency debasement is the "obvious" play here --- because it has ALWAYS been the obvious play, as it has always worked.

css1971's picture

The guy who steps into the office of president is going to continue the current set of policies just as if Obama never left, no matter what his name is.

i.e. doesn't matter whether it's Obama or Romney. You have to watch what they actually do, not what they say they are going to do.

Put another way. Politicians lie to you to get into office. And by the way, is this news to everyone?

billsykes's picture

Doesnt matter who will win. All you can bet on is that america as a whole will get worse.


Name a great president that really changed the country for the good in the last 150 years.

and those guys who got one to the head really went that great, so don't even mention them (just a great myth).


Dollar Bill Hiccup's picture

Mittens don't need no stinkin MPT.

Embrace idiosyncratic risk, embrace concentration.

Who is really happy owning systemic risk?

aerojet's picture

Permanent loss of capital--yup, that sums up every remaining retail investor perfectly.

redd_green's picture

It's called Diversifonics.  Lets all sing along folks...

css1971's picture

So basically Modern portfolio theory today would look something like:

Cash: 50%

Assets: 50%

This is basically because the problem is actually a currency problem and everything is denominated in currency, particularly the world reserve currency.