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.