By Jim Hawley, Head of Applied Research at Truvalue Labs and Professor Emeritus, Saint Mary’s College of California, and Jon Lukomnik, former Executive Director, IRCC Institute, and soon to be Visiting Professor, Judge Business School, University of Cambridge
This article is part of the PRI’s efforts to stimulate conversation around the implications of modern portfolio theory on the changing investment landscape. It feeds into the PRI’s academic research programme, which supports responsible investment research and provides channels to showcase research findings and insights to the wider investor audience.
Modern portfolio theory (MPT) is in major need of a refresh; it needs to be brought up to date. Simply put, MPT is not up to the challenges that confront investors. Indeed, the day-to-day practices of large institutional investors contradict a fundamental tenet of MPT. It also challenges what it means to “invest” in today’s world. MPT as it is practiced and formulated needs to evolve.
We believe that although this widely-accepted Nobel Prize-winning financial theory enriched the world in the 20th century, its narrow focus, and the consequences of this, look to diminish wealth and well-being in the 21st. Finance has two main purposes: to provide adequate risk-adjusted returns to individuals and to direct capital to where it is needed in the economy. In our opinion, there is a new way forward that will help finance fulfil this; we call it ‘better beta’ – a focus on improving the systematic risk and opportunity of the market as a whole. Among other implications better beta expands the types of risk that can (and should) be addressed by investors.
MPT regards non-diversifiable market risk (or ‘beta’) as entirely unaffected by and exogenous to the actions of investors. But we know that beta is unintentionally affected by such investor actions as psychology (risk on/risk off markets) and the rise of passive investing (index effects), to name just two. We also know that alpha (commonly thought of as incremental risk/return due to security selection and portfolio construction) and beta are not distinct and permanent, but inextricably linked. For example, connected as increasing numbers of market participants discover systematic factors such as size, style, quality, ESG and other intangible factors, etc. Disaggregating individual security return into these and other attributes has led to the rise of ‘smart beta.’ The very terms are illustrative of the links between alpha and beta.
Of course, beta, or non-diversifiable risk, still exists. But that does not mean you can’t take actions to mitigate beta, or even the real-world issues which cause beta, such as climate change. Some of the largest investors in the world mitigate market risk directly, an action not considered possible by traditional MPT, whose signature – diversification – only deals with diversifying idiosyncratic risk. These investors take actions, individually and sometimes coordinated with others, which broaden the traditional definition of investing from security selection and portfolio construction to market-wide engagement around issues such as corporate governance, country risk, gender diversity, economic inequality, and climate change. These initiatives have often been successful. Nonetheless, despite the proven power of these actions, MPT continues to restrain more consistent and effective focus on such “beta activism”. But these new forms of investment understanding and activity have the potential to transform financial markets, more closely integrating them into the broader socio-economy.
MPT states, quite correctly in our view, that you can diversify many risks through creating a portfolio of stocks rather than just holding a few and choosing them only on their individual risk profile, as was typically the case prior to MPT. But MPT argues that you cannot escape the impact of systematic risk on your investments. Rather, you just have to accept market risk, or beta. Whether caused by economic distress or climate change, MPT claims that beta will impact your portfolio, but that you cannot affect beta.
The MPT paradox
However, this claim goes to the very heart of what we argue is ‘the MPT paradox’. There are two major elements to this. The first is that innumerable studies1 prove that beta affects investment returns by a far greater amount than an investor’s skill in picking securities or constructing diversified portfolios. Hence the first part of the paradox: MPT tells us that what you can affect is what matters least.
The second part is that MPT is wrong about systematic risk. As mentioned above, the risks and returns of “the market” are affected by investors’ decisions and what is considered an idiosyncratic source of alpha by one generation of investors may be considered “smart beta” by the next. The borders between the actions of investors and systematic risk (and the feedback loops between them) are becoming ever more porous and provide examples of how financial value and socio-ethical values have become more tightly interlinked. Secondly, the nature of institutional ownership of assets has fundamentally changed, thereby providing a powerful, ready-made conduit for these links as well has having affected how markets are structured and function, something for which MPT in its various forms does not account.
That, in turn, suggests that deliberately adding a systems focus to MPT can mitigate many of the causes of systematic risk that in turn are inputs into beta. Preventable surprises should be fewer and result from a lack of understanding or a failure of will, not from an inability to prevent, or at least mitigate, them. The largest investors in the world are trying to mitigate systematic risks, from climate change to lack of gender diversity to political risk2. Their actions speak more loudly than the MPT traditionalists denying the ability to affect beta. Because each of these sources of risk is also a major socio-political issue, they are often viewed through that lens as a sequential series of “one-off” actions. But viewed through an MPT lens, rather than being a series of isolated incidents, these real-world actions form a coherent challenge to MPT’s central tenet that investors lack the ability to affect beta.
Recognising the ability to mitigate systematic risk changes almost everything. It means that improving the marketplace overall is both more powerful than beating the market through security selection (a zero-sum game) and that it is possible to do so. A corollary is that much of today’s focus on relative performance (‘benchmarking’) is myopic, because focusing on system health (which cannot be benchmarked on a relative basis) over the long term will have greater impact financial returns. And it foreshadows a powerful new force in the fight against global warming, income inequality, gender discrimination and other systematic risks that threaten to depress returns3.
Our perspective tackles big issues focusing on the social purpose of investing, thereby confronting the shibboleth of MPT. We think this shines a light on a truth hiding in plain sight: the biggest investors globally have evolved beyond the limitations of current theory, affecting how they invest, as well as the economy, the environment and the investment community’s social conventions.
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Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.
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1. Notably Brinson, Hood and Beerbower, Financial Analysts Journal, 1986
2. Davis, Lukomnik, Pitt-Watson, The New Capitalists, Harvard Business School Press, 2006, p 9
3. Hawley, Lukomnik, The Long and Short of It: Are We Asking the Right Questions? Modern Portfolio Theory and Time Horizons, 41 Seattle U.L. Rev 449 (2018), for a focus of this argument on timeframes