Is the modern portfolio theory still as modern as the term ‘modern’ suggests?

In this edition of the Stock Exchange Robert van Loon explains why the traditional approach to the portfolio theory does not apply anymore in the rapidly developing, modern financial markets.

Is the modern portfolio theory still as modern as the term ‘modern’ suggests?

It needs no explanation that the financial markets nowadays are totally different from the financial markets in the 1950s. Shares were practically only traded in North America, derivatives barely existed and there was a significant information asymmetry between different geographical locations.

The modern portfolio theory, developed in the 1950s  by Harry Markowitz[1], brought revolutionary insights in the field of investing and portfolio construction. At the time it was not too complicated to create a portfolio consisting of 30 relatively uncorrelated financial equity certificates. In this way, a portfolio with an optimal risk-return ratio could be compiled.

But does this theory still apply on nowadays financial markets? Most asset managers, banks, pension funds and insurance companies worldwide seem to think so. The classic 40/40/20 mix (40 percent bonds, 40 percent equity and 20 percent other investments) still  lies at the hart of many model portfolios and long-term strategic investment plans. Most banks recommend a similar spread for the portfolio of private investors.

In this article I will explain briefly and pragmatic why I think this traditional approach no longer holds in the modern, very heavily changed (and still changing faster than ever) financial markets.

Considerable increase of trade in index products

Index products have gained great popularity in recent years, both among institutional and private investors. An increased focus on cost reduction among investors, the demand for transparency and the increased need  for easier investment products will only strengthen the popularity of index products and this trend is likely to continue in the coming years.[2]

The first Exchange Traded Fund (ETF) was traded in 1993 in America. Today, the ETF has accumulated more than 1,5 billion in total assets under management.[3] This increased trade in ETFs and other index products implies ETF investors trade several shares within one transact ion, even shares they would not trade whenever these shares were no integral part of the ETF. These investors impact an increasing variety of stock then before. In addition, more and more ETFs invest globally and combine different asset classes. That means that if an investor has an ETF that has been invested globally and he sells this position because the result is negative in for example the European market, he will influence stock markets all around the world. Thus, developments in one market have a stronger influence on other markets with ETFs than when one would act using individual stocks. It is increasingly difficult to find financial products that are really uncorrelated with each other.

New products that link real estate markets with lending markets

We all know what the consequences of the proliferation of the Collateralised Debt Obligations (CDO) has been to the U.S. and the world economy and how the financial system was on the brink of disaster. A rationale person would expect we have learned from previous mistakes. However, comparable products like CDO arise in the institutional investors world currently, whether under a different name or not. This is largely driven by the low yields on government and corporate bonds, causing investors to search for returns in other asset classes. These new products pretend to be more safe because they do not only contain U.S. mortgages (as was the case with most CDOs) bus also European and Asian mortgages. In this way we link global real estate markets and this will result in a decrease of geographical diversification possibilities for investors.

The systematic risk has increased

According to the theory of Markowitz unsystematic risk in a portfolio can be minimized by diversification. The remainder is the systematic risk. However, the systematic risk nowadays is much greater than in the 1950s. Banks have fallen, banks have to adjust to higher capital requirements, countries have to be saved from bankruptcy, the Eurozone which is still very unstable, “risk free” assets that do not actually exist, and so on. In addition, the overall stress level in the market increased since the financial crisis in 2008. Due to the events of recent years investors are inclined to sell risky positions in any state of uncertainty. And since the concept “risky” significantly changed last years, correlations will strongly increase in times of stress. This undermines the modern portfolio theory.

The influence of politics and central banks on the market

The politics and policy of central bankers always had an impact on financial markets. However, since 2008 this influence has increased significantly. It started with the U.S. government and the FED who had to bale out their banks as a consequence of the crisis in the U.S. housing market. And whenever that storm abated, the problems in Greece emerged and resulted in a wider European crisis. A crisis European politicians still try to tackle today. In addition, the traditional instruments of control for most central banks (the interest rate) is exhausted. So in recent years, a range of “extraordinary measures” was introduced. All these events led to a flood of new regulations (Dodd Frank, EMIR, MiFID II, etc.) for financial institutions.

The behaviour and decisions of politicians can not be captured in a model. Moreover, many central banks are currently working on incentive programs on such a large-scale we never saw before in history. The long-term effects of these programs is uncertain, to say the least. Altogether, we should not undermine these new risks investors are not able to diversify, let alone mitigate.

All in all, I think we may conclude that because of all changes in the financial market since 2008, we need to modernise the “modern portfolio theory”. This is a major challenge facing science as well as the financial world.

This article is translated from Dutch to English by the Editorial Board of Asset | Accounting & Finance.

[1] http://en.wikipedia.org/wiki/Harry_Markowitz

[2] http://www.ey.com/GL/en/Industries/Financial-Services/Asset-Management/European-ETF-survey-2013—The-future-of-the-European-ETF-market

[3] http://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp