{"id":5526,"date":"2017-04-05T11:15:33","date_gmt":"2017-04-05T15:15:33","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5526"},"modified":"2018-09-21T02:03:27","modified_gmt":"2018-09-21T06:03:27","slug":"the-active-equity-renaissance-the-rise-and-fall-of-mpt","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2017\/04\/05\/the-active-equity-renaissance-the-rise-and-fall-of-mpt\/","title":{"rendered":"The Active Equity Renaissance: The Rise and Fall of MPT"},"content":{"rendered":"

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\u2019s 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.<\/span><\/p>\n

The Rise of MPT<\/strong><\/span><\/p>\n

Pillar I<\/strong><\/em><\/span><\/p>\n

In 1952, Harry Markowitz published his article on portfolio selection<\/a>, 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.<\/span><\/p>\n

Pillar II<\/em><\/strong><\/span><\/p>\n

Combining Markowitz\u2019s model with restrictive assumptions regarding investor rationality, information availability, and market trading structure, Bill Sharpe (and others) derived a model of capital market equilibrium<\/a>\u00a0in the mid-1960s. Soon the capital asset pricing model (CAPM) became a central tenet of MPT.<\/span><\/p>\n

Pillar III<\/strong><\/em><\/span><\/p>\n

Eugene Fama erected the final MPT pillar<\/a>\u00a0in 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<\/em> relevant information and thus generating excess returns through active management is impossible.<\/span><\/p>\n

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.\u00a0Now they had a rigorous theory of markets and a rational approach to building investment portfolios.<\/span><\/p>\n

But their conception could not have been further from the truth.<\/span><\/p>\n

The Fall of MPT<\/strong><\/span><\/p>\n

The first shots were fired across MPT’s bow in the late 1970s.<\/span><\/p>\n

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.<\/span><\/p>\n

As EMH came under attack,\u00a0Sanjay Basu\u2019s research<\/a> demonstrated that low P\/E stocks outperformed high P\/E stocks. In the early 1980s, Rolf Banz showed<\/a> 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.<\/span><\/p>\n

In response, EMH proponents integrated these anomalies into a new \u201cfactor model,\u201d 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 \u2014 investment consultants, for example \u2014 to create that classic active management handcuff, the style box. In turn, the style box unintentionally led to\u00a0additional active management restraints<\/a>, such as style drift and tracking error.<\/span><\/p>\n

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.\u00a0Russ Wermers<\/a>\u00a0demonstrated that the average stock held by active equity mutual funds earns a 1.3% alpha, and\u00a0Randolph B. Cohen, Christopher Polk, and Bernhard Silli<\/a>\u00a0found that ex-ante best idea stocks earn a 6% alpha.<\/span><\/p>\n

In the early 1980s, Robert Shiller argued that almost all volatility observed in the stock market, even on an annual basis, was noise rather than the result of changes in fundamentals. Since EMH held that prices fully reflect all relevant information, volatility driven by anything other than fundamentals strikes at the very heart of the theory.<\/span><\/p>\n

Shiller\u2019s noisy market model<\/a>\u00a0also created problems for Markowitz’s portfolio optimization. If volatility is the result of emotional crowds, then . . . emotion has been placed in the middle of the portfolio construction process.<\/span><\/p>\n

So rather than being a risk-return optimization, it is an emotion-return optimization.<\/span><\/p>\n

In summary, all three pillars supporting EMH have been toppled.<\/span><\/p>\n

Rejecting the World Rather Than the Paradigm<\/strong><\/span><\/p>\n

Much of finance pushes aside the mounting contrary evidence and soldiers on under the yoke of the MPT paradigm. This might seem surprising: Isn’t finance a discipline based on empiricism, one that only accepts concepts supported by evidence? Unfortunately, as Thomas Kuhn argued years ago in his classic work,\u00a0The Structure of Scientific Revolutions<\/em><\/a>, scientific and professional organizations are human and are susceptible to the same cognitive errors that afflict individual decision making.<\/span><\/p>\n

The concepts underlying MPT have not been rejected. Instead, they are widely used in studies and show up in textbooks all over the world. MPT’s ubiquity confirms its legitimacy through social validation rather than empirical evidence. Emotional decision making is rampant in what is supposed to be a rational discipline.<\/span><\/p>\n

Just because something is widely used doesn\u2019t mean it’s useful. The conventional wisdom is often wrong.<\/span><\/p>\n

Let the Transition Begin<\/strong><\/span><\/p>\n

After decades, there is little evidence to support MPT. It is time to move on.\u00a0There is an alternative way to view securities markets, their movements, and their participants: behavioral finance.<\/span><\/p>\n

At some point, the industry will make the transition to something other than MPT. Behavioral finance is the leading candidate. Then the investment world as we have known it will be changed forever. As Kuhn observes, when paradigms change, everything changes, including basic concepts, facts, history, tools, and methodologies.<\/span><\/p>\n

After the dust settles, virtually nothing of MPT will remain.<\/span><\/p>\n

The ultimate irony of rationally based MPT is that it gives advisers and analysts the tools to enforce “The Cult of Emotion<\/a>,” including volatility as risk, efficient frontier, downside capture, downside risk, R-squared, and the Sharpe ratio.<\/span><\/p>\n

The law of unintended consequences should not\u00a0have the last word. As MPT fades into history, so will these tools. It’s just another step on the road to the Active Equity Renaissance.<\/span><\/p>\n

Image credit:\u00a0\u00a9Getty Images\/mmac72<\/span><\/p>\n

 <\/p>\n

Originally published on CFA Institute\u2019s \u00a0Enterprising Investor<\/a>.<\/em><\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

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