Fri, 31/08/2007 - 07:00
Shoham Cohen, co-founder of Singapore-based hedge fund service provider ESC Financial Services, says that Harry Markowitz's modern portfolio theory, introduced in 1952, is no longer fully adapted to today's financial environment, and it's time for portfolio construction theory to move on.
Portfolio management is undeniably a challenging task - while you have to aim for high returns, you must do so at the lowest risk possible. For more than a hundred years, the financial industry has been looking for the ultimate code that reveals the correct combination of variables that would result in long-term, optimised returns at a relatively low risk.
It seems, however, that this code evades current portfolio managers despite the wealth of talented economists out there, and the experience, information and advanced technology to their advantage.
Harry Markowitz seemed to have found the ultimate code in modern portfolio theory, which he introduced 55 years ago. Since then, however, no new theory has made as much impact. My feeling is that we should produce contemporary theories that represent more accurately the reality of modern finance. What we have seen so far are not enough, although the best minds are behind these attempts.
But does an ultimate code really exist? Maybe. One thing is certain, though: modern portfolio theory has to evolve, adjust and be revised to adapt to modern realities. No theory can be applied in the same way for 55 years. With due respect to Professor Markowitz, it seems that professionals in the investment community are still clinging on to MPT in its original form.
Technical analysis, fundamental analysis, and historical behaviour are important, but how can it be that hedge funds, portfolios and allocations are applying and practising a theory that may not work ideally today? And why has there been no major breakthrough and development of Markowitz's work since its introduction?
Markowitz first wrote about MPT in his paper Portfolio Selection in the Journal of Finance in 1952. He was honoured with the Nobel Prize for Economics in 1990, along with Merton Miller and William Sharpe.
Markowitz and his contemporaries were not the first or last to attempt cracking the ultimate code. Pre-Markowitz theorists and economists Irving Fisher, John Maynard Keynes, and John Burr Williams - who recognised risk and portfolio selections factors - certainly influenced Markowitz in his work.
Post-Markowitz theorists and economists Eugene Fama, Paul Milgrom and Nancy Stokey also entered the fray, but they did not match up to the exacting standards of modern critics, and mostly focused on contradicting one another. In sum, theorists and economists both before and after Markowitz failed to have the same impact as Markowitz himself, seemingly lacking the same breadth of theoretical views to develop something as solid as MPT.
Undoubtedly, MPT is still serving the vast investment community, in the traditional segment and in the alternative arena since the 1980s. Assisting millions to minimise portfolio risk and maximise returns, MPT is still the most fashionably applied portfolio theory to date.
I urge professionals, investor, and managers to advance and innovate, to seek and develop new theories that would reflect today's market conditions in a more accurate and dynamic way. I argue for the obvious - the pace in recent years has increased immensely in comparison with the 1950s and 1960s.
Over the past 55 years, markets have changed, correlation coefficients have changed, economics have changed, investment tools have evolved, and investors' sentiment has changed. Aren't we underestimating the power of evolution?
While there is a current debate about the applicability of MPT, few have tried to establish and construct a more contemporary investment portfolio theory that reflects the current circumstances.
Inevitably, though, in the future we will start seeing theories as grand as MPT providing better portfolio construction and practices. Combinations of fully systematic models alongside fundamental analysis, new investment vehicles, and more importantly, experimentation by individual investors could crack the ultimate code. The question is: Will this be shared with the investment community?
Allow me to share with you what might not be the ultimate code, but an advancement to Markowitz's MPT that reflects some of the modern conditions in the financial environment. What I call the funds' life cycle portfolio theory (FLCPT) suggests that funds have four stages: introduction, growth, maturity, and decline. It argues that with the right portfolio management, the extension of a fund's life cycle is possible.
This sophisticated approach, which is being practiced today by a few reputable institutions, takes Markowitz's balanced portfolio theory and enhances the diversification and weighting factors. The FLCPT suggests that investors should look at the life cycle of funds and the strategy they are representing. It also notes that correctly identifying an emerging fund manager and/or an emerging strategy can help in constructing a better portfolio, enhancing its returns and minimising its risk. It is similar to venture capital, only focusing on funds.
The FLCPT should encourage professionals in the financial industry to apply, construct and experiment with new variations and combinations, and to share this knowledge with the investment community.
It may or may not be the ultimate code, but this is definitely a wake-up call to the investment community: we definitely can reinvent MPT and develop it into a more modern theory - modern in terms of 2007, not 1952. The future of investment portfolio construction is in our hands, and it is entirely up to us how it will evolve from Markowitz' MPT.
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