Modern Portfolio Theory (MPT) provides a very useful framework to think about investing, giving investors tools to help manage risk and better understand the drivers of return.
But, as a recent paper by Epoch Investment Partners points out, ultimately MPT is simply an economic model and, as helpful as it is, investors still need to understand the why behind a successful business.
MPT involves finance, which in the end is an inescapably human activity, subject to all the vagaries and unpredictability of anything that involves people interacting with each other. It does not allow precise and accurate predictions.
Investors should never get so caught up in a model that they lose sight of what investing is all about - the real world. Successful investing in equities is about identifying companies that create value for their owners by earning high returns on the capital that they take from those owners and invest in their business.
One unintended consequence of MPT’s focus on indexing is that active management has come to be less about identifying businesses that add value, and more about positioning yourself relative to an index. And in the process, managers have adopted methods that have made it less likely that in the long run they will generate returns that are better than an index.
MPT has also led to an ever-increasing level of abstraction in the way that many asset owners and asset managers think about investing. Stocks are viewed not as businesses, but as collections of factor exposures. The higher return that equities have earned over time is viewed not as a simple reflection of the fact that companies have been able to earn returns on their invested capital higher than their cost of capital, but as the result of a hypothetical equity risk premium.
The framework has been a positive development in helping people to better understand investing, but like any theory, MPT is only a model of the way the real world works; it is not the real world itself. Over the last 50 years, some investors have become so enamoured of the theory that they have lost sight of the real world underlying the theory.
Back to basics: What is a stock?
A stock does not carry exposure to just one form of systematic market risk; it has exposure to a whole gamut of risk factors. Depending on what model you are using to define and measure these various risks, the factors might go by names like size, volatility, financial leverage, growth, quality, or value.
Risk models measure factor exposures in “normalised” terms. At the end of a given time period, an analyst versed in MPT will take the returns that various stocks have experienced, regress them against the “factor exposures” of the stocks at the start of the period, and produce a set of “factor returns”. But many investment practitioners have become so enamoured of this theoretical framework that they reverse cause and effect in the way they think about the world.
Stocks are more than a collection of statistics such as mean return, variance, or a set of factor exposures - they are actual businesses. Their success or failure as businesses, which is dependent on their ability to meet the needs of customers and to allocate their cash flow sensibly, ultimately drives their stock price higher or lower. And it is the success or failure of actual businesses in the real world that creates the theoretical factor returns through the resulting stock price movements.
Consider what happens when a company reports disappointing profits and lowers its outlook for the future, and the company’s stock falls. After the fact, this fall in the stock price, when combined with the factor exposures that the stock had just before its decline, will clearly affect the calculation of the factor returns for that time period. But if a company with, for example, low financial leverage and high momentum disappoints the market and the stock falls, the market is not punishing low financial leverage and high momentum per se: it is punishing a specific company because its outlook for future cash flows deteriorated.
Now, an MPT advocate might respond to the preceding section by saying that yes, of course individual company stock prices react to changes in the outlook for each company’s future cash flows. But almost invariably, some companies are experiencing upward changes in expectations while others are experiencing downward changes.
This is what MPT means when it says that the market does not reward idiosyncratic risk, because by holding many stocks you can eliminate that risk. Why should you get paid for risk you don’t need to take?
Why do stocks historically outperform bonds?
So, why have stocks historically generated higher returns than Treasury bills (and bonds in general)?
So where does that systematic market return come from? In the world of theory, the answer is straightforward: systematic return is the reward for taking systematic risk. Stock returns are more variable than Treasury bill returns, and as variability is the very definition of risk in MPT, investors must be paid higher returns on stocks to induce them to take on that risk. Investment practitioners today often call this gap between stock market returns and the return on Treasury bills (also known as the “risk-free rate”) the “equity risk premium,” and view it as the reward that investors get for taking on the undiversifiable, systematic risk of owning equities.
Just as factor returns do not have an independent existence that drives stock returns, neither does the equity risk premium. The equity risk premium is not some sort of force of nature, driving stocks to produce better returns than risk-free assets. It is an after-the-fact derivative. And what is the “fact” that the equity risk premium derives from?
Regardless of what industry a company is in, management in every firm is trying to do the same thing: take capital that costs X per cent and earn a return higher than X per cent. That is the definition of how a business creates value for its owners. When companies earn higher returns on their invested capital relative to their cost of capital, they create more value for the owners of that capital, and stock prices rise at a faster rate. After the fact, we observe that as a higher equity risk premium.
The point is, there is really no mystery behind the equity risk premium. It is simply an outcome of the fact that businesses, as a group, are more often than not able to take a dollar of capital and, net of the cost of that capital, turn it into something more than a dollar. And in theory, the upside to that transformation is unlimited. In practice, the upside for the growth in the value of a successful business is astonishingly high. To take some extreme examples: a dollar invested in Apple stock at the end of 1992 was worth over $91 at the end of 2017, twenty-five years later (assuming you reinvested all your dividends back into the stock). A dollar invested in Microsoft was worth $48 at the end of those same 25 years.
On the other hand, a Treasury bill, or even a corporate bond for that matter, is a fundamentally different instrument. They are called “fixed-income” securities for a reason - they offer fixed payments, with no opportunity for your money to grow in an unbounded way.
What does a stock index represent?
The idea that there is one optimal portfolio that we would all want to hold is predicated on the assumption that we all agree on how to define and measure risk, and that we all perceive the riskiness of each asset and each portfolio in the same way. As we mentioned earlier, MPT uses the variance of an asset’s returns as the definition of risk. The work of behavioural economists has made it clear that this assumption about risk is invalid, so it is simply not the case that there is one portfolio that every investor would agree is optimal.
Think about the logic of holding an index fund. Essentially, you are surrendering your ability to render any judgment about which companies to invest in. If a company chooses to go public, you are obligated to buy it, because it is now part of the market portfolio. The choice as to whether that company ends up in your portfolio is being made not by you, but by the board of directors of the company when it decides to go public. Is it a good business - that is, one that earns a premium over its cost of capital? You’re not even bothering to check. If the company is public, you buy it.
Managers today generally do not focus on identifying attractive businesses; they focus instead on trying to figure out which stocks are going to outperform the index over some short to medium term.
These are different objectives, and they lead to different analytical methods.
Similarly, the client focus on indexes has played a role as well, because managers know that many clients will not retain them if their performance falls behind that of their benchmark over a three-year period. The fact that clients compare managers to an index leads managers to think of risk in terms of tracking error, rather than in terms of some broader measures of overall risk.
Clients might be better served by giving individual managers free reign, so that the managers would worry less about the index and more about only investing in good businesses.
Damien McIntyre is the chief executive of Grant Samuel Funds Management.