Challenging Orthodoxies: The Distraction that is Modern Portfolio Theory

Monday, November 21st, 2016


In September 2013, Julie Segal asked “Is Alpha Dead – beating the market has become nearly impossible.”

“….struggles to find excess returns…What had become common wisdom and the science of markets suddenly didn’t work…[The Endowment Model] stresses diversification into all types of equities and employs huge allocations to alternative investments like PE and Hedge funds.  The model, which produced stellar long-term investment returns for Yale, failed during the crisis….The mix of all those asset classes did not provide any cover from the losses in the public equity markets, and investors had to scramble to access other sources of cash once they got a real taste of what it meant for their funds to be locked up in illiquid investments.”[1] 

The coverage and research that went into the Endowment Model in the face of post-crisis structural changes, like global deleveraging and unprecedented monetary policy by central banks around the world, was broadly negative. The Yale Model was attacked and active management was questioned in the subsequent rally that has continued for seven years.

Seven years into a global dilemma and we have zero interest rates, exhaustive central bank asset purchases, which might be good for current conditions but very bad for future returns, the value of quantitative easing becoming less effective, record high valuations, and record low volatility.

The typical 60/40 portfolio return in 2007 was 7.5%, now investors will be lucky to generate 4%.

While we think the Yale Model is probably only sustainable for Yale, (with its AUM, board, staff, fundraising capabilities, tolerance for risk, and long term horizon) the reports that the endowment model’s “death is greatly exaggerated” (Mark Twain). Over generational cycles, you can likely take Harvard or Wake Forest and compare their returns and, perhaps more importantly, their risk profile and the portfolios easily outperforms state and corporate pensions, and a 60/40 portfolio by a healthy margin on a risk-adjusted basis.

What did happen was that the financial crisis forced the industry to rethink basic assumptions of Modern Portfolio Theory, such as normal distributions, market efficiency, and risk-free rates of return. Investors and providers alike are recognizing inherent weaknesses in these assumptions, which they have come to realize, are not so modern at all. We still see too many institutions trying to solve for return, a variable that they have little control over. Larry Davanzo at Wilshire reminded me often: “…you can only control two things, risk and fees, you can’t control returns.”  Yet consultants all over the country still print, every year, expected risk and expected returns for every asset class for the next 12 months.  Every year they are wrong. To paraphrase Galbriath, I think these forecasts are only useful to make astrology look respectable.

Verger is recognized as an early adopter of a factor model. Our asset allocation model endeavors to gain exposure to the factors that drive return and not just rely on traditional asset classes. This model also doesn’t need to be reliant on what bucket a manager might fall in but rather what drives an investment’s return, correlations, and constraints during the optimization process. We still utilize diversification and optimization but it’s a blurry lens and interestingly enough, we still generate similar returns to our peers while taking less risk.