Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Listen in as host Steve Bleiberg discusses his white paper and explores the limits of MPT in aiding successful investing. (July 10, 2019)
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Listen in as host Steve Bleiberg discusses his white paper and explores the limits of MPT in aiding successful investing. (July 10, 2019)
Hello, and welcome to Actively Speaking. I'm your host, Steve Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 2:I'm Mar McNulty, head of Institutional Relationship Management at Epic Investment Partners. Before we get to today's episode, I would like to share with our listeners a bit more about its host and my colleague Steve Blyk. Now, what our listeners might not know is that in a prior life, Steve was a journalist of sorts. He wrote for the Harvard Lampoon, which counts among its alumni, William Randolph Hurst, Conan O'Brien, Mike Reese, and Jeff Martin At Epic, we have continued to put his creative writing skills to the test, and it has resulted in one of our most popular white papers to date the limits of theory. Steve points out that while modern Portfolio Theory M P t dominates investment thinking today, he argues that living in such a world is frankly unrealistic, and a pre m PT view of the world still holds valuable insights. And now I invite you to enjoy Steve's discussion.
Speaker 1:Welcome to Actively Speaking. Uh, I'm Steve Weiberg, your host. Uh, today it's just gonna be me. Most of the time we are planning to have guests. Uh, but today, uh, I'm gonna talk about a white paper that I wrote last year that's on our website called The Limits of Theory. And, uh, I'll tell you how this white paper came to be. It was actually sort of bouncing around in my head for, uh, literally 35 years. Uh, and the story begins in 1980. I was a senior in college, and I took a class about American architecture from Civil War to the present. Of course, the present at that time was almost 40 years ago, but I got very interested in architecture as a result of that. And a few months later, Tom Wolf, the the recently deceased writer, published a book called From Bowhouse to Our House. And it was about modern architecture. And it was a kind of a follow up to a book he had written a few years earlier called The Painted Word, which was about modern art. And I, I read from Baha to our house eagerly because, uh, I was already a Tom Wolf fan. And, and I had just gotten this new interest in architecture. So I read that, and then I went back and read the Painted word. And the, the message of both books is quite similar, which is that in both of these fields, he was arguing that the practitioners had become so caught up in the theory of what they were doing, that they had kind of lost touch with, uh, the actual end users, uh, viewers of art or people who were going to live or work in the buildings that the architects were building. Uh, with art, for example, he made the argument that so much of, much of modern art was really about theories of art. And that if you didn't know the theories of art that the artists were familiar with, you really couldn't understand what it was they were trying to express in the paintings. And with architects, they were so caught up in the idea that buildings had to have this architectural purity and expressing their structure and so forth. And ornament was considered, uh, a bad thing. And even though people like it, this, you know, this was the case he was making, that the, the practitioners had turned these fields into, um, very self-referential theoretical realms. So I read those books. That was, uh, I guess 1981. A year later I was in business school. I, I started business school, and that's where I first started to learn about modern portfolio theory. And I had the, it struck me at the time in, in 1982, so I guess actually 37 years ago, that, uh, what I was seeing, the way Modern Portfolio Theory described the world of investing, uh, was very similar to what Tom Wolf had been writing about with what that, what had happened to art and architecture, which is that there was this kind of ascendancy of theory. And it seemed to me that modern portfolio theory was like that. It's a, it's a very interesting and elegant model and, um, it does contain valuable insights. But at the same time, I thought, wow, this is really quite theoretical. And I'm not sure that somebody, anybody who's not versed in the theory really can't understand what the people who who use it are talking about. And it's become kind of divorced from the, the, the way that most investors, or not finance, uh, you know, uh, either grad students or CFAs, whatever, um, the way they think about investing is quite different from the way that people who have learned modern portfolio theory think about investing. And it has struck me ever since that, you know, that pre M p T view of the world is, is really a valuable view that we need to hold onto. And, uh, that M p t, while it is an interesting model, is still just a model. It's not actually a description of, of reality. Uh, so I wrote the paper, uh, again, it, it had been kind of bouncing around in my head for years and I finally put it down on paper last year, which was actually quite a relief cause I could stop thinking about it. Um, but I, I considered in the paper three pretty fundamental questions, and I, uh, contrasted the way a non M p t person would, would think about them and answer them versus the way M p t thinks about them. And the three questions were, first, what is a stock? Second, why have stocks outperformed bonds over time? And third, what is an index for a stock index for? So let me talk about those three questions. So on the question of what is a stock? So modern portfolio theory tells us that, uh, really all you need to know about a stock is, you know, well, so modern as we, we talked about this a little bit on the first podcast with, uh, with Bill Priest, uh, MPT views, uh, things through this quote, mean variance framework, meaning all you need to know about an asset is its mean return, the expected return, and the variance of those returns on say, an annual basis or a monthly basis. Um, that's really all you need to know about a stock, is it's expected return and the variability of those returns. Uh, you don't really need to, you know, worry so much about a lot of the stock specific things because, uh, M P T tells us that, well, you don't get paid for that kind of risk because you can diversify that away by holding a lot of stocks in your portfolio. So, you know, something that affects one company positively might affect another, negatively, you hold them both, doesn't matter. Uh, really all you need to care about is the, uh, exposure that the stock has to this level of systematic risk. So systematic risk is what you can't eliminate through diversification. There's just, there's inherent risk in holding stocks as an asset class that you can't diversify away just by holding more of them. Even if you hold them all, you still are gonna have some variability. So there's that quote, systematic risk. And M p T came up with this way of measuring each stock's level of systematic risk, and we call it beta. And, uh, so all you really needed to know was, you know, the, the mean variance, uh, statistics for the stock, what's its beta? And that's, that's the story. Now, in subsequent years, uh, that's gotten a little more refined because, uh, after the first version of M P T came along in the sixties, people did some empirical analysis, and they found that beta really wasn't a very good predictor of returns. That stocks that it had higher levels of systematic risk in the past didn't necessarily do better in the going forward in the future than the stocks that it had lower levels of beta. Uh, and so I, I remember, you know, when I was in business school, the standard response of, of a professor to this kind of thing was to say, uh, oh, well, the model is mis specified, and so we just need to come up with a better model. As opposed to saying, well, maybe the model just isn't a very good representation of reality. It's always, oh, no, no, no, we can come up with a better model, just add more factors. And, and that's what's happened is, you know, we've, we've gone from, in essence, you could think of the original version of M PT as a single factor model where the single factor was beta. And, uh, in subsequent years, we've had a first a three factor, uh, cap Am capital asset pricing model. Uh, Fama and French came out with, uh, in the early nineties, and they added, uh, some, uh, variables for size and for valuation based on price to book ratio, because people had discovered what seemed to be anomalies in the original cap am of small si small size and low price to book value stock seeming to do better than their betas would suggest. So yeah, again, the academic response as well, we'll just add them as factors. Um, and then, uh, they actually came out with a five factor CAPM about five years ago that that added profitability and investment. Um, and there are other people also look at other factors these days. You're, I'm sure you're familiar with them, quality, momentum, things like that. And so the idea is, you know, really all you need to know about a stock is, is its exposure to all these factors. And there's, you know, there's factor strategies, there's factory ETFs. Well, a traditional investor, you know, would really doesn't know much to make of all this. They say, look, when you own stock, you own a share of the business. And look, the goal of any business doesn't matter whether it's a steel company or a software company, they're trying to do the same thing. They were, they have capital that they've been, that investors have put up to start the business. And the job of the management is to earn a return on that capital that's greater than the cost of the capital. If you, you do that, you're creating value for the people who gave you the capital. You know, if it cost you 5% and, and uh, you earned 10, you've, you've made, uh, you've made some money for the owners of that capital. If it cost you 10 and you only earned five, well, yes, you've earned five, but, uh, you know, the, the cost that 10% quote cost represents what people could have expected to earn elsewhere on some other, uh, similar kind of investment. It's really an opportunity cost of capital. Uh, but so if you cost you 10 and you're only earning five, you're actually destroying value for the people who put up the capital. Uh, so if the business earns higher, R O I C return on invested capital, then it's cost of capital, it's gonna grow, the value of the business is gonna grow. Um, and you know, these are very divergent views, obviously between a collection of factor exposures and it's an actual business, you know, and so the, the point is, if you, you say after the fact, you look back at, say, 2018, and you say, well, gee, why did this particular stock do? Well, somebody who's very versed in M P T is, is more likely to say, well, did well because, you know, it has positive exposure to quality and momentum and negative exposure to size. And, you know, quality and momentum had positive factor returns and size had a negative factor return. And so those factor exposures are why the stock did well. Whereas the traditional investor will say, stock did well because the business did well, you know, they, they, they grew their, their profit, whatever. Uh, and you know, that's, that is the reality that businesses, stocks do well because the underlying or poorly because the underlying business does well or poorly after the fact, we can take those returns that the stocks generated and compare them to what exposures the companies had to these factors. You know, you can, you can always measure stocks on all these different characteristics like size or, or, or price to book ratio and come up with a score. And then, you know, six months later you can take the returns that occurred over the six months and regress them against those factor scores and say, AHHA, see, this was the return to these factors. Uh, but the factor returns are entirely derivative of the returns that the, the stocks generated because of the business success or failure. It's not the other way around. It's not, it's not like a, you know, apple does well or poorly because of its exposure to the size factor, it does well or poorly because of how many iPhones it sells. And then after the fact, you know, that that success or failure flows through into a, what we call factor returns, uh, based on whatever characteristics it had. But that's not really why the stock did well or poorly. It did well or poorly cuz of what the business did. So now, uh, what I said about, you know, if a business does well, if it earns a high return on capital compared to the cost of capital, the value of the business grows. Well, that leads to the second question. Why have stocks outperformed bonds over time? So in the modern portfolio theory view of the world, we'll start with that again. There's this thing people talk about called the equity risk premium. And, uh, I, in the, in the the white paper, I, I refer to a, uh, another white paper, I guess that was done by the New York Federal Reserve Bank actually a couple years ago, where they talk about the equity risk premium and they talk about it as if it's, you know, a, a phenomenon of nature like the speed of light or, or you know, gravity, uh, that there's this thing called the equity risk premium and trying to figure out ways to measure it. It just strikes me as funny because the idea, again, in modern portfolio theory as I talked about with Bill and the the last podcast, is that you can capture risk through one simple statistic, which is the variability of an assets returns. So applies not just to stocks, but to bonds as well. Uh, bonds, you can measure their return every year. You can look at the standard deviation of that series of returns, and you can compare that standard deviation to the standard deviation of, of the returns you get from the stock market. And what you'll find is that bonds have lower standard deviation than stocks. The their returns don't vary as much. And so MPT says, aha, the, the higher return that stocks have generated over time is a payment for taking on that risk. People don't like risk. Uh, and so you have to be paid to take on risk. And the higher return that stocks have earned is a, is a, you know, direct payment for, for the risk you have to suffer through to own stocks. Now what would a traditional investor say? Well, as I said, you know, the job of any company is to take the capital that they've been given, which has a cost associated with it, earn a higher return than that. And if you do, you create value over time. Companies have on average been able to do that. Not every company and not every year, obviously. But over time, uh, stocks in general, which, you know, if you think about it, it just represents ownership of the economy and the economy has grown over time. Uh, and and on average companies, uh, more often than not are able to earn a return on their capital that is higher than their cost of capital. And that means the value of the business grows. Now, think about the difference between stocks and bonds. A bond is a loan, it's just a securitized loan. You've lent some money either to the government or to a company, and you can trade the ownership of that loan or the right to the cash flows associated with that loan. And that's what a bond is. What's the best you can do. The best you can do is you get your money back, is that they pay off the loan, they don't default. And along the way you collect interest. So that's, you know, the upside is capped. You'll get your money back when you own a stock, the upside is not capped. Uh, I mean, theoretically nothing can grow to be worth all the money in the world. But, you know, if you had invested in, you know, a company like Apple 25 years ago, you made multiple, you know, times your money on that investment, which you can't do if you, you know, loan somebody money, you're not gonna make multiple times your investment. So think about what that means, the range of outcomes for a bond, well, it, it can go to zero, the company can default. So the price of it can go to zero. So your downside is, you know, you can lose a hundred percent, um, but the upside is kind of capped where a stock can also, you can go, you can go to zero, they can go out of business. So you can lose a hundred percent, but the upside is not capped. You could make hundreds or thousands of percent return on your investment. Well, that means obviously the range of outcomes is much higher with stocks than it is with bonds. They're just different animals. And so of course the the standard deviation of the returns is higher for stocks than it's for bonds because again, they're just fundamentally different kinds of things. Does that mean that the higher return that stocks have earned is some sort of payment for that, uh, higher variability of outcomes? I would not necessarily characterize it that way. In, in economics, economics is full of discussions of quote, tradeoffs. I mean, that is one of the things that economics is all about. Tradeoffs, you know, how do we allocate scarce resources? There's always trade offs. Um, and so for example, if, if a city, uh, wants, you know, to experience fast economic growth, that's usually gonna come with some trade-offs. Like there will probably be more congestion, more, more, you know, the public transportation will, will, you know, be more heavily used. There will be more cars on the streets, there might be more pollution in the air. We'd say these are trade-offs. That's the faster growth will generate higher wealth for the residents of the city. But there will be negative consequences too. It's a trade-off. Would we ever say that the, um, you know, that the higher income people earn is, is a payment for the congestion they have to live with? No, we, we don't really think of it that way, but that is what modern portfolio theory does. It says, we can quantify this, this relationship between return and the variability of return. That one, the, the return is a payment for the variability. And we can quantify that relationship. And I think that's kind of a heroic assumption. I, I, in fact, when you look at, um, the difference in performance between stocks and bonds over time, it correlates very well with the, the return on invested capital that companies are earning in periods when companies earn are, are able to earn high returns on capital, which tends to be when the economy is expanding more quickly. You see that stocks do better than bonds by a wider margin in periods when the economy is shrinking. And usually companies, their return on invested capital declines during those periods, and sometimes it falls even below the cost of capital. You find that stocks, uh, often underperform bonds and periods like that. Uh, you know, that's, that's what's driving it. It's the success or failure of the businesses. It's not that there's some payment going on for volatility or at least, you know, that's, that's what I would say is the traditional, uh, view. And now it's turn to the third question, what is an index for? And again, I talked about this a little bit on the first podcast with Bill Priest about how modern portfolio theory, uh, comes to the using that mean variance approach where you assume that you can define risk with this one objective number, the variability of return. Uh, there is a logical argument that comes, flows from that, that there is one portfolio that is the, is optimal, uh, in the sense that you combine that portfolio with cash depending on how much volatility you are willing to suffer. And, and you can get the most quote efficient, uh, uh, portfolios, uh, mix in the sense of you couldn't get a higher return for the level of volatility that you're comfortable with than by mixing that optimal portfolio with cash and the right mix. Um, and again, it's a logical deduction. Well, what's the only portfolio we could all hold at the same time? It's got, it can only be true if we're all holding a miniature version of the market, or in essence an index fund. Um, but, uh, again, there are problems with this fir first is the, um, I mentioned in the previous podcast about, well, you, you can't really assume that we all can agree on the riskiness of an asset because, uh, it's not the case that, uh, that that volatility of return captures it properly. We have the, there's this phenomenon of, uh, loss aversion that varies from person to person and, and we're not going to agree on, on how risky, uh, a given stock is. But, uh, more importantly, the the idea that you should own every stock out there in proportion to its weight in the market, uh, I think suffers from some, some kind of logical flaws of its own. Even when you just think about the practical consequences of that, it means that you should not even think about, uh, is this a good business? And by good business, I mean, is it earning a return on capital and it's greater than its cost of capital. There are plenty of public companies that do not earn good returns on capital and they do not perform well over time as a result. But what modern portfolio theory is telling you is don't even try to figure that out. Just own everything because that's optimal. Um, but again, not all businesses are good businesses and just because a company goes public, it's not a reason to own it. You know, in fact, these days, um, you know, with, uh, there's a lot of new companies that are in these businesses where it's, uh, they're, the biggest value of the business is essentially in some intangible capital. Uh, the platform companies, for example, um, they, uh, have chosen to remain private much longer than would've been the case in in previous generations because they, they prefer to deal with kind of specialized private equity or venture capital investors who know more about how to value the business. Uh, and by when they do go public, it's often because they figure, well, you know, we just want to finally make this thing liquid and allow people to cash out doesn't necessarily mean that, you know, they're not going public out of the goodness of their hearts, uh, cuz they want you to get in on this, uh, this gold mine. Uh, they have other criteria and other motivations for going public. And so the idea that, you know, just because a company goes public, you should buy it is something you should be very suspicious of. Um, and there are, there are unintended consequences as well of, of the idea that, uh, that the optimal portfolio is, is the index. Uh, number one, it's that, uh, I think what's happened to a lot of active managers, and I think it explains some of the struggles that active managers have had over the years since this became, since indexing became popular, is that they, rather than approaching the task, as you know, look, my job is in, I'm an investor. I wanna identify good businesses again, ones that are investing, uh, earning good returns on capital relative to their cost of capital and, and invest in those. And I wanna steer clear of the ones that are bad businesses. Instead, the, the objective becomes, I have to beat this index over the short term. And, you know, there are practical motivations for that. If you underperform an index, uh, if you're an active manager and you underperform for, you know, a couple of years, there's a good chance, uh, your clients will leave. And so of course you wanna, you're gonna think about, you know, oh, I don't, I don't want to underperform this index over the short term. Well, what if, you know, what, if you correctly identify that? Well, you know what, the stocks that are probably gonna do well in, in the environment for the next year are, are the ones that are not really good businesses, and they will eventually give that back. But, you know, gee, if I feel like I have, if I have to beat the index every year, I'm gonna say, well, I guess I need to own some of these bad businesses. Uh, just so it's not underperform, the index doesn't really serve anybody's interest to do that. Uh, and, and what I would say is trying to pick stocks that you think will beat the index in the short term is a very different task than trying to identify good businesses and, and hold them, uh, for the long term. It's, those are very different jobs and, uh, the, they're not necessarily, you can't necessarily do both at the same time. So what are the practical lessons we can take from all of this? Uh, I, I would point to three. Uh, number one, keep in mind that modern portfolio theory is only a model. It's a very interesting model. I mean, I have always found it fascinating and, uh, it's very good in looking backwards in, in sort of explaining things that have happened in the past. It's not really very good at, uh, telling us much about the future. And it's, it's certainly not a literal description of reality. And in particular, where it's most unrealistic is in how it defines and measures risk. Again, it, it falls, uh, it relies on this one number, uh, the, the volatility of a, of an assets returns, which is an objective number that's independent of who's measuring it. But the truth is, uh, the perception of risk is a very, idio is a very idiosyncratic thing that varies from person to person. And no two people will ever fully agree on the riskiness of a, of a given asset or a portfolio. Uh, second lesson I would say is that all the factors that people talk about, um, really don't tell us much about the true sources of return and of risk of a business. Uh, if you think about, um, you know, a steel company or a tire company or, or a, or target or somebody, uh, a retailer, what are the, what are the true sources of return and risk for them? Do, do you think they sit around at, at the management meeting saying, well, we have a real problem that, you know, our exposure to size is a little too low and our exposure to momentum is a little too high right now that would never even come up. They don't even think about that stuff. They think about, you know, gee, is, is a competitor gonna come along and figure out, you know, have some new product that's going to put our, make ours obsolete? Um, have they figured out a way to just, you know, sell to customers that's more effective than ours? Those, those are the sources of risk for a business. And, um, you know, the, it's the return comes from, again, the ability to provide a good or a service in such a way that, that meets consumer demands, such that the company's able to earn a good return on its capital, that it invests in the business. That's what drives return, uh, and risk and connected to that one. The third thing to take from all this is that not all businesses are good businesses. Uh, you know, a a a company goes public doesn't, just the fact that it is publicly traded doesn't mean it's a good business. Meaning a business that earns a good return on its cost of capital, and in the end, why, why would you want to invest in a business that doesn't earn its cost of capital? But if you buy into the logic of modern portfolio theory and, and hence you believe in, in holding the whole index, you are signing up to own a lot of businesses that are really not good businesses. Uh, so we, we'd say, you know, it's, it's worth the effort to try to figure out what are the good businesses out there, and those are the ones you want to invest in. Thanks for listening to all that. Uh, hope you found it interesting. If you wanna read the, the whole white paper, uh, not that there's, you know, much left after my lengthy description, but if you wanna read the whole thing, you can find it on our website, uh, www.eipy.com. Hope you'll listen into future podcasts. We've got some great ones coming up. We're gonna be talking about driverless cars, trade wars, things like that. Uh, and most of the time, as I say, we will have guests, you won't have to just listen to me. So thanks for listening. Remember to subscribe to Actively Speaking on Apple Podcast or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com. We'll talk to you again soon.
Speaker 3:The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the, the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.
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