A number of beliefs and practices have grown up in the area of portfolio management that may be detrimental to the financial well-being of clients. Here are a few of them.
The MPT problem. Modern portfolio theory is an elegantly wonderful confluence of insight and mathematics. Efforts to implement MPT have not been as beautiful as the theory itself.
To build an “optimal” portfolio you must know three things—the future expected returns, volatilities and correlations of the asset classes in your portfolio. Unfortunately, no one knows what those numbers are.
Optimal portfolios are like unicorns—they don’t exist in real life. Nevertheless, we act as though our capital market assumptions have a magical predictive quality. If they tell us to trade, we trade, thus incurring transaction and tax costs.
Let’s recognize that our capital market assumptions are guesses about the future, but the fees and expenses we incur trying to stay locked onto our optimal allocation are real.
The rebalancing problem. Even if our expectations about the future have not changed, we feel compelled to tweak our portfolios to bring them back to our “optimal” mix. This is called rebalancing.
Research suggests that its utility is dependent on factors such as time period, the direction of the market and the relative future expected returns of the asset classes being rebalanced. Yet we employ simple, mechanical rebalancing strategies that generate plenty of transactions, but add little or no value. A more thoughtful approach could improve results and reduce costs.
The style-drift problem. Just to make sure everyone knows how much we love our optimal mix, we punish active managers who commit the sin of “style drift.” Forget the fact that the manager was led astray by a perceived opportunity to make money. We want them to strictly adhere to their mandate. Even though we hired them for their skill, we want them to be closet indexers.
The asset class selection problem. Another problem is that most of us do not have a scientific process for selecting the asset classes we use in our portfolios. We just keep adding asset classes until it feels about right. Remember, every additional asset class brings with it additional transaction and tax costs.
Fear of volatility. Ah, volatility reduction. Is that a good thing, or a bad thing, or does it depend? Certainly all things being equal we’d like less volatility rather than more. But we rarely have the choice of getting the same return with less risk if Mr. Market is being efficient.
We get paid to take risk and to generate the returns our clients need; we must experience some volatility. Let’s not become overly fixated on eliminating it.
The data-mining problem. It has become popular to use our massive computing power to mine data in search of winning patterns in the historical tea leaves. Some of these patterns take the form of “factors” that, we are told, will allow us to tilt our portfolios in one direction or another to give us an edge.
In investing, there is no strategy that always wins. The future rarely replicates that past. Let’s set our expectations and those of our clients accordingly.
Conclusion. Every portfolio we manage has a client attached to it. We should examine our beliefs and practices to make sure they are consistent with the best interests of those clients.