New Age Paradigms for the Post-MPT World
July 9, 2013
Since 2008, you can't have an investment-related conversation without somebody saying that Modern Portfolio Theory (MPT) is outmoded, old-school or irrelevant in this New Age of investing. But usually that's about as far as the conversation goes. Advisors are paying more attention to the news, and to potential downside risk, and they're secretly hoping that some insight will help them steer their clients clear of the next major market downturn.
If we are indeed moving into a Post-MPT New Age of investing, then we're going to need something more substantial than better intuition and a closer read of the Wall Street Journal. Over the past four years, I've been collecting the most tangible, concrete post-MPT insights offered by professional investors – those that improve on the standard model.
Below are the five best New Age investing ideas I've heard so far:
Replace static risk and correlation measurements with dynamic ones
Jerry Miccolis, chief investment officer of Brinton Eaton in Madison, N.J., has an unusual background in our business: he was a Towers Perrin corporate consultant for 25 years and wrote a book on how corporations manage the business risk of their "portfolios" of products or subsidiaries: Enterprise Risk Management: Trends and Emerging Practices.
Enterprise Risk Management (ERM) is actually an outgrowth of modern portfolio theory, adapted and refined over the past half-century to fit the myriad management challenges of the business world. So when Miccolis switched careers to join an investment management firm, he was astonished to discover that MPT had not gone through a similar decades-long evolution in precision and sophistication. In particular, he found it odd that advisors would assign a single standard deviation number to each investment or asset class.
"Nobody in the corporate world would measure risk as a single static measure in a dynamic marketplace," Miccolis said. "In the corporate world, there is broad understanding that the degree of risk, and the nature of the risks, change as the marketplace changes."
Corporate managers and consultants monitor this ebb and flow of their business lines' volatility using GARCH models. The acronym stands for 'generalized auto-regressive conditional heteroscedasticity,' where you constantly sample the volatility of each individual component of the overall enterprise, and, at the same time, sample the rates of change to see how each is trending. The more sophisticated models will draw tentative conclusions about future risks. In either case, as a matter of managerial routine, business executives will compare those risks to the degree of risk they're willing to take on behalf of their shareholders. Whenever risk exceeds stomach for risk, they look for ways to take chips off the table.
In the investment world, Miccolis was surprised to learn, a comparable activity is regarded as heresy and market timing. The assumption is that you can't monitor changes in risk in the investment markets, but he believes this isn't true.
"We are learning that when market volatility rises, it tends to stay high – what some call volatility clustering," he said. If an advisor sees a rise in the VIX index after a period of relative calm, he might reduce allocations to risk assets.
The same reasoning can be applied to the other inputs in an MPT optimizer. Miccolis was surprised to learn that advisors measure the correlation of price movements between different assets (or asset classes) with a single number. A corporate manager with ERM training is naturally curious about how the correlations between different divisions or product lines will change over time, and what market conditions have, in the past, caused which kinds of changes – which Miccolis views as a perfectly natural thing to spend time understanding.
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