Most folks acknowledge that long term Strategic Asset Allocation creates the bulk of investment returns. Yet, hundreds of software vendors, tens of consulting firms and robo advisors, thousands of RIAs and Broker Dealer systems still doggedly cling to and defend outdated notions encapsulated in sixty years old Modern Portfolio Theory (MPT).
MPT no longer serves affluent investors well. It is also responsible, in part at least, for disillusionment with a Financial Advisor’s value add. This has to change. At www.activeallocator.com we are changing the quality of discourse by blending the digital with the human.
Challenge your advisor with some questions:
- MPT assumes returns and risks are measured comparably and accurately across all asset classes. Reality is that they are not. Our optimization algorithms account for the fact that it is not possible to observe market prices (and hence returns), (and hence by extension volatility of returns = risk ) for illiquid investments such as in private equity, private debt or private real estate.
- MPT assumes all investors and fund managers possess comparable information. The reality on the ground is often fund managers know more than investors do – asymmetric information. We attend to this in our portfolio construction part using a probabilistic Bayesian construct with assigned confidence levels.
- MPT assumes that liquidity in each asset class is similar. However, we know that many alternative investments contain significant tradability restrictions affecting rebalancing. We account for disparate and time varying illiquidity premiums in our optimization methods. We calculate how far and for how long an illiquid portfolio is from a theoretical efficient frontier and extract a dynamic illiquidity premium to compensate.
- MPT assumes markets are efficient and new information is priced immediately. The reality is that Active managers seek restricted markets to exploit inefficiencies. We separate between market exposure and manager skills when we implement portfolios to fulfill the strategic asset allocation.
- MPT assumes volatility accurately reflects risk, and investors only worry about variance of returns. The reality is that returns are not distributed symmetrically (or as in high school we learnt ‘normally’ around their mean). Volatility understates downside risk and that’s why we account for downside risk by taking into account skewness and kurtosis.< N.B. we do not optimize across these moments as it is hard to calculate co-skewness and co-kurtosis as implementing extreme value theory is very difficult>.
- MPT suggests investing passively at the broad asset class level using inexpensive indices is a good idea. The reality is that solving for complexities of alternative investments— illiquidity, asymmetric return distributions and active management techniques— and purposively including into the portfolio construction process is hugely beneficial. In our approach returns come from fundamentals, manager skills, unlocking illiquidity premiums & managing downside risks.
I had learnt this the hard way at CAI and ActiveAllocator brings clarity in thought process to all investors now.
