From Revolution to Evolution

By: David Ott

In his 1992 book, Capital Ideas, Peter Bernstein guides us through the four decades when Modern Portfolio Theory (MPT) revolutionized Wall Street. Now, fifteen years later, Bernstein’s new book Capital Ideas Evolving (referred to as Evolving hereafter) critically examines MPT from three perspectives.

In the first section, he presents the two most substantial academic critiques of MPT that attack some of the underlying assumptions within the theory. For example, MPT assumes that investors are rational. These fictional investors are emotionless automatons that are absolutely capable of making optimal decisions about their portfolio.

This is obviously false. It may make sense with respect to the creation of a theory, but any practitioner will tell you that neither markets nor investors are rational. A whole new field within economics, referred to as behavioral finance, seeks to examine investor behavior in attempt to mitigate some of the frequent problems that arise.

For example, one study looked at how 401(k) participants make decisions about their retirement savings based on the choices that their plan sponsor provides them. The study breaks the participants into three groups and gives each group a choice between two mutual funds.

The first group was given a choice between a stock fund and a bond fund. This group split the money basically down the middle and basically had a 50/50 stock/bond allocation.

The second group was given a choice between a stock fund and a balanced fund that split the money 50/50 between stocks and bonds. Instead of putting all of the money into the balanced fund, the participants split the money between the two funds, which meant that their stock/bond split was 75/25.

The third group was offered a bond fund and the same balanced fund that split the money 50/50 between stocks and bonds. Investors split their money half and half between the two funds instead of the balanced fund and ended up with a portfolio heavily weighted towards bonds.

The researches subsequently interviewed the participants and found that they had wanted to diversify, and since they didn’t understand their options, they just split the money half and half into each option thinking that being diversified into two funds was better than one, even though the results of that simple decision had radically different asset allocation implications for the 401(k) assets.

Whether it is a problem of being uneducated about investments or acting irrationally, this experiment shows that investors are generally not well equipped to make appropriate decisions about their investments. Even Harry Markowitz, the great-granddaddy of MPT says that many of the theories “make unrealistic – absurd – assumptions about the actors.”

In the second section of the book, Bernstein revisits many of the academics that led the revolution to ask if their theories are still relevant. In short, they all seem to agree that the theories aren’t perfect, but are clearly relevant and useful in today’s environment. As Nobel Laureate Robert Merton says, “there is much left to do because so little has been done.”

In the third section, Bernstein describes a variety of practitioners who have put the MPT to work with a great degree of success. The first case is an extension of one of the real world examples in Capital Ideas. In the first book, he describes how Wells Fargo created the first index fund. It seemed odd that they had no visible name regarding indexing in today’s investment landscape.

The answer to that riddle is that Wells Fargo wasn’t making any money indexing, so they sold it to Barclays who – years later – turned their experience in indexing into the dominant player in the exchange traded fund and exchange traded note industry under the successful brands iShares and iPath.

He also describes the Yale Endowments diversification efforts through the extensive use of private equity, long-short and absolute return funds as well as other esoteric strategies like ‘portable alpha.’ The basic idea is use leverage to invest in an equity index like the S&P 500 using futures and invest what you don’t need for collateral into something that will earn interest in excess of your borrowing rate.

The idea was first developed by bond king Bill Gross at PIMCO in a product called StocksPLUS. The result is an investment with the same volatility as the S&P 500, but slightly more return, creating what is known as alpha. The portability refers to the use of capital not used to fund the futures contract in any investment that is likely to earn returns in excess of the cost of capital.

Interestingly, Bernstein mentions that StocksPLUS as an institutional product had earned positive alpha over the S&P 500 in 194 of 195 rolling three year periods from July 1989 through September 2005. For the ten years ending in September 2005, the fund added 50 basis points of performance annually to the S&P 500 with basically identical volatility and nearly perfect correlation.

Since that time, however, it would appear that it has been harder for Gross to find portable alpha since 2005. A review of the data from Morningstar regarding their retail offering of the same name shows that for the three years ending July 31, 2008, the fund has trailed the S&P 500 by 148 basis points per annum and produced negative alpha. This may be a reflection of increased market efficiency.

Additionally, upon review of the mutual fund, the strategy may sound very appealing, but it has some clearly negative implications for taxable investors. According to Morningstar, the fund has had pretax return of 1.41 percent for the three years ending July 31, but the tax-adjusted return is -2.05 percent over the same time frame. One would have done much better to forgo the excess returns and pay less in taxes.

This highlights one my own critiques of the some of the high-minded strategies seem so appealing. While it is amazing what Gross and Swenson have done, it isn’t repeatable for most investors. Of course, we could use StocksPLUS in an IRA or some other deferred account, but how could we replicate Swenson’s ownership of timberlands? Despite the new stream of products, it seems highly unlikely that an individual investor could replicate many of these strategies.

In some respects, the inability to mimic these strategies may be a good thing. All of Bernstein’s examples cover those who were immensely successful at the time he went to print, and a few things have changed since then. The description of Goldman Sachs flagship hedge fund, known as Global Alpha, sounds like investment nirvana. As their chief of quantitative strategies, Bob Litterman says, “We run an alpha factory here.” That was before the fund lost ten percent in 2006 and additional 40 percent in 2007.

Of course, these changes are what keep investing interesting, and Bernstein has enjoyed a front row seat through his career initially as a successful investment manager, then as the first editor of the Journal of Portfolio Management, and finally as a top-tier consultant and critically acclaimed author. As with his other books, this is impeccably written and his direct access to all of the subjects in his book brings you much closer to the story.

Although Evolving isn’t a quite a classic like Capital Ideas, it would be unfair to expect as much since it chronicles a slow-burning evolution rather than an explosive revolution.
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Recommendation: Buy

Capital Ideas Evolving
By: Peter L. Bernstein

John & Wiley & Sons, Inc., Hoboken, New Jersey 2007
First Published: 1993

ISBN: 978-0-471-73173-3