Modern Portfolio Theory: The Efficient Frontier

Over time, as investors approach and enter into retirement, fixed income is often viewed as the stable portion of one's investment portfolio. Today though, central banks around the globe have implemented monetary policies that have pushed interest rates to near record lows. Does this artificial stimulus then make fixed income a not so safe investment asset class?

From a prudent point of view, some factors investment advisors inquire about of their clients is an appropriate investment objective, time horizon for the investment funds and risk tolerance. Much thought should certainly go into these decisions so an appropriate asset allocation and investment strategy can be developed. The ultimate asset allocation goal often leads advisors to talk about risk adjusted returns and possibly modern portfolio theory (MPT). The MPT discussion likely will not occur in those exacts words, but some form of generating returns by assuming less risk will be a general theme of the discussion. The advisor's goal in the discussion is to develop a portfolio that lies on the so-called efficient frontier.

We have written a number posts on the limitations of MPT, (here, here and here) and increasingly believe the artificial distortions unfolding in the fixed income markets could provide further risk to investors that rely strictly on MPT. In a recent introductory paper on Modern Portfolio Theory and authored by Donald R. Chambers, he states,

"...In the wake of difficult times such as the financial crisis that began in 2007, the concept of market efficiency is sometimes criticized. However, while no market is perfectly efficient, the evidence suggests that behaving as if markets were highly efficient provides investors with a solid approach (emphasis added)."

Simply having a "solid approach" does not necessarily lead to higher returns though. Many managed futures funds are constructed using a solid approach. Morningstar reports the average one year return for the managed futures category is a negative 4.73% as of May 24, 2013. The best returning fund over one year reported a return of 9.22%. This compares to the return for the S&P 500 Index of nearly 28%. As a category, the managed futures funds achieved the return with half the risk of the market or S&P 500 Index. For investors then, do you prefer this 9.22% return or the 28% return knowing the market portfolio assumed 50% more risk. Hindsight is a wonderful perspective.

A recent interview by Citadel strategist, Maarten Ackerman, contains a pertinent discussion on MPT and the efficient frontier. The risk for bond investors in this low interest rate environment is evident in the discussion with Ackerman. Ackermann continues to have confidence in MPT; however, discusses the risk inherent in bonds in this low interest rate environment. One weakness in MPT is the use of past returns and risk. Using potential returns and potential risks certainly is a preferred approach. He mentions an alternative to bonds is higher yielding high quality dividend paying stocks. In my view, stocks are not bonds. This chasing of yield has pushed the valuations of the defensive stocks to potentially stretched levels as noted in several earlier posts.

For investors, keep in mind that during financial market stress, the correlation of most assets classes moves to near 1.0, i.e., they all go down together. Additionally, these are unique times with central banks flooding economies with liquidity. One technical investor commentary I follow is Charles Kirk of The Kirk Report. He has noted on many recent occasions that the "technical" trading setups are not unfolding as one would have expected in the past. The artificial stimulus activity from central banks could be playing a role in this. One quote scrolling through our Horan website is from Sir John Templeton, "The four most dangerous words in investing are: 'this time it's different.'"

Maybe it is different this time and another event transpires that highlights the weakness in Modern Portfolio Theory.