The world and the stock market were in a very different situation when economist Harry Markowitz won the Nobel Prize for his modern portfolio theory almost 60 years ago. His pioneering work, which quickly became canon, posits that investors could build an efficient, diversified and risk-responsive portfolio by considering how the risk and return profile of each investment affects the portfolio as a whole.
Decades later, the risks are very different, and a new article questions the limits of modern portfolio theory (MPT). Jon Lukomnik heads Sinclair Capital, a consulting firm specializing in corporate governance. He was previously an investment advisor for the New York City Pension Fund and has been repeatedly named one of the 100 Most Influential People in Corporate Governance in the United States by the National Association of Corporate Directors. Lukomnik and James P. Hawley, Senior ESG Advisor at Factset, recently published Moving Beyond Modern Portfolio Theory, which argues that MPT, with its narrow focus on diversification, subjects investors to systemic risk. We met with Lukomnik to discuss the issues with MPT. Read the following edited excerpts to learn more.
Barron’s: Where are we with modern portfolio theory?
Lukomnik: Everyone sees MPT as diversification, but we go back to Miguel de Cervantes in 1690 writing in Don Quixote not to put all your eggs in one basket. Harry Markowitz gave us the math and the rationale for diversification. A host of enabling theories have sprung up around MPT that allow mathematics to work without taking into account the complexities of the real world. The efficient market hypothesis, in its strong version, says that all knowledge is known and rationally exploited by the market, and even in its weak version, that the market will tend towards knowledge-based rationality. The “random walk” theory says you can’t predict things the next toss. All of them are intuitive, logical and autonomous, but they are wrong. Daniel Kahneman won a Nobel Prize for proving that we are not rational: in fact, we are opposed to losses. If the market worked at random, we wouldn’t have contagion. And you can’t avoid losses if you don’t know what price you paid for a stock. Momentum strategies depend on the trajectory. MPT is not the alpha and the omega.
Your book provides yet another review.
MPT claims that diversification works on idiosyncratic risk: company A outperforms company B. But it does not work on systemic risk, which is a risk to a real system, such as climate change, or systematic risk, which is an undiversifiable risk in capital markets, often caused by systemic risk in the real world.
So MPT provides us with a tool to deal with what matters least. An obvious example was the global financial crisis, where people tried to diversify poorly underwritten loans but did not face the real problem that underwriting standards had declined. Eventually the risk metastasizes, and we have a global financial crisis. So what we’re saying is you can’t diversify systematic risk. If you go back to the real world and try to deal with climate change or the growth of antimicrobial resistant superbugs, you can mitigate the real risks to environmental, social, and financial systems that result in systematic, undiversifiable risk to the markets. capital. Our book is a finance book that ends up looking at why we should care about climate change or gender diversity or any of those issues from a risk and return perspective. You can create huge value by lowering the real-world risk that affects the capital markets as the capital markets revalue, and you can build huge wealth. And then you can apply MPT to a better performing capital market.
Talk about what you call beta activism.
People are aware of traditional activism, when Trian Fund Management or Bill Ackman take on a poorly performing business and try to turn it around. Beta activism tries to manage systematic risk in the real world. It uses stewardship, proxy voting, organization, and politics to try to deal with real-world systemic risks that people fear will spill over into capital markets. So what various [investors] do about climate change – it’s not about targeting a sole proprietorship, it’s beta activism. Billions of dollars in assets under management have signed the Principles for Responsible Investment. Climate Action 100 is home to the world’s largest climate change investors: these investors have been very active in pushing governments to adopt climate change mitigation strategies. When we started the book, we thought we were going to detail all the beta activist campaigns. The number has exploded. For example, Domini Impact Investments works on deforestation. There was a very successful mine safety intervention led by the AP funds of Sweden after the Vale mine collapse which reduced their market capitalization by $ 19 billion.
What should the asset management industry do?
Two things. Pay attention to the health of the market in general, not just how your portfolio is performing relative to the market. Second, professionalize things other than trading and portfolio building. I’m going to give you an example. New York City has something called Proxy Access, a way to appoint directors for public companies in the United States. Three economists, including an economist from the Securities and Exchange Commission, discovered that [this system] added 53 basis points of excess return per year. We glorify traders and portfolio managers. Yet we don’t pay the people responsible for stewardship, nor do we pay attention to them.
Environmental, social and governance investment has become a force in financial markets. Why is this so important?
There are different strains of ESG: socially responsible investing, ESG integration, sustainability, impact investing. Directionally, and in terms of strength and amplitude, it is this massive, somewhat unruly force rolling in one direction. Over the past three to five years, it has been recognized that value and risk are created in the real world and are reflected in the capital markets. If I were a private investor or a small business owner, I would be keen to create value and minimize risk in dealing with these real world issues. Why, as an investor in the public market, have we arbitrarily sealed them and somehow said that these are not legitimate investments? From a societal perspective, bringing capital markets together with the real world, with intentionality, is appealing.
What do you advise individual investors and advisers who want to protect themselves against systemic risk?
Pay attention to what your asset manager is doing. Many publish reports on sustainability, impact or stewardship. How real are they? What issues do you care about? It’s not simple. Sometimes environmental or social issues collide. Carbon tax without any mitigation is great for the environment, but it’s really bad for income inequality. And communicate. I have been a member of a mutual fund board of directors for 15 years. Do you know how many letters I received from end investors during this period? Zero. Let your asset manager know if you don’t agree with something he’s doing. And if you are an advisor, be aware of the problem. If you are an individual, ask your advisor what they do on ESG issues. What strain of ESG is the advisor following? How involved are they?
Finally, what’s in your personal portfolio?
In fact, I choose individual actions myself. I own a lot of municipal bonds. People forget about them, but they have infrastructure and green aspects. I own
Invesco Water Resources ETF
(HSIC), among others.
Write to Leslie P. Norton at [email protected]