Presentation Transcript

1. Modern Portfolio Theory: Its unintended contribution to financial crisisProfessor Jim HawleySaint Mary’s College of CaliforniaDirector, Elfenworks Center for the Study of Fiduciary CapitalismSRI in the Rockies-- November 2010San Antonio, Texaswww.fidcap.org Hawley-www.fidcap.org
2. Brief Roadmap Modern portfolio theory (MPT), the power of ideas and the financial crisis MPT assumptions Correlations and risk Tipping points and feedback loops Benchmarking Passive and active portfolios Transaction costs and the investment chain Hawley-www.fidcap.org
3. Power of Ideas “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” John Maynard Keynes “[Academic] financial economics…did more than analyze markets; it altered them.” Donald MacKenzie Modern Portfolio theory (MPT) underlies most financial theory and innovations of the last 50 years. Hawley-www.fidcap.org
4. 4 MPT assumptions A rapid review of four assumptions—all false in the real world and/or in theory: 1- The Efficient Market Hypothesis (EMH)—the theory was a cart before the horse development Method was developed before the empirical evidence. Louis Bachelier, early 20th century: Stock prices follow a stochastic process—normal bell distributions; finite variance; returns are independent of each other Three versions: strong, semi strong and weak. Semi strong version dominates But: assumes independent decision making by investors. Poincaré suggested in markets this assumption is false: investors watch other other and tend to herd >>constant feed back loops. Evidence suggests that returns are not independent, distributions are not Gaussian/bell shaped; there is possible infinite variance (fractal like). Hawley-www.fidcap.org
5. MPT assumptions 2- The Rational Investor (or even the semi- rational investor)—critical assumption for EMH and thus for MPT Information is symmetric; immediately available; and ‘knowable’ (that is, understood, digested and becomes ‘knowledge) and is immediately acted on. What if it occurs in ‘clumps’? Or is ‘digested’ in a non-linear way? Work in behavioral finance and common observations contradict assumption about rationality, information and knowledge. But ‘inefficient’ markets (with irrational investors) can become ‘efficient through arbitrage However: Little evidence arbitrage clears markets which would thereby rapidly revert them to ‘efficient’. 3- Indexes (e.g. S&P 500) can be used as proxy for market portfolio 4- Investors are price takers and cannot affect security prices by placing orders. This ignores the massive growth of institutional investors who as a group can move markets. Hawley-www.fidcap.org
6. Assumptions Therefore: rational investor (#2) plus efficient markets (#1) = Random Walk: probability distribution is about normal (returns’ distribution has finite mean and variance). This is the basis for risk measurements Additionally a ‘proof’ that: Options can be priced (and therefore serve as a hedge against future price changes) Hawley-www.fidcap.org
7. Where’s the baby? Is there a baby in the MPT bathwater? (What is useful about MPT?) Yes: Diversification and risk are inherently related: there is an efficient frontier for portfolio construction. BUT limiting parameters: At one or few points over time, and, If MPT is not too widely adopted Otherwise risk metrics (beta) are not accurate. This is especially so in ‘stressed’ and bubble markets as they understate market and liquidity risk. Problem of accurate risk measurement MPT suggests two types of risk: Portfolio-idiosyncratic risk—can be hedged and diversified away so correlations are at or approaching 0. Systemic—cannot be hedged Assumption: portfolio diversification/hedging does not affect systemic risk (exogenous). They are independent. Problem here is with beta (mean variance) as (a or the) risk metric Also misses difference between risk and uncertainty (Knight) Assumes portfolio risk can be entirely quantified. Hawley-www.fidcap.org
8. Correlations, risk and the ‘real world’ "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that's not true of a portfolio of correlated risks.” Harry Markowitz on the financial crisis (2009) “Models fail because they fail to incorporate the inter-relationships that exist in the real world.” Myron Sholes (2005) This is what the Markowitz quote misses: the real institutional context of MPT’s essential insight about risk, return and correlation Financial engineers didn’t know, and/or couldn’t know and/or were incentivized to not to know or care Markowitz seems to ignore the real institutional reality. Example of how MPT ignores, at its peril, massive conflicts of interest both within firms (internal governance), and in the investment chain (external governance) issues Initially uncorrelated risks can and do become correlated over time by the very act of portfolio diversification en masse and by widespread adoption of MPT’s and risk management techniques. Hawley-www.fidcap.org
9. Tipping points and feedback loops Tipping points and feedback loops Underlying MPT problem: Fallacy of composition=feedback loops MPT does not account for its own widespread adoption When a few adopt, (e.g., a hedging strategy, may effectively hedge and may also increase ‘alpha’) but there is a tipping point when many adopt them The paradox: increases risk through the very acts of diversification and hedging as ‘risk management’. E.g. Justin Fox—1987: widespread adoption of ‘portfolio insurance’ (derivatives) increased systemic risk. E.g. widespread use of CAP-M in 1980’s undermined its prior predictive power. Hawley-www.fidcap.org
10. Benchmarking What is driving this, in large part? Benchmarking relative performance on basis of and/or in relation to indexes (e.g. S&P 500). leads to herding Typical investment managers avoid above all else failing as an individual, being unconventional; better the group should fail so the individual performs relatively well in relation to the group. This dynamic unintentionally buttressed by fiduciary and fiduciary- like law—’the prudent person’ or ‘prudent investor standards’. The Lemming Standard. Additionally: short term holding combined with (short term, quarterly) benchmarking amplifies herding effects Hawley-www.fidcap.org
11. Indexed portfolios and tipping points Many indexers in market, using mostly similar strategies and risk management techniques, affect the market as whole. E.g. price taker role changes into a sort of ‘super portfolio’ that can move markets The indexation paradox, growth of indexation (with its compelling logic) has led to undermining the efficacy of the risk metrics essential to calculating risk adjusted returns (the efficiency frontier): Makes markets less efficient by encouraging lockstep investing (benchmarking) This has increased search for alpha to hedge portfolios and ‘beat’ markets/benchmarks (a zero sum game) Thereby increased ‘speculation’ based on complex securitization, including increasing leverage. Thus: over time portfolio risk management (through diversification/hedging, etc) contributed to systemic risk, in turn negating over time the desired benefits claimed by MPT. Why? Portfolio risk managers search for non correlated risky assets to boost returns. But as more and more search and hold risky complex assets which had been not previously been correlated, they become: 1- more correlated 2-previously higher returns revert to the mean. Thus, risk increases through increased correlation even as returns decline. This sets off new round of ‘risk management’, creating, again, demand for risk products, and here demand creates its own supply. Hawley-www.fidcap.org
12. Therefore… MPT and the innovations following in its wake became their own worst enemy. Mandelbrot: “…stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it.” Hawley-www.fidcap.org
13. Active portfolios: do they hug indexes? These trends are largely true for non index portfolios as well (‘stock pickers’) as they mostly benchmark against similar indexes and tend to pick relative to that index—they hug the indexes. Active portfolios (and indirect active, e.g. pension fund investing in those who are active traders, hedge funds, banks/shadow banks) Logic of relative benchmarking underpins ‘alpha’ seeking Lake Woebegone phenomena Increasingly in alternative asset classes, which is often just seeking beta in alternative assets; not ‘real’ alpha Real alpha by definition is a zero sum game. But this has undermined the purpose of diversification (risk adjusted returns) itself as it has been leveraged and contributes to systemic risk. Hawley-www.fidcap.org
14. Transaction costs and the investment chain These trends have: Increased transaction costs Increased investment chain conflicts of interests (rent seeking behavior) because ofan agency problem based on asymmetric information. Money managers, investment consultants, advisers E.g. ‘Sophisticated investors’ (a 1940 Investment Act category) have proved not sophisticated in the financial crisis in their risk assessments. Very important as these institutions are major suppliers of investment funds to all asset markets. Hawley-www.fidcap.org
15. And there’s more….of course More to the financial and economic crisis story, including: Deregulation and lobbying Growth of computing power ‘Financialization’, shadow banking growth, and globalization Corruption and fraud Corporate governance failures Perverse compensation schemes Failure to monitor for risk by large institutional investors Specifics of real estate bubbles in U.S., Spain, Ireland, U.K., etc. and of various bank failures (e.g. Northern Rock) And more Hawley-www.fidcap.org
16. But those are for another time….. The key point: MPT, and its foundational assumptions, has been one important contributor to financial crisis. It is essential to move beyond MPT, EMH and the ‘rational’ investor. Among other things investments should: Focus more on absolute not relative returns Focus for the long term For universal owners, focus on economy-wide growth minimizing externalities. Hawley-www.fidcap.org
17. Modern Portfolio Theory: Its unintended contribution to financial crisisProfessor Jim HawleySaint Mary’s College of CaliforniaDirector, Elfenworks Center for the Study of Fiduciary CapitalismSRI in the Rockies-- November 2010San Antonio, Texaswww.fidcap.org Hawley-www.fidcap.org