Three Key Questions for Jon Lukomnik and Jim Hawley, authors of a really important new book, “Moving Beyond Modern Portfolio Theory: Investing That Matters”. As you’ll see, this book provides a new, and necessary, reframing of finance theory that breaks down the barriers between capital markets and the real world. Lukomnik and Hawley contend that those barriers are artificial and an aberration traceable in recent decades to the influence of modern portfolio theory (MPT).
Preventable Surprises: What’s the change you wish to see?
This is not a modest book. Our intention is to redefine what investing is, how it’s done, and what it’s true north is. To achieve that, all we have to do is critique modern portfolio theory (MPT), reintegrate finance with the real world, and present a unifying theory for why investors act as they do. So, it is an ambitious effort.
Let’s start with MPT. It was a revolution. MPT’s math for diversification is phenomenal for extracting the best risk adjusted available portfolio from the market at any point in time. That said, risk, to MPT, is just volatility. MPT doesn’t care if the source of risk is the normal ups and downs of the economy, or the global financial crisis, or the pandemic, or income inequality, or lack of diversity on Boards and executive suites, or climate change.
As human beings, we certainly hope that we care for the workers who suffer in stressed economies; for the societal fraying that comes from high levels of income inequality; for the essential unfairness of gender, racial, ethic, and sexual orientation discrimination; for the lives lost and ruined in conflict areas; for our planet. But MPT is bloodless: The only thing that matters to MPT is that those risks create price volatility.
And the only tool MPT has for volatility is diversification albeit in a very sophisticated form. Unfortunately, while diversification works on idiosyncratic risks such as those caused by the successes or failures in execution by a specific company, diversification doesn’t help when the sources of risk are systemic, such as climate change, a pandemic or a financial crisis. Such real-world systemic risks create correlated price volatility, or what the markets call non-diversifiable systematic risk.
The problem is that systematic risk determines 75-94% of your return. So, MPT provides an effective tool that only affects a small portion of your risk/return profile. The result? MPT focuses us on what matters least. In our book we call this the MPT paradox.
Even worse, MPT assumes that while the systematic risk of the market affects your portfolio, your portfolio doesn’t affect the market. MPT says all that systematic risk is exogenous. The result is a self-referential framework, delinked from the real-world purposes of investing. For instance, if the market is down 10%, but your portfolio manager is only down 8%, he/she/they have 200 basis points of outperformance, and you’ve beaten the S&P. Your portfolio manager is a hero and will likely get a bonus because the returns succeeded according to MPT. But you – the actual investor — still only have 92 cents on the dollar on which to retire, buy a house, pay for college, or whatever. But because MPT believes there’s nothing you can do about the overall risk/return of the market, absolute efficiency has become subsumed to benchmark-adjusted efficiency disconnected from the non-financial real economy or an investor’s real-world needs and desires.
Moreover, the assumption of exogeneity of systematic risk is just plain wrong. Think about things like “risk on/risk off” markets or index effects. Those are people’s portfolios affecting the overall market.
Preventable Surprises: What’s your theory of change?
If investors can affect systematic risk unintentionally mostly on the downside increasing and/or transforming risk, then they can do so intentionally, with the goal of improving the overall risk/return profile of the market. In other words, investors can try to mitigate the causes of risk that affect the 75%-94% of return diversification can’t touch.
And, in fact that’s exactly what’s happened. Practice has led theory. Today, investors attempt to mitigate systemic risks to the real world’s environmental, social and financial systems, which, in turn, create systematic risk (and its opposite, opportunity) in the capital markets.
This is a major change and differs both from 1) MPT, which says take the markets as they are and do your best to extract the best available optimized risk/return portfolio from it, and 2) traditional corporate governance activities, which focuses on individual companies. Investors are beginning to understand that they can actually affect risk and return more by engaging the real world than by moving electronic blips on a trading screen.
We call this beta activism, because the idea is to improve the overall market (or beta) by addressing systemic risks. We have counted more than 100 such efforts around the world. Among the more prominent are a myriad of climate change and gender diversity campaigns. But there are also muscular efforts that focus on an industry or sector, such as combatting anti-microbial resistance in both the food chain and pharmaceutical manufacturing sectors, and the investor coalition seeking to improve mining safety.
This type of beta activism is incredibly powerful. Financially, we estimate it has added $2-5 trillion to global wealth by reducing the market’s perception of potential systematic risk. But more importantly, it reunites finance with the environmental, social and financial systems where value is created or destroyed in the real economy. Economists from Adam Smith’s time forward have understood those feedback loops. For example, Smith wrote in The Theory of Moral Sentiments “As society cannot subsist unless the laws of justice are tolerably observed, as no social intercourse can take place among men who do not generally abstain from injuring one another…” And again he argued: “Concern for our own happiness recommends to us the virtue of prudence: concern for that of other people, the virtues of justice and beneficence”. In other words, there is an interplay between self-interest and benevolence. In the late 20th century, Nobel Prize winner Oliver Williamson suggested that “If changes in property rights, contract laws, norms, customs, and the like induce changes in the comparative [transactions] costs of governance, then a re-configuration of economic organization is usually implied”. Our contention that MPT is artificial and nearly singular among important financial-economic theories in viewing investing as disjoint from the causes of value creation can be seen as innovative, even radical, but it reflects classical and more recent economics’ concern with the feedback loops that affect and evolve economic decision-making.
Preventable Surprises: Who are the agents that can make your theory of change a reality?
Investors, corporate officials and board members, regulators, and legislators. As we said, practice has led theory. Investors have begun to focus not just on how the world affects their portfolio companies – the traditional outside in version of materiality – but also on how their companies affect the world,A even when just dealing with one company. For example a shareholder initiative at Yum Brands, the parent company of Taco Bell, KFC and Pizza Hut resulted in the company agreeing to examine the systemic impact of its use of antibiotics in its food supply chain.
One reason practice has led theory is that generations of students have been taught theories like the efficient market hypothesis and random walk theory. In many ways, they combine to create the perfect myth: Easy to understand, powerful in their explanatory power, and wrong. So, we would also like to single out the academic faculties around the world.