New York (HedgeCo.net) – Modern Portfolio Theory (MPT) has been a successful investment theory over the years. At the heart of MPT is the idea of diversification and the fact that risk can be reduced through a well-diversified portfolio with the goal of maximizing returns while minimalizing risks.
The problem with MPT is that it was introduced by Harry Markowitz in a 1952 article and a 1959 book. We are talking about a theory that is over 50 years old and is still being applied successfully today, so how can there be a problem or why does it need to be modernized?
MPT was developed before many modern investment vehicles were introduced or widely available. Mutual funds were in their infancy stage in the 1950s and the first hedge fund had just been introduced in 1949. It wasn’t until 1993 that the first ETF was introduced and the idea of liquid alternatives didn’t become widely accepted until the 21st century. Alternative investing and hedge fund strategies weren’t part of the original thought process when MPT was developed. Mainly because alternative strategies were too new and had too high of a minimum investment for them to be included in MPT.
Now we have automated investment programs like Betterment and Wealthfront that use modern technology to apply Modern Portfolio Theory for the masses and these sites do a great job of aiding investors in diversifying their portfolios and helping them attempt to meet their investment goals. However, these sites are still using the models that were developed in the 1950’s and build portfolios using strategic asset allocation. They almost exclusively use stock and bond ETFs to construct their portfolios and alternative investments are excluded. They also don’t take tactical asset allocation in to account.
We believe for a true “Modern” Portfolio Theory to be applied, alternative investment strategies have to be included in the asset allocation models. By including alternatives, the more modern MPT will include a certain amount of tactical asset allocation and it will help reduce risk even further.
To give you an idea of how it would have worked recently, we constructed three portfolios. Portfolio A has 100% of its money allocated to the Spyders (SPY), Portfolio B has 50% allocated to the SPY and 50% allocated to the iShares 20+ year Treasury Bond ETF (TLT), and Portfolio C has a third allocated to the SPY, a third allocated to the TLT and one third allocated evenly to the HedgeCoVest Long/Short Composite Models. We compared the portfolios for the third quarter thru August 25 while the market has been extremely volatile and stocks have moved down and we compared the portfolios on a year to date basis. In both instances, Portfolio C performed better than Portfolio A or Portfolio B.
On the quarter to date basis, Portfolio C lost 0.38% while Portfolio B lost 1.37% and Portfolio A lost 9.03%.
|Portfolio||Balance||Equity Allocation||Bond Allocation||Alternative Allocation||SPY Q3 Return thru 8/25/15||TLT Q3 Return Thru 8/25/15||HCV Long/Short Composites Thru 8/25/15||Portfolio Value|
Looking at the YTD numbers, Portfolio A lost 8.04%, Portfolio B lost 3.93% and Portfolio C lost 0.79%.
|Portfolio||Balance||Equity Allocation||Bond Allocation||Alternative Allocation||SPY YTD Return thru 8/25/15||TLT YTD Return Thru 8/25/15||HCV Long/Short Composites YTD Thru 8/25/15||Portfolio Value|
Granted we are looking at data for approximately eight months and a little less than two months in these instances, and the S&P has been down in both time periods, but in both instances, adding alternative strategies like the ones used in the HedgeCoVest Composite Long/Short models, created a smaller loss than the portfolios that had just an equity allocation or just an equity and bond allocation.
This is why we continue to stress how much alternative strategies can help investors, especially during a time of increased volatility. This is also why we believe Modern Portfolio Theory needs to be modernized in order to include alternative investments.