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Multi-management View: Fine in theory but does MPT really work?

Portfolio diversification is becoming more difficult. Historically, one would have balanced a holding of UK shares with some in the US, Europe and so on, the theory being that when UK shares slumped, the loss would be offset by a gain in the overseas element of the portfolio.

However, globalisation and the internet appear to have diminished the importance of domestic factors and increased the correlation of world stockmarkets.

Investors must instead use all the available asset classes at their disposal. It is not by accident that the two sectors where equity exposure is limited – balanced (maximum 85 per cent) and cautious (maximum 60 per cent) – have outperformed the active sector (no limit) over the last dozen years or so.

But knowing which assets to hold and when to buy or sell them is tricky. There are a few different opinions on the matter. One that looks mathematically sound and that earned its creator, Markowitz, a Nobel prize in 1990, is modern portfolio theory. This is the philosophical opposite of traditional asset allocation. It is the creation of an economist looking at the market as a whole, rather than asset allocators looking for what makes each investment opportunity unique. Investments are described statistically, in terms of their expected long-term return and short-term volatility. Volatility is equated with risk, measuring how much worse than average an investment’s bad years are likely to be. The goal is to identify an acceptable level of risk tolerance and then find a portfolio with the maximum expected return for that level of risk.

MPT theory has now reappeared in the guise of online stochastic planning tools. But while it appears fine on paper, without a significantly long time horizon, it can have disastrous effects. Around the time MPT last became popular in the early 1990s, practitioners in this science demonstrated that by adding emerging market funds to a portfolio, potential returns could be increased and risk could be reduced, due to low covariance with the rest of the world. Those who took this advice would have suffered throughout the 1990s and only in the last few years has this region added value.

The lesson is not that MPT does not work but that market conditions change and static portfolios will not always work. You do not want to have a static approach in a dynamic world. This is where the additional services of an asset allocator come in. For IFAs and clients who do not have the time, skill, resources or experience to constantly evaluate changing market dynamics, this extra level of management is invaluable.


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