HPT Vs MPT

Modern Portfolio Theory was introduced to the investment world in the early 1950s and through its evolution has fundamentally changed the way that investments are managed and portfolios constructed. Though there are much more complex and detailed extrapolations of the concept, at the core of modern portfolio theory is the idea of the mean variance portfolio. The thought behind the idea is that if you hold a portfolio’s mean return constant you can minimize its variance, or inversely if you hold a portfolio’s variance constant you can maximize its expected return. In other words, an investor or portfolio manager first chooses a level of return (or variance) for their portfolio, accepts the corresponding variance (or return) according to the efficient frontier and then goes about the business of constructing an optimum portfolio that would produce those results.

When constructing a portfolio, assets are not chosen simply based on their expected return and variance characteristics. Instead, other important factors are taken into consideration, such as correlation coefficients and/or covariance of assets in determining the level of return variation built into the portfolio. Modern Portfolio Theory also uses Capital Asset Pricing Models in determining expected returns for assets when optimizing their portfolios. With this model, assets are correlated to indexes that are supposed to represent market expectations for return, as well as introduced to other unique variables to determine their individual expected returns. Past this point portfolio managers carry these concepts forward into more complex and detailed operations but the basic idea is the same.

Now, for my opinion; first of all, Modern Portfolio Theory has one key assumption that after much academic deliberation has resulted in a seemingly unsatisfactory conclusion. Mean variance portfolio theory was developed to construct an optimum portfolio when focused on return distributions in a single period. Therefore, all correlations or covariance, as well as expected return and variance calculated are for a single period. The assumption is that asset returns and their derived calculations are independent of each other between periods. Intuitively, I just don’t see how last period’s returns don’t affect this period’s returns, and so on, but that’s just me.

There’s no big picture view for the portfolio, and so no chance of preparing for any changes in underlying relationships. Mean variance theory calculations are supposed represent 2-3 standard deviations (95% – 99.7%) of all possible observable market outcomes. And they work just fine when observed market data falls within the 2-3 sigma range, but when we witness for instance a 6 or 7 sigma event like the 2008-09 financial crisis, mean variance calculations just can’t accurately predict return distributions. Within the spectrum of all possible observable market outcomes, 2-3 standard deviations can capture and model events relatively accurately. But when we start looking at outcomes that have a less than 0.3% chance of occurring at any given time they begin to become much harder to model and adjust for. At the point where you get black swan events as far out as 6 or 7 standard deviations, the probability of occurrence is very low (but not zero).

I think this is exactly what goes wrong when we see a protracted market-wide correction or even just a consolidation period turn into a market crash. Some exogenous factor disrupts the underlying correlations and associational assumptions that Modern Portfolio Theory relies so heavily upon, and since the success of the portfolio approach depends on these relationships, when they breakdown portfolios breakdown. Simply put, if variation can’t be accurately estimated then it can’t be accurately hedged and investors ‘freak’ out.

An emerging alternative is Hybrid Portfolio Theory. Actually, it’s not an alternative in the complete sense. Hybrid Portfolio Theory is based on the concept of positive asymmetric income, which if you are familiar with the cashflow pattern of a call option, you already understand the concept of positive asymmetric income. For those that aren’t; it’s simply limiting the downside while partaking in the upside of the security’s cashflow in the presence of volatility. Now the reason that I said it’s not an alternative in the complete sense, is because to accomplish such a cashflow structure within a portfolio requires a minimum of two sub-portfolios (or a portfolio of all call options). And even with an all call option portfolio, in a worst case scenario where the correlations used to structure the portfolio break down you would watch the portfolio mature to a value of zero.

In its simplest form, two sub-portfolios with opposing objectives can be used to structure the positive asymmetric income of Modern Portfolio Theory. For example, the first can be directed towards capital preservation, liquidity, and current income; call it sub-portfolio A. And the second can be directed towards absolute returns through leveraged or multiple beta investments; call it sub-portfolio B. The two combined gives you the [master] portfolio. Sub-portfolio B carries above average risk and is meant to benefit from upside volatility, which boosts the overall return on the [master] portfolio combined with the current income from sub-portfolio A. In the case of downside volatility, sub-portfolio B suffers losses, but sub-portfolio A (if constructed properly) should still be earning current income, which puts an effective floor on the losses of the [master] portfolio. The qualifier of course, is that the sub-portfolios be constructed properly, and the only accepted way of constructing a ‘proper’ portfolio is with the use of Modern Portfolio Theory. Therefore, the only added benefit that I personally think Hybrid Portfolio Theory brings to portfolio management is that it gives the manager a second (or however many sub-portfolios they utilize) chance to get it wrong before loosing all of their invested capital.

Keishaun Mark of Foresight Investment Fund is an exclusive Contributor to Bonds Mutual