We define the portfolio construction process as one that integrates investor risk and return objectives into the design, implementation, management and ongoing measurement of a portfolio. It is our belief that a less subjective, more quantitative, approach that focuses on outcome-based portfolio construction has benefits for both the client and the advisor.
This more quantitative approach is built on a deeper, consultative relationship between client and advisor, during which the conversation focuses on the client portfolio experience as opposed to statistical metrics. It provides a greater sense of client self-advocacy with emphasis by the advisor on “managing to the mandate, not the market." The focus on risk, and not just return, is a reconciliation of behavioral finance, or a blending of cognitive psychological theory with conventional capital market theory.
In effect, we hope to draw a distinction between modern portfolio theory (MPT) and post-modern portfolio theory (P-MPT).
Differing Portfolio Theories
A point that helps bring to light the difference between modern portfolio theory and post-modern portfolio theory is that too often the focus of an investment policy statement (IPS) has been solely based on return as opposed to the risk taken to accomplish the return. When risk is measured or discussed, its meaning relative to the clients' potential loss experience is often misunderstood or unclear.
Modern Portfolio Theory
The MPT framework assumes returns generally are normally distributed, and that capturing two of the four moments of a return distribution is sufficient in determining the risk view of a manager, asset class or portfolio. Another broad metric of risk generally used in the MPT framework is standard deviation, or volatility without a perspective toward tail risk. Volatility is the statistical measure of how much variation (noise) there is around an average value or outcome. The idea that most outcomes over time occur around a central measure, with few outlying events, is why the use of the traditional measure of standard deviation is useful, however, when investing in less efficient asset classes or within multi-asset class portfolios, it may present an incomplete picture of risk.
Further complicating this approach is the potential for mislabeling investment strategies. For example, placing a master limited partnership (MLP) or real estate (REIT) strategy into the fixed income asset class because they deliver a bond-like income stream. This subjective classification often mischaracterizes the real risk of the fixed income asset class, as well as each strategy. Both MLPs and REITs have volatility, drawdown and correlation features that are more closely tied to the broad equity market than to investment-grade fixed income markets.
From a behavioral perspective, client expectations and definitions of their originally stated objectives change over time and their application of these definitions to portfolio results and advisor performance become misplaced. In the case of investment committees, the institutional memory of the IPS is often lost with the rolling off of legacy committee members. This creates a scenario in which IPS scope creep becomes a challenge to manage.
Post-Modern Portfolio Theory
In contrast, post-modern portfolio theory suggests that a more thorough and "experience-based" approach may be utilized to communicate risk in a multi-asset class portfolio given the illiquidity that may permeate a more complex strategy. Specifically, P-MPT suggests that all moments of a return distribution (mean return, standard deviation, skewness and kurtosis) be incorporated and non-normality of return distributions be taken into consideration. Implicitly, that the risk experience is best understood via a drawdown-based measurement whereby the frequency, depth, duration and recovery time of loss is utilized — not solely a volatility metric.
This philosophy translates well when establishing an investment policy statement for a portfolio built around experience-based metrics, as the client may more easily relate to acceptable return and loss ranges during different market scenarios.
Most importantly, the same experience-based metrics utilized to construct the portfolio are also used to measure success in a simple, quantitative framework that removes human assessment bias.
Conclusion: The Importance of the IPS
Post-modern portfolio theory requires a well-written, rigorously vetted investment policy statement, in order to provide a framework for proper portfolio construction, management and measurement. In "The Importance of the Investment Policy Statement," we go into more detail about what constitutes a good investment policy statement, and how it can be better integrated into a portfolio.