Understanding Modern Portfolio Construction
[drizzle]Over the last 75 years there have been great strides in modern finance, portfolio theory and asset allocation strategies. Despite this progress the process of portfolio construction remains grounded in many theoretical concepts that can result in inappropriate or unrealistic frameworks. In this paper we provide an overview of the development of these ideas, construct a general foundation for understanding portfolio construction and produce a framework for simplifying, systematizing and streamlining the process in an attempt to establish a realistic and suitable process for portfolio construction.
Understanding Modern Portfolio Construction – Introduction
This paper introduces the basic historical background upon which modern finance and asset allocation is implemented, provides a general understanding for portfolio construction and offers some ideas for improving the methodology for Modern Portfolio Construction (MPC).
This paper is organized in three sections. Section One discusses the historical background of Modern Portfolio Theory (MPT) and how its influence resulted in many of the ideas that dominate portfolio modeling today. Section Two discusses the general building blocks of portfolio construction and how one should begin to approach the process of asset allocation. Section Three builds on many of the positive developments in MPT and modern finance and helps develop a realistic and practical framework for Modern Portfolio Construction. We develop a general framework for understanding portfolio construction and conclude that a low fee, tax efficient Countercyclical Indexing™ strategy results in a rational and suitable approach to portfolio construction.
A Brief Review of Modern Portfolio Theory & Modern Finance 1952 marked the birth of Modern Portfolio Theory when Harry Markowitz (Markowitz, 1952) developed his methodology of mean-variance optimization (MVO).i Markowitz, widely recognized as the father of modern finance, established an approach by which asset allocators could quantify how best to efficiently allocate assets by measuring the degree of risk one takes in achieving a certain type of return. Arguably, the most important development in the MPT framework (most notably Markowitz 1959) was the development of a cohesive language and process for portfolio construction. Several key concepts were derived from MPT including:
- The importance of understanding covariance and diversification as well as the tendency for uncorrelated assets to create superior risk adjusted returns when combined in a portfolio by reducing the total portfolio variance.
- The utilization of portfolio “risk” as standard deviation which helped develop mathematical models for understanding risk in a portfolio.
- The development of the data driven concept of the Efficient Frontier which allows asset allocators to create a systematic method for portfolio selection and risk management.
MPT was a sufficient starting point for asset allocation models, but only laid the theoretical foundation. The two most important developments in Modern Finance that built on MPT included the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis which is often commingled with the Fama French Factor Models.
The Capital Asset Pricing Model (CAPM) was developed by Jack Treynor, William Sharpe, John Lintner and Jan Mossin in the 1960s.ii CAPM formalized a framework by which asset allocators could understand the relationship between asset returns and risk according to mean variance analysis. This mathematical model distinguished between two specific types of market risk: 1) systematic risk (i.e., diversifiable risk), and; 2) non-systematic risk (i.e., undiversifiable risk). This asset pricing model helped asset allocators distinguish between the returns generated from “the market” (i.e., beta), and any excess return (i.e., alpha). According to CAPM there are two ways to generate returns: 1) take the market return and; 2) beat the market. The development of MPT and CAPM popularized the idea of using a market cap weighted indexing portfolio as these methods emphasized the importance of a diversified market portfolio. This era coincided with the significant growth in both beta replicators (index funds) and excess return chasers (most active mutual funds).
In 1976 Stephen Ross expanded on CAPM when he introduced Arbitrage Pricing Theory (APT), which identified multiple sources of systematic risk.iii The crash of 1987 and the East Asian Currency Crisis increased focus on tail risk in portfolios and other sources of market risk while diminishing the credibility of ideas like the Efficient Market Hypothesis. These events resulted in greater research into market anomalies and challenged the overly simplistic single factor approach like CAPM. These tail risk events led to a widespread focus on Value at Risk models that use statistical properties to calculate the worst case scenarios across portfolios. This increased the focus on hedging strategies as well as the use of portfolio insurance such as options and futures contracts. This era coincided with the significant growth in hedging strategies and hedge funds specifically.
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