Tuesday, April 10, 2007
Only the frontier is efficient?
I just got off the phone with the trust advisors running a trust that I'm an eventual beneficiary of. It's not a very large trust, but it's important, as my mother relies on it for much of her income. The advisers had just put together a super duper plan to manage the trust based on the concepts of the "efficient frontier". In case you don't know, the "efficient frontier" is a portfolio management concept that sprang from the efficient market theory. The idea is to allocate a portfolio across groups of uncorrelated investments to reduce volatility as much as possible without giving up much in the way of long term returns.
To do this in the trust, they overweighted large cap equities 3-1 over small caps and 2.5-1 over mid caps. They dabbled in international real estate as well as domestic, and even threw in a small (4%) proportion of commodities. The entire portfolio is is adorned with a big fat Sharpe ratio, telling you proudly how well it plans to reduce your volatility.
When I asked why the overweight in large caps, they rattled off about computer models, macro economic predictions, and recent small cap out performance. I asked why commodities then, since they are on a two year period of out performance, have no intrinsic value and are just a playground for speculators. Inflation they mumbled. Lastly I asked why almost all of the equity funds they recommended are actively managed. They responded that their bank does intensive work to vet mutual fund managers and choose only those who will beat the market.
So this is what it comes down to. The EMT, Modern Portfolio Theory and the efficient frontier have permeated large money management organizations. They've adopted the parts they like (putting together complex portfolio allocations) and ignored the parts they don't like (that you can't time the market, predict the future, and you can't pick out performing mutual funds), and cover it with a dollop of MPT jargon to dazzle the client.
I wanted to ask them how they could throw out the foundation of Modern Portfolio Theory and still use the remnants left literally hanging in space without support, but it would have been unfair. They weren't bad guys, just salesmen, selling what their company had given them to sell. I just smiled over the phone, thanked them for their time and asked again to increase the yield as much as they could. Mother isn't getting any younger.
Posted by Randy at 8:02 AM