Modern Portfolio Theory 2.0 By: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ Partner, Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, www.kitces.com Blogger, Nerd’s Eye View, www.kitces.com/blog Twitterer,, @MichaelKitces Twitterer @MichaelKitces,, www.twitter.com/MichaelKitces © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Markowitz establishes the roots of what we now call “Modern Portfolio Theory” – “Portfolio Selection” – Journal of Finance, Finance, Vol. 7,, No. 1,, March,, 1952 – Seeking a method to determine how to allocate a multi multi--asset diversified portfolio – Decided optimal would be defined in terms of a balance between return and risk © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Defining Return and Risk “...The concepts of 'yield' and 'risk' appear frequently in financial writings. Usually if the term 'yield' yield were replaced by 'expected expected yield' or 'expected return,' and 'risk' by 'variance of return,' little change of apparent meaning would result.” - Markowitz - In addition, correlations are required for multiple asset classes. © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 1 Revisiting MPT Creating an optimal portfolio – Optimal portfolios are evaluated in terms of both risk and return – Ideal goal is to maximize expected return for a given level of risk, risk, or to minimize risk for a given level of expected return – Created to define “optimal” portfolios, not maximum return portfolios Highest return portfolio Æ 100% of the highest returning asset under a buybuy-andand-hold scenario But Markowitz viewed diversification as required © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Defining the Efficient Frontier Subset of "most efficient" portfolios © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Finding the Efficient Frontier – Volatility based on overall portfolio volatility Comprised of volatility of individual assets, in addition to their correlations – Return based on the expected return of the underlying assets – Purpose of MPT is to take these inputs – return, volatility, and correlation – to return portfolio return and volatility, to determine optimal portfolios © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 2 Revisiting MPT Markowitz on his own methodology “The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage.” stage.” - Markowitz © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Using MPT – MPT was intended as a process to take the inputs (return, volatility, and correlation) to provide an output p p ((the optimal p allocation balancing risk and return) – It does not address what those inputs should be in the first place, or how to determine them – How should you develop the inputs to determine an appropriate portfolio? © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Markowitz on MPT inputs “To use the EE-V rule in the selection of securities we must have procedures for finding reasonable [estimates of expected return and volatility]. These procedures, I believe, should combine statistical techniques and the judgment of practical men. My feeling is that the statistical computations should be used to arrive at a tentative set of [mean and volatility]. Judgment should then be used in increasing or decreasing some of these [mean and volatility inputs] on the basis of factors or nuances not taken into account by the formal computations…” © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 3 Revisiting MPT Markowitz on MPT inputs ((con’t con’t)) “…One suggestion as to tentative [mean and volatility] is to use the observed [mean and volatility] for some period of the past. past I believe that better methods, which take into account more information, can be found.” - Markowitz © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Using MPT – Planners most commonly use historical data as inputs to MPT and portfolio design processes, despite p the fact that even the designer g of MPT stated 59 years ago that “better methods, which take into account more information, can be found.” – Our challenges with portfolio design in recent years may not be a problem with MPT, per se, but with how we use it (or in other words, the inputs we use) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Revisiting MPT Recent Problems with MPT – Returns seem to vary for an extended period of time Is distribution of returns in 2000s an unlucky streak compared to 1990s, or did something else change? – Standard deviations seem similarly unstable Distinct high volatility and low volatility periods? – Correlations aren’t stable; they all rose towards 1.0 in the financial crises Who said they were going to be stable in the first place? What would MPT look like if we assumed the inputs change over time? © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 4 MPT 2.0 The Future of MPT – MPT 2.0 – Dynamic Inputs lead to Dynamic Outcomes Source: H. Woody Brock, Strategic Economic Decisions Inc. © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Factors in Dynamic MPT Inputs Technical/ Momentum/Trend Analysis y Used to develop forward-looking expectations of MPT inputs Macroeconomic/ Market/Business Cycle Analysis Traditional Valuation Measures © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Valuation to Adjust MPT Inputs 2000 1982 Source: Crestmont Research (www.CrestmontResearch.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 5 MPT 2.0 Using Valuation to Adjust MPT Inputs 10-year annualized returns by valuation deciles, with probability of less-than-3% annualized growth Valuation Decile 10 9 8 7 6 5 4 3 2 1 High 10.04% 12.29% 16.16% 16.79% 17.68% 17.41% 16.22% 15.84% 17.88% 16.56% Low -4.83% -2.42% -0.79% 0.01% 0.83% 1.43% 3.08% 4.01% 4.12% 3.45% Average 3.72% 6.38% 6.38% 7.29% 7.03% 7.30% 8.51% 10.70% 11.94% 11.31% Prob <3% gain 36.17% 14.18% 17.61% 13.38% 14.79% 11.27% 0.00% 0.00% 0.00% 0.00% Source: The Kitces Report on Valuation (www.Kitces.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Valuation to Adjust MPT Inputs Relative Value of top-30 biggest in S&P 500 stocks vs bottom-30 smallest Source: Hussman Funds on Relative Value (www.HussmanFunds.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Valuation to Adjust MPT Inputs Relative Value… and Subsequent Relative Performance of Small vs Large Source: Hussman Funds on Relative Value (www.HussmanFunds.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 6 MPT 2.0 Using Valuation to Adjust MPT Inputs – How would your portfolio design advice change if the expected return on stocks was 3.2% vs 13.4%? – How would your portfolio design advice change if smallll caps were expected t d tto outperform t f large l by b 40%? Or underperform by 30%? – Would it change the efficient frontier? – Would it change your optimal portfolio & asset allocation? – How much would it change when compared to other investment choices (e.g., if bonds return 6%?)? © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Macroeconomics to Adjust MPT Inputs – Watching for recessions… Source: Hussman Funds on Recessions & Bear Markets (www.HussmanFunds.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Macroeconomics to Adjust MPT Inputs – Watching for recessions… Source: Hussman Funds on Recessions & Bear Markets (www.HussmanFunds.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 7 MPT 2.0 Using Macroeconomics to Adjust MPT Inputs – Rotating through the economic cycle… Health Care Contraction Telecommunications Cons. Staples Utilities Energy Financials Industrials Technology Materials Expansion Cons. Discretionary © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Macroeconomics to Adjust MPT Inputs – Economic cycle relevant for fixed income too… Credit Credit C dit Corporate Bonds High Yield Mortgages Emerging Market Debt Interest Sensitive Interest Sensitive Treasury Bonds Foreign Government Bonds Expansion Neutral Contraction © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Using Macroeconomics to Adjust MPT Inputs – Would you manage risk differently if economic signals were deteriorating instead of rising? – Would you feel more comfortable about market pullbacks llb k if economic i signals i l were rising i i iinstead t d off deteriorating? – Could you change which risky assets you own to help take advantage of expansions or defend against contractions? © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 8 MPT 2.0 Using Technical Analysis to Adjust Allocations – Simple Moving Average Analysis… © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 The Instability of MPT inputs – Applies for volatility too… Monthly S&P 500 Total Returns 50% 40% 30% 20% 10% Jan-07 Jan-04 Jan-01 Jan-98 Jan-95 Jan-92 Jan-89 Jan-86 Jan-83 Jan-80 Jan-77 Jan-74 Jan-71 Jan-68 Jan-65 Jan-62 Jan-59 Jan-56 Jan-53 Jan-50 Jan-47 Jan-44 Jan-41 Jan-38 Jan-35 Jan-32 Jan-29 Jan-26 0% -10% -20% -30% Source: The Kitces Report on Revisiting MPT (www.Kitces.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 The Instability of MPT inputs – And for correlations… Rolling 12-month Correlation (and overall correlation) S&P 500 vs. EAFE Price Returns 1.2 1 0.8 0.6 0.4 0.2 0 -0.2 -0.4 12/92 8/93 4/94 12/94 8/95 4/96 12/96 8/97 4/98 12/98 8/99 4/00 12/00 8/01 4/02 12/02 8/03 4/04 12/04 8/05 4/06 12/06 8/07 4/08 12/08 8/09 12/80 8/81 4/82 12/82 8/83 4/84 12/84 8/85 4/86 12/86 8/87 4/88 12/88 8/89 4/90 12/90 8/91 4/92 -0.6 Source: The Kitces Report on Revisiting MPT (www.Kitces.com) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 9 MPT 2.0 MPT 2.0 – Bringing It All Together – From its start, MPT was intended as a system to combine expectations about returns, volatility, and interrelationships between assets into a portfolio Developing p gp proper p inputs p was left up p to the user Even Markowitz recommended to go deeper than just long--term averages long – Developing more complex inputs and expectations for portfolio design can be accomplished based on different ways of looking at the same data – As the inputs shift dynamically over time, so too will the resulting portfolios – applies to assets & asset classes © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 The theory of the Tactical Approach – From EMH to Adaptive Market Hypothesis (AMH) Prices reflect as much information as dictated by the combination of market conditions and market participants (investors, market makers, brokers, lenders, clients, etc.). Behavior can affect markets Individuals make mistakes, but learn and adapt Competition drives adaptation and innovation Markets evolve as this process takes place – Evolving markets mean: Risk/return tradeoff will vary over time Strategies will go in and out of favor Risks will shift across markets and asset classes © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Traditional Portfolio Construction MPT Portfolio Allocation Decision (Client) Asset Allocation Active Managers in each asset class Passive Indices for each asset class © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ Investment Selection Decisions (Advisor) www.kitces.com 10 MPT 2.0 New Face of Modern Portfolio Construction MPT Portfolio Allocation Decision (Client) (Advisor) Asset Allocation Active Passive Managers in each asset class Investment Selection Decisions (Advisor) Indices for each asset class © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Portfolio Construction matters at 2 levels – Active vs. Passive management at the asset allocation level – the portfolio manager Passive, “strategic” asset allocation Active, “tactical” asset allocation – Once asset allocation approach is chosen, then active vs passive is further implemented via investment selection Passive, index index--based investment selection Active, manager manager--based investment selection © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 New Face of Modern Portfolio Construction Portfolio Manager Styles Activ ve Passive Investment Selection Style Asset Allocation Style Active Passive Manager-Based Tactical Asset Allocation Manager-Based Strategic Asset Allocation (active, active) (passive, active) Index-Based Tactical Asset Allocation Index-Based Strategic Asset Allocation (active, passive) (passive, passive) © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 11 MPT 2.0 Components of Modern Portfolio Construction Portfolio Management amongst Asset Classes Top-Down Research Client Portfolios Implementation within Desired Asset Classes Bottom-Up Selection © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 Components of Modern Portfolio Construction – Top Top--down Macroeconomic research Absolute & relative valuation measures Market/Cycle analysis External factors and exogenous events – Bottom Bottom--up How are investment holdings constructed? Manager searchsearch-and and--selection Liquidity, trading efficiencies, etc. – Implementation Timing Technical Analysis? © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com MPT 2.0 The New World of Portfolio Construction – Will require you to develop an expertise at forecasting market events and their consequences – But there is data available to help! If you’re willing to go and look for it! © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 12 MPT 2.0 New World of Modern Portfolio Construction – Forecasting – Be aware of your surroundings Investment Selection is like studying the trees But you also need to be aware off what’s happening h t’ h i to the entire woods Is there a fire you’re not aware of? Which direction is the wind blowing? – It can pay to watch out for forest fires… even if you’re not always right! © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com Questions? Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ Partner, Director of Research, Pinnacle Advisory Group Publisher, The Kitces Report, www.kitces.com Blogger, Nerd’s Eye View, www.kitces.com/blog Twitterer,, @MichaelKitces Twitterer @MichaelKitces,, www.twitter.com/MichaelKitces [email protected] © 2008 Presentation created by: Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, CWPP™ www.kitces.com 13
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