Modern portfolios cry out for a touch of spice

The investment industry has been bruised since the global financial crisis of 2007-2008, the worst since the Great Depression of the 1930s. Eight years later, wealth and asset managers are beginning to regain the confidence which was battered out of them by banks, markets and regulators.

The discussion of what post-crisis wealth managers and fund houses should actually look like, behave like, how they should treat clients and what sort of framework they should build for successful asset allocation is just beginning to gain momentum.

Remarkably, most private banks still cling to ‘modern portfolio theory’ (MPT), a concept linking risk and return, introduced by Harry Markowitz in 1952, which eventually won him a Nobel Memorial Prize in Economic Sciences in 1990. 

This school of thought assumes there is a scientific method to diversifying an optimised portfolio of assets and is closely linked with ideas around ‘Rational Expectations’ that emerged from the University of Chicago.

Many of the cross-border wealth managers that enter PWM’s Global Private Banking Awards clearly subscribe to this old-school theory, even though events from 2007 onwards would suggest that MPT is no longer watertight.

Most importantly of all, the so-called “risk-free” assets and mainstay of conservative Swiss private banks such as government bonds, which formed the very bedrock of MPT, can clearly no longer be relied on as part of a diversified portfolio.

The search is on for a sure-fire substitute, encompassing hedge funds, real estate and other income-producing alternatives.

The fact that old ways of working need to be changed does not always go down well with industry stalwarts, promoting comfortable ways of diversifying and constructing portfolios.

But clients have often been the ones to suffer from the blind application of sometimes obsolete theorems, while failing portfolio managers have still managed to line their own pockets. Indeed leading investment thinkers of today such as Professor Amin Rajan have been staggered at the opprobrium heaped on them by defenders of the guidelines.

“The amount of hate mail that I received was really quite breath-taking,” recalls Create-Research CEO and economist Mr Rajan, after penning an article questioning the theories, having realised they were impossible to model correctly.

Forward thinking private bankers and asset managers are now looking for a new way forward, probably more flexible and less prescriptive than before. Nobody is saying that leading researchers of their day should be stripped of their prizes. Indeed, their painstaking work provided a systematic framework for portfolio management and asset allocation.

But they did their research in a different era, when investments were often domestic, there was little international diversification and a lack of co-ordination between central banks on monetary policy. Investments from different markets were relatively uncorrelated. 

In today’s often closely correlated environment, the concepts can still be useful, and asset allocation – the ability to forecast how much to set aside for bonds, equities and alternatives – has to start from somewhere and requires some ground rules.

But wealth managers – for the good of their clients – must be done with the lazy fashion of blindly following the output of a flawed model.

The “new normal” is as exciting as it is unpredictable. It involves a greater understanding of macro-economics and a closer tab kept on the psychology of central banks and political decision-makers.

Private bankers are adding spice to portfolios in terms of emerging and frontier markets and illiquid assets such as private equity and hedge funds. “I don’t see a limitation there in the field, in the scope for diversification and this is really our job,” says Didier Duret, chief investment officer at ABN Amro Private Banking.

For investment brains such as Mr Duret, there are no longer any borders