According to Steven Bleiberg, portfolio manager at New York-based Epoch Investment Partners, modern portfolio theory (MPT) has been a good thing for people’s understanding of investing, but can also hinder those seeking active management.
“It is our contention that over the last 50 years, some investors have become so enamored of the theory that they have lost sight of the real world underlying the theory,” he said.
Mr Bleiberg argued that investors relying on MPT are viewing stocks as collections of factor exposures, rather than businesses and that MPT-reliance has contributed to the belief that a market index is more than a broad measure of the market, but is an optimal portfolio.
“This has led people to believe that it is a positive good to make no effort to judge whether a business is worth owning,” he said.
“We need to remember that in reality individual stocks rise and fall because of the success or failure of the underlying businesses; that the market as a whole rises or falls because of the ability of the average business to generate a premium over its cost of capital; and that not every publicly traded company is a business worth owning.”
Stocks are more than just a set of statistics, Mr Bleiberg reminded investors, and investors who correlate returns with factor exposures also run the risk of reversing cause and effect in how they think about the investing world.
He explained, “Many investment practitioners have become so enamored of this theoretical framework that they reverse cause and effect in the way they think about the world.
“They seem to think that a stock did well because it had exposure to certain factors that did well, as if the factor returns have an independent existence of their own out in the cosmic ether, apart from the success or failure of the underlying companies.”
It’s the performance of the business that results in changing stock prices and theoretical factor returns, Mr Bleiberg said.
“That is, company stock price movements drive factor returns; factor returns don’t drive company stock price movements,” he said.
“Or to put it yet another way, markets don’t reward or punish abstract factors; they reward or punish companies because of how well or poorly their business is doing, and that in turn creates what we end up measuring as ‘factor returns’. But we should never lose sight of the fact that those factor returns are a derivative. They are not the starting point.”
Mr Bleiberg said investors should take care to not become “caught up” in a model and lose sight of real-world investing.
“Successful investing in equities is about identifying companies that create value for their owners by earning high returns on the capital that they take from those owners and invest in their business,” he said.
He concluded, “As helpful as it is to have all of the insights that MPT offers – and it offers many – an investor still has to understand the ‘why’ behind a successful business.”