Sep 04

Modern Portfolio Theory – Passive versus Active…again!

Not a great deal of posting the last couple of months due to a combination of  conferences, flu, and just plain busy so hopefully I can increase the frequency moving forward.

A couple of weeks ago I was at a conference and Modern Portfolio Theory was receiving an absolute caning from those on stage. They basically suggested that it obviously failed during the GFC, markets are clearly inefficient and its time to start trying to time markets and move towards dynamic asset allocation…apparently timing markets and successfully implementing dynamic asset allocation to add value to client’s portfolios is easy. Anyway, whilst I believe there is potential value in moving towards dynamic asset allocation (let’s face it clients want it) unfortunately Modern Portfolio Theory is not to blame and its the poor implementation of Modern Portfolio Theory from an asset class perspective that has failed, not so much the theory (although its far from perfect and is flawed). Modern Portfolio Theory says the optimal portfolio is the”Market Portfolio” and across asset classes we have never actually seen this portfolio or been close to this portfolio and probably never will. The 70/30 default superannuation portfolio in the Australian industry is so loaded with equities that to suggest that it is diversified sufficiently and that Modern Portfolio Theory is to blame for its recent failure is ludicrous.

Anyway, I digress…where Modern Portfolio Theory has been implemented well is within the Asset Class…that is, market-cap weighted index funds are very good replication of what Modern Portfolio Theory is supposed to produce in terms of the optimal portfolio within an asset class. However, if the market is so inefficient as the conference speakers explicitly said, then professional active managers should be able to outperform the index consistently…because, lets face it, these anomalies and mispricings are apparently so prevalent that “how can you not notice”…yes I am being a little facetious.

So, around a week and a half ago the latest SPIVA report (yes, my favourite report due its consideration of survivorship bias) was produced on the Australian retail funds management industry and still the index is the convincing winner…except, once again, in small cap Australian shares where the big boys don’t play.

To save you reading the headlines, the key takeouts for each major asset class are…

  • At least 70% of active retail funds UNDERperformed the benchmark over the last year and last 3 years
  • Approximately 69% of active retail Australian equity general funds failed to beat the S&P/ASX200 Accumulation index
  • Almost 90% of active international equity general funds underperformed the benchmark over the last year. Over 3 years and 5 years, at least 72% underperformed.
  • ALL ACTIVE RETAIL AUSTRALIAN BOND FUNDS studied in the SPIVA report failed to beat the S&P/ASX Australian Fixed interest index over the last year!!!! 92% failed over the last 5 years.
  • 30% of active Australian bond funds failed to survive over the last 5 years…and this has been a good performing asset class.
  • 86% of active A-REIT funds failed to beat the S&P/ASX 200 A-REIT index over the last year and 65% failed over the last 5 years.

Source: Standard and Poors

As the above chart shows, buying active managers in retail space ahead of the low cost index funds is a very difficult sell unless you’re looking to buy in small cap space (and you’d be hard pressed to provide a strong reason for going with index funds there).

I’m afraid Modern Portfolio Theory is far from dead and the active guys are continuing to struggle and if you think that this may be Australian specific then one look at the SPIVA reports from other regions will show you that that’s not the case. Whilst these results are compelling in favour of index funds…never forget that index funds cannot exist without the existence of active managers.


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