Hansi Mehrotra, who leads DiligenceVault in Asia recently posed a question – Has Goals-Based Investing (GBI) Ruined Modern Portfolio Theory (MPT)? Especially for retail investors? Read it on CFA’s Enterprising Investor blog
What has driven the recent popularity of goals-based investing for retail investors? The two key arguments on MPT that Hansi discusses are also relevant in the institutional investing space:
Exclusion of Illiquid Assets in MPT
In the institutional world however, most investors do in fact include illiquid assets via a liquid proxy, which attempts to capture the liquidity premium. Investors also optimize resulting asset allocation for liquidity needs in both normal and stressed market conditions.
But isn’t this mixing up too dissimilar concepts and creating a patchwork of methodologies after all? Is the liquidity optimization a good solution for exclusion from MPT?
Difficulties in Forecasting, Risk Profiling, and Definitions
What is the classic asset class definition? Should it be based on investment structure and market focus? Or do we identify better with risk characteristics? Or is it based on cash flow characteristics?
Once one anchors the asset class definition, what assumptions are being made on expected risk and returns, and correlations amongst the asset mix? Most investors derive these assumptions from history, with futuristic overlays. The divergence in MPT outcomes for different investors is a consequence of:
- What is the look back period and how is it treated? All else being equal, in year 2019, firms that employ 10 years look back will see 2008 global financial crisis fall of, while firms that use 15 years rear view mirror will have a different view of the risk in the world. At that stage, who will be right in defining the asset allocation of the future?
- Is the rear view mirror calibrated on simple average, exponential weighting, or another methodology? Is certain historical time period more important than others?
The reality is that while there are a multitude of outcomes generated by these assumptions, the winning solution often ends up being arbitrary. On the other hand, the goal of an investor is to meet expected objectives of the investment mandate, whether it be; funding of university cash flow needs, fulfillment of retirement promise, creation and/or preservation of wealth, or making the world a better place, et al.
Investors that focus on liability driven investing, the endowment model of investing, as well as impact and responsible investing are emulating elements of GBI. Should investors continue to find an optimal intersection of MPT and GBI, or shift completely to GBI?