Would You Call Elvis Presley a Modern Rock Act?

How relevant does Modern Portfolio Theory (MPT) remain to contemporary wealth management? A provocative new paper argues this issue.

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Would You Call Elvis Presley a Modern Rock Act?

Would You Call Elvis Presley a Modern Rock Act?

The “King of Rock and Roll” transformed pop music, gaining instant fame in 1956 with “Heartbreak Hotel.” No one questions Elvis Presley’s impact on music and American culture, but would anyone today call him a modern rock artist. Consider now the bedrock of 21st century wealth management, Modern Portfolio Theory (MPT), a framework for portfolio construction that dates back to four years before the release of “Heartbreak Hotel.” Which begs the question, how relevant does MPT remain to contemporary wealth management?

MPT is not Client Centric

In a provocative new paper, “How Wealth Management Lost Clients in Translation,”1 the author, Sassan Zacker, argues that classical asset allocation was built on a foundation of finding better ways to price assets, with financial markets in mind, not the needs of investors.

Zacker suggests one significant shortcoming of classical asset allocation is its one-dimensional customization of traditional asset allocation models—plug in the client’s stated risk tolerance and out comes the most optimal portfolio. In fact, the efficient frontier is not a fixed point on some imaginary line, but an average of possible optimal portfolios; Zacker calls it the “efficient cloud frontier.”

A further indictment of traditional asset allocation is that it is structurally passive, defeating active management by nature of its framework. In other words, asset allocation built on MPT and Capital Asset Pricing Model (CAPM) principles makes alpha a negative-sum endeavor.

The paper further posits that individual investors may actually have greater risk capacity than what is recognized by traditional risk tolerance assessments, which focus on short-term volatility, leading to underinvestment in risk assets.

Perhaps most troubling of all its shortcomings is that the strategic asset allocation recommendation is predominately driven by the client’s stated risk tolerance, which, in effect, shifts the risk and performance responsibility to the client. Thus, wealth managers, on whom clients are relying for their investment skill and knowledge, are unwittingly transferring this essential role to clients.

Where From Here?

There seems to be only a few choices for the wealth management industry: stay with the “modern” asset allocation status quo, adopt the more liability-driven approach of institutional money management or build a new asset allocation framework more relevant to individuals, like goals-based asset allocation.

Interested advisors can decide for themselves whether MPT should still be viewed as modern and if it remains central to today’s wealth management by reading Zacker’s full research paper.

Source:

  1. https://poseidon01.ssrn.com/delivery.php?ID=299118127070014119103112069111117107103081020021005061018084072068096119022117012030107045042043006097108095119009117064025123042090023016077064098082123113066126074027079048119081006002030105087007101124100123026005102121073091065008011065115090100070&EXT=pdf

See referenced disclosure (2)and (3) at http://blog.americanportfolios.com/disclosures/ 

About The Author

Keith Carravone

 

Director of Insurance Products 
631.439.4600, ext. 177 

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