Beyond Modern Portfolio Theory (MPT): Finding a Third Way to Enhance Investment Returns

Conventional investment theory suggests that there are only two sources of return: what the market gives you (beta) and what you can extract from skill (alpha). However, there may be a third way, and it may change the way asset managers approach investment management and enhance investment returns.

Enhancing Beta

A fundamental premise of MPT is that the market will deliver some return over which no single investor or portfolio manager has control.

In a recent paper, “The Third, System Stage of Corporate Governance: Why Institutional Investors Need to Move Beyond Modern Portfolio Theory,” its authors argue that investor returns could be boosted by enhancing market beta. ¹  This increase in beta can be achieved by transitioning from the current approach of focusing on governance activism on a company-specific basis to an approach that focuses on corporate governance on a system-wide basis.

The mindset of large institutional investors and other major players may already be headed in this direction. One significant example of this Larry Fink’s Annual Letter to CEOs, in which he communicated his view that it was a fiduciary responsibility of BlackRock to “engage with companies to drive sustainable, long-term growth that our clients need to meet their goals.”¹

While Fink recognizes that index fund managers have historically been passive owners, he believes the time has come to be more active under a new model of investment engagement and stewardship to effect changes that produce more sustainable returns to shareholders.

This movement toward a system-wide approach to a corporate governance model is also finding impetus from outside the asset management community. For instance, the Sustainability Accounting Standards Board (SASB) is working with companies, regulators and asset managers to implement standardized accounting disclosures on a range of general and business-specific measures to better inform investor decisions. Similarly, the Financial Stability Board (FSB), an international organization that monitors and assesses global financial risks, is advising the G20 nations on implementing financial reporting standards on issues related to the environment.

Post-Modern Portfolio Theory

Modern Portfolio Theory profoundly impacted portfolio construction since its introduction in the mid-20^th century. It was a significant step forward for designing well-diversified portfolios, but it was not without its consequences, including fostering a focus on relative returns, short-term investment bias and the dogma that capital markets are unable to mitigate systemic risks.

If market beta can be raised through the application of system-wide corporate governance initiatives geared to promoting sustainable gains, it just may brighten the future retirement security for countless individuals.

Sources:

1. https://poseidon01.ssrn.com/delivery.php?ID=175031100004092103076125115088102002127084029081049078120117102110125026069029064071102061063097020028117125090126091067127120024026024023001030104092072116090085038023095017119001123082002125080113093092093028094089124124026118026075017091029031&EXT=pdf
2. https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter

See referenced disclosure (2) at https://blog-dev.americanportfolios.com/disclosures/