Is Portfolio Theory Harming Your Portfolio?
Journal of Applied Research in Accounting and Finance (JARAF), Vol. 6, No. 1, pp. 2-13, 2011
19 Pages Posted: 10 Nov 2011
Date Written: July 9, 2011
Modern Portfolio Theory (MPT) teaches us that active equity managers who use judgment in making investment decisions won’t be able to match the returns (after fees and expenses) of blindly-invested, passively-managed index funds. Data on returns supports the theory, so it’s no surprise that investors are leaving actively-managed funds in droves for the better average returns of super-diversified index strategies. Yet the reality is much murkier than we’ve been led to believe.
It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes.
Regardless of MPT’s shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. However, as highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals. Individual investors, seeking to exploit these inefficiencies and outperform indexes, should invest in several concentrated funds with strong track records. Managers of these funds have proven themselves adept at turning inefficiencies into strong returns for their investors, and persistence data demonstrates that past performance can indicate which managers are likely to continue to outperform. Concentrated fund returns may exhibit more volatility than indexes, but we now have proof that over the long-term, good judgment will be rewarded.
Keywords: MPT, investment fund, index
JEL Classification: M40, M41
Suggested Citation: Suggested Citation