Moving mountains and markets

Markowitz gave investors their only ‘free lunch’ – diversification. At the heart of his article Portfolio Selection, for which he received the Nobel Prize in Economic Sciences, is a simple rule: no risk, no reward.

In taking risk, Markowitz tells us, don’t put all your eggs in one basket – diversify! But he also brought new meaning to diversification, arguing it must be the “right” kind. That is, “it is necessary to avoid investing in securities with high covariances among themselves”.  

Yet, while diversification may be the best mechanism for reducing risk (framed in terms of ‘variance’), it has a propensity to dampen the opportunity to generate higher returns that might be obtained from more concentrated holdings.

Bill Sharpe, father of the Capital Asset Pricing Model (CAPM), built on this by starting from the basis all investors want to hold the most ‘efficient’ portfolio. In making a number of enabling assumptions, such as risk-free borrowing and lending, Sharpe concluded the optimal portfolio along Markowitz’s Efficient Frontier must be the market portfolio, a proxy for which would be the S&P 500 Index, which represents a broad basket of US stocks.³

From this, Sharpe could then calculate the price of each individual asset in capital markets. According to his CAPM, the only risk investors would be rewarded for bearing was that which could not be diversified away. Sharpe called this “systematic risk”, which has come to be represented by beta (β). Beta is a measure of an asset’s co-variance (or correlation) with the market. Sharpe distinguishes “systematic risk” from “unsystematic risk” – the portion of an asset’s risk that is uncorrelated with the market.

The problem? Once unsystematic, or idiosyncratic, risk has been diversified away, systematic (or market) risk accounts for as much as 91.5 per cent of the variability in investment returns.⁴

One of the major failings of MPT, however, is a narrow conception of risk and the assumption all risks can be measured mathematically. In his 1921 work Risk, Uncertainty, and Profit, University of Chicago economist Frank Knight distinguished between risk and uncertainty. Whereas the former was quantifiable, the latter wasn’t.

The disproportionate focus on volatility as a proxy for risk, and the subsequent overreliance upon diversification has the effect of placing what are systemic risks into the realm of uncertainty.

Jon Lukomnik, co-author of the 2021 book Moving Beyond Modern Portfolio Theory: Investing That Matters, holds a similar view. He wrote: “Prevailing investment orthodoxy just can’t simply deal with systemic risks, which has led investors to focus on the manifestation of risk as volatility but do nothing to tackle the underlying risk”.

In the never-ending quest to seek more sophisticated means by which we can manage risks, we risk relegating the art of investing to the very rules of thumb and folklore these evolutions in theory proclaimed to take us away from. The implicit assumption of exogeneity, and the notion a well-functioning market is a constant from which investors can make allocations to exploit inefficiencies, is starkly undermined by the threats we face today.

Once you challenge the idea markets are immovable objects, the next question becomes: “How might we rethink approaches to risk and return, or opportunity?”

The first point to make is ESG integration, the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions,⁵ still fits into EMH as it simply represents consideration of information relevant to asset prices. Used properly, it can help investors achieve a more rounded view of diversification and risk.

From a downside perspective, the moral case for greater sustainability, fixing market failures and removing negative externalities is colliding with the financial one. The timelines of climate change and other major risks are collapsing in on us. No longer are they a problem of some distant tomorrow. They are affecting lives and portfolios, now.

This is why engagement with the underlying drivers and sources of risk, in a way investment orthodoxy does not envisage, is critical. Engagement with holdings, what we call micro-stewardship, is one important aspect of doing so; promoting sustainable practices and mitigating contribution to risks that may undermine the system within which they operate.

Macro stewardship – engagement with the system itself, via collaboration and consultation with peers, regulators, sovereigns and policymakers – is another mechanism for engaging with the underlying causes of risk. As Jess Foulds, global responsible investment senior manager at Aviva Investors, puts it: “What might active engagement look like if we thought about it through a systems lens, rather than merely at the local, individual issuer or corporate entity level?”

Aligning micro and macro stewardship efforts is crucial. “We can affect risk by changing the way capital is allocated, but we can also reduce overall market-level risk by engaging with governments,” says Foulds. Sovereign bondholders are yet to fully tap into their influence.

It is not just a risk mitigation story, though. As capital is increasingly directed towards transition themes, opportunities to generate returns are created as well.

“It will be increasingly important for those who are managing money to understand how policy will change,” notes Tom Tayler, senior manager in the Aviva Investors Sustainable Finance Centre of Excellence.

“The design of markets can be changed. They are human constructs. And, intuitively, market participants like professional investors are well placed to help advise on how to fix the cracks and weaknesses in the system,” argues Morriss.

In his mind, we need to re-imagine what it means to have an efficient market; that is, not just a market that is hard to beat, but also one that doesn’t jeopardise its functioning tomorrow because of how it operates today.

Policymakers and regulators, as the shapers of the investable universe, are critically important for ensuring the integrity of the market. But they cannot act alone and must be informed by financial market participants as part of a robust feedback loop. To that end, investors should look to collaborate with other institutions to complement their own bilateral engagement with governments and regulators.

Morriss reckons attempts to mitigate risks of a non-diversifiable nature suggest we are moving towards a Sustainable Market Hypothesis (SMH). Investors are starting to acknowledge that rather than being exogenous to financial markets, they are indigenous to it. Therefore many of the risks to the financial system are endogenous; they originate from within.

“Investor activity can and does have an impact upon the extent to which markets function. If we can accept a well-functioning market is the lifeblood that generating a risk-adjusted return relies upon, it is high time we move to develop and embrace the SMH as a genuine theory for ensuring the market’s integrity,” says Morriss.

Although such an idea might seem far-fetched, just imagine what could be achieved if we set some of the brightest minds running towards the challenge of creating a more sustainable market structure. It is an ambitious thought, but maybe that metaphorical mountain of a market can be moved to a higher plane after all.