Moving mountains and markets

According to Jonathon Burton, Markowitz came along and then there was light.⁶ To put it another way, 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”. 

The relative performance between portfolio assets, rather than the quantity of assets owned, became the focus. By creating a portfolio of imperfectly correlated assets, investors could in theory minimise the amount of risk they take. This is because the aggregate risk of the “least mean variance” portfolio will inevitably be less than that of its individual securities. After all, “the whole is greater than the sum of its parts”. As a result of this breakthrough, the risk of the asset was now only as important as its impact on the overall portfolio.

Reducing variance became the goal. Markowitz declared such a diversified approach to investing “is both observed and sensible; a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim”. 

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. Pre-empting this shortcoming, Markowitz argued “the investor should diversify and that he should maximise expected return. The rule states that the investor does (or should) diversify his funds among all those securities which give maximum expected return… and commends this portfolio to the investor”.⁷

The commended portfolio, for Markowitz, is the one that maximises output for a given (but preferably minimum) input; in other words: efficiency. The ‘efficient’ portfolio, therefore, was to be one that generated the highest expected return (output) for the risk required to achieve it. Having identified efficient portfolios, these should be ranked in order of expected return or riskiness. The resulting collection of efficient portfolios formed what Markowitz termed the ‘Efficient Frontier,’ whereby increasing the level of expected returns incurs an increase in risk.

The seeds were sown, and the roots of modern finance began to take shape. In the years that followed, almost all theoretical development sprouted from these initial insights.

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 – efficiency in the Markowitzian sense of the word. 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.⁸

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. It compares the volatility in returns on a particular security with the volatility of the overall market. Sharpe distinguishes “systematic risk” from “unsystematic risk” – the portion of an asset’s risk that is uncorrelated with the market.

Naturally, Sharpe recognised no model can precisely predict returns, and CAPM’s beta prediction will often differ from reality. As such, he classified the actual realised return on an individual asset as alpha – which can be both positive and negative – with positive alpha indicating one has “beaten the market”.

The significance of this decomposition of risk into “systematic risk,” which we are unavoidably exposed to, and “unsystematic risk,” which we can control through diversification, has done much to frame and measure risk in relative terms, as well as inducing a focus on the latter at the expense of the former.

As Sharpe concluded: “Diversification enables the investor to escape all but the [systematic] risk resulting from swings in economic activity – the type of risk remains even in efficient combinations. And, since all other types [such as unsystematic risk] can be avoided by diversification, only the responsiveness of an asset’s rate of return to the level of economic activity is relevant in assessing risk.”⁹

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.¹⁰

Ignoring that huge caveat for a moment (just as the key theorists and practitioners did), the CAPM paradigm of investing dovetails neatly with an understanding of markets that emphasise their efficiency and composition by rational actors. The “Efficient Market Hypothesis” (EMH), postulated by Eugene Fama, argues market prices always reflect all relevant information.

By this logic, supported by the empirical analysis of Michael Jenson¹¹ and Jack Treynor¹², while beating the market is possible, attempts to consistently outperform the collective wisdom of all other market participants may be futile. On average, in an efficient market, information flows into prices so quickly the overall market knows more than the individual investor can. As such, any deviations from the equilibrium value cannot last long.

Cautioning against looking for the alpha needle in the haystack when you can just buy the haystack¹³, the self-fulfilling prophecy of EMH provided the intellectual foundations that spawned the behemoth (passive) index fund market, which consequently reshaped the dynamics of markets. In efficient markets, short-term irrationality will always be rectified by the collective wisdom of the investment community over the long run.

Enter derivatives. Again, with their roots in the MPT paradigm of investing, derivatives acted like icing on an already well-baked cake. Crystalised in the Black-Scholes-Merton formula, derivatives presented a way to build risk pricing into futures markets, further embedding and institutionalising the naive notion all risks can be transferred and avoided.

The influence on financial and economic thinking cannot be overstated and was neatly summed up by former US Federal Reserve chair Alan Greenspan in 1997: “The use of a growing array of derivatives and the related application of more sophisticated methods of measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial institutions... as a result, not only have financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more stable.” We all know how wrong that proved.

To summarise, Markowitz put risk at the heart of all investment decisions and showed the whole is more than the sum of its parts. Sharpe’s CAPM demonstrated the expected return of an asset depends largely, though not exclusively¹⁴, on its relationship with the market itself. Eugene Fama articulated the EMH and, along with Jenson and Treynor, established markets, despite the contestations of fund managers, are hard to beat.

MPT and the explosion in financial innovation that followed entirely changed the game of finance. And for us to move to a higher plane, this extensive context is crucial.

As Pulitzer Prize-winner Louis Menand said about Freud’s infamous treatise, Civilisation and Its Discontents: “[T]he grounds have been entirely eroded for whatever authority it once enjoyed as an ultimate account of the way things are, but we can no longer understand the way things are without taking it into account.”

One of the major failings of MPT 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 implied a fundamental degree of ignorance, a limit to knowledge, and an essential unpredictability of future events.

Risks, as Nobel Laureate Kenneth Arrow once put it, come “trailing clouds of vagueness”¹⁵ and variance is particularly conspicuous in its ability to obscure the danger that lurks. The disproportionate focus on volatility as a proxy for risk, and the subsequent overreliance upon diversification has the effect of placing 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.”

Morriss agrees. “While a diversified portfolio and managing exposure to risks through hedging instruments such as derivatives are important tools, an inherent reliance upon volatility can breed ignorance to the risks building up at the systemic level,” he argues.

All these approaches to risk management can have the appearance of prudence at the local level. But the aggregate market, where everyone adopts these approaches, is a different matter altogether. After all, the sum of individual actions is the genesis of a financial crisis. What these sophisticated financial innovations, with their roots in MPT, have facilitated is a widening of the gulf between financial market participants and the integrity of the overall system within which they operate.

It is often useful to check in with the founding fathers of disciplines later in their lives and careers. Finding out what such intellectual giants had to say about their own theories and the way they have been developed and interpreted can be revealing.

In his autobiography My life as a Quant, Emanuel Derman wrote of his mentor Fischer Black: “In one short essay he struck at the foundation of financial economics, writing that ‘certain economic quantities are so hard to estimate that I call them unobservables.’ One unobservable, he pointed out, is expected return, the amount by which people expect to profit when buying a security. So much of finance, from Markowitz on, deals with this quantity unquestioningly. Yet, wrote Fischer, ‘Our estimates of expected return are so poor they are almost laughable.’”¹⁶

An entire school of thought has arisen around applying the assertions in financial theory to the messy real world. Behavioural finance recognises we are human beings; our choices are not made in a vacuum but moulded by various heuristics and biases incompatible with that which theory assumes.

We are prone to fear, impatience, overconfidence, analytical errors, herding and irrational exuberance that divorces asset prices from their fundamentals¹⁷, to name but a few. In other words, we are hard-wired to disappoint the homo economicus-envisaging models we have devised.

Andrew Lo acknowledges this reality, reconciling the financial theories rooted in EMH with the challenges presented by behavioural finance as part of his ‘Adaptive Market Hypothesis’.¹⁸ He argues that in the face of limited computational ability, investors engage in ‘satisficing’, making choices that are satisfactory even though they are sub-optimal, thereby culminating in applying heuristics of old to new emergent contexts in which they are ill-suited.

As G.K. Chesterton put it in Orthodoxy: “The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

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?” Or rather: “What does all this mean in practice?”

The first point to make is ESG integration, the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions¹⁹, 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.

As Tom Chinery, senior credit portfolio manager at Aviva Investors, argues: “Ensuring the companies we invest in are developing the appropriate corporate strategies to navigate the changing world is essential and only possible through sound, forward-looking analysis – something no simple screening process can replicate.”

Ahmed Behdenna, senior multi-strategy portfolio manager at Aviva Investors, believes: “Systemic change is an important consideration for investors, especially when it is happening on such a scale.” He perceives it as both a risk and opportunity. “Managing those risks is a key part of our portfolio management activity, and of our economic scenario-building work. One example is the integration of climate change variables into capital market assumptions and macroeconomic forecasts,” he adds. 

Most viscerally 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.

Steve Waygood, chief responsible investment officer at Aviva Investors, agrees. “Risks like climate change could cause a domino effect. If parts of the insurance market collapse or become uninsurable, then this will spread throughout the system, threatening not only insurers but also banks. At that point, the market itself will look very precarious and could easily seize up.”

The late economist Hyman Minsky understood these linkages and argued that stability breeds instability – with misleadingly precise risk metrics leading a false sense of security and, ultimately, to what has come to be known as a ‘Minsky Moment’.

“The financial crisis was triggered by the failure of one (relatively) small market in one country. Imagine the impact if multiple markets, across multiple geographies, fail simultaneously,” argues Waygood.  

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 companies’ 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.

Morriss believes there is a growing desire among investors to up the ante. He believes professional investors should take a more hands-on approach to investing by tackling what they perceive to be various market failures, from climate change to biodiversity loss, and from human rights violations to labour abuses.

“By mitigating the concomitant risks, the aim is to enhance the long-term value of investments. In doing so, they are implicitly challenging investment orthodoxy, as represented by MPT,” he says. “Alpha means nothing if beta implodes – and we are facing existential crises that threaten the very integrity of markets.”

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. “Those shifts will transform industries, creating losers but also huge winners. Anticipating them means asset managers can be on the right side of those trends for clients.

“As a heavily regulated industry, we understand regulation, so we can and do advocate for legal and regulatory changes that help bring more sustainable practices into place,” he says.

Investors should be careful in trying to time the market though. “Trying to precisely time the market is not a great idea in general, and even less so in the case of systematic risk,” warns Behdenna.

 “Collaboration with our colleagues in the macro stewardship team is key, so that portfolio managers have those issues on the radar and can incorporate them into broader portfolio construction thinking. It is also about thinking creatively, and reflecting not only on the short-term issues, but also the long-term consequences, and also the first and second derivatives,” he adds.

Carbon futures are a recent investment example from the multi-asset & macro team at Aviva Investors as they provided exposure to carbon emission prices. Another climate-related example is increased exposure to companies improving their buildings' efficiency, from heating and cooling, to lighting.

Economics and finance are unique scientific subjects in that they deal with human behaviour – a notoriously hard variable to pin down. They essentially try to analyse, map and predict what we will do in the aggregate. But both disciplines are caught in a dangerous no man’s land between the hard and soft sciences. The precision of mathematics pitted against the messy reality of social structures.

The result is a perpetual game of cat and mouse, where the whims of market participants influence end outcomes. It is a circular dance – or rather a reflexive one, to use the technical jargon.

However, individuals and institutions can and do influence the market – for better or worse, whether by trying to beat it or simply following it. And while we have plenty of examples of participants doing so for the worse, why can’t markets be nudged, designed and influenced for positive change? As Chinery notes: “Markets may not be efficient, but they can be used to drive change.”

Morriss agrees. “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.”

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.

“Intricate understandings of regulation, standards, policy tools, market dynamics and pricing mechanisms, fiscal levers, and so on. These are our bread and butter,” he says.  

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.

Lukomnik also dispels the notion it is solely for governments​ to tackle systemic issues. “​Choosing government or capital markets is a false dichotomy. No one has ever said addressing systems risk, environmental systems risk in this case, is a substitute for government action. ​Investors understand that:  I don't believe the Paris Agreement ever would have gotten done had the institutional asset management industry not united and lobbied for it,” he says.

To that end, investors should look to collaborate with other institutions to complement their own bilateral engagement with governments and regulators.

Attempts by investors to mitigate risks in this way is something not envisaged by investment orthodoxy. And Morriss argues 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.”

If we agree with Markowitz that the whole is indeed more than the sum of its parts, we ought to apply such thinking to the overall market.

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. We have already seen what happened in reverse when the employment void for physicists and rocket scientists left by the US government’s scaling back of its space programme was filled by Wall Street in the 1970s and 80s.

Clearly many PhDs and years of research will be required to explore whether this embryonic idea is viable. However, if the EMH says it is essentially impossible to beat the market, an SMH suggests it is possible to positively contribute to the integrity of the market.

It is an ambitious thought, but to paraphrase Nelson Mandela: “Things always seems impossible until they are done.” Maybe that metaphorical mountain of a market can be moved to a higher plane after all.