Getting Back to Business: Why Modern Portfolio Theory Fails Investors and How You Can Bring Common Sense to Your Portfolio. 2018. Daniel Peris, CFA.
Toward the end of Getting Back to Business, author Daniel Peris, CFA, illustrates the power of a dividend-oriented equity strategy. He tracks a hypothetical $100,000 investment made at the end of 1997 in 10 reliable dividend payers, with dividends reinvested. By 2017, the stocks were paying out $29,370 in dividends. Along the way, the annual dividend total declined in just one year. The investor who withdrew the annual income along the way still collected $17,770 in dividends in the final year.
Peris, who heads the Strategic Value Dividend Team at Federated Investors, does not recommend holding as few as 10 stocks. Neither, though, are hundreds of issues needed to achieve satisfactory diversification, he contends. In the author’s view, both individual and institutional investors have, sadly, been trained to ignore these commonsense principles by the proponents of modern portfolio theory (MPT). Academics have given investors a bum steer, he asserts, by training them to be indifferent between income and appreciation. That indifference, says Peris, has induced investors to focus on short-run price fluctuations, which reflect mere changes in market sentiment rather than the health of the businesses underlying the stock quotations.
Peris recites the standard criticisms of MPT and its stepchild, indexing. Owning the entire market means holding some obviously flawed or overvalued stocks. Such indexes as the S&P 500 are not truly passive instruments anyway; rather, they are managed portfolios. The index managers use judgment in deciding which stocks to include, which to remove, and which to select as replacements.
These points are correct, but their practical significance is elusive. What ultimately matters to investors is whether a particular active strategy outperforms a low-cost, passive portfolio. Any investment manager who consistently outperforms will have no trouble attracting clients who still believe it is possible to beat the averages.
Managers who follow Peris’s advice and ignore interim fluctuations will find it easier to convince prospective clients that they are delivering superior results if they can persuade them that volatility-versus-return is the wrong framework for performance evaluation, as Peris contends. Unfortunately for such managers, many investors who have never heard of modern portfolio management theory care about drawdowns, even if Peris thinks them wrong to.
The author maintains that MPT has failed because it “did not put an end to economic cyclicality.” He cites no instance, however, in which MPT advocates ever vowed to tame the business cycle. Their objective was rather to help investors deal with inevitable market volatility arising in part from fluctuations in economic output. Peris also faults MPT for failing to abolish bubbles, including the one he believes arose from quantitative easing. This, too, is a case of blaming the theoreticians for not achieving something they never promised to achieve.
Peris is more on the mark when he faults “closet indexers” for charging fees as high as those of bona fide active managers. Similarly sound is his view that investors with no liquidity needs should avoid letting concern about price volatility get in the way of long-term wealth maximization. Additionally, Peris successfully refutes what he says has been an objection to calls for greater distribution of corporate income to shareholders—namely, that it would cut into economically vital business investment. All that would be required to fund adequate capital expenditures, Peris points out, is for corporations to redirect cash currently being used for share repurchases.
At the same time, Peris recognizes that companies in the high-growth phase of their life cycles should reinvest rather than distribute their cash flows. There may be a place for those companies’ stocks, he adds, in the portfolios of investors who sensibly allocate most of their assets to consistent dividend payers. The author goes so far as to approve of taking an occasional flyer on commodities, a classic non-income-generating asset.
Peris is unsparing in his criticism of MPT and the practices he sees as proceeding from it, but he does not claim that his prescription of approaching stocks as the owner of a business would is the only alternative. Notwithstanding his own involvement in active management, he leaves it to the reader to choose between active and passive strategies. He merely wishes to steer more investors away from concentrating solely on price and ignoring actual companies’ operations, a mindset spawned by MPT, in his view.
Leaving aside the fact that an exclusive focus on price, as practiced by technical analysts, antedated Harry Markowitz’s seminal work, expecting a massive shift of investor orientation in response to exhortations by income specialists is probably not realistic. Neither does it ring true that institutional investors became overly concerned with managers’ short-term performance as a consequence of reading the works of Markowitz, Sharpe, and Fama. That preoccupation was probably the inevitable result of advances in data processing technology, which facilitated increasingly sophisticated benchmarks, combined with the birth of the pension consulting industry.
The author’s combination of a scholarly background and experience as a practitioner has produced a thoughtful and well-researched book. Getting Back to Business enhances practitioners’ understanding of MPT by tracing the history of financial theory. Although Peris does misidentify Abraham rather than Moses as the biblical figure who “came down from the mount” with timeless principles (according to Genesis, Abraham did descend from a mountain after an angel prevented him from sacrificing his son, Isaac, but he did not have stone tablets in hand), on the whole, his book renders a valuable service by challenging an orthodoxy and offering an analytical framework for seeking price inefficiencies.
For more from Martin Fridson, CFA, check out “Foundations of High-Yield Analysis” from the CFA Institute Research Foundation.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.