The investment world as we know it refuses to look at that which clearly lies in front of them; the philosophical worldview of how to navigate the capital markets, mitigate risk, and achieve investment success simply does not work.
Matthew P. Erickson makes this argument in Asset Rotation: The Demise of Modern Portfolio Theory and the Birth of an Investment Renaissance, his critique of modern portfolio theory and its many shortcomings, as he sees them. Erickson claims that “modern portfolio theory (MPT), like many investment methods, was merely an aberration in time, and not a blueprint for long-term success.” Considering that Harry Markowitz won the 1990 Nobel Prize in Economic Sciences for his work in modern portfolio theory, Erickson’s claim that MPT’s past success as an investment tool was a fluke will certainly raise a few eyebrows. Interestingly, although the book sets out to discredit MPT, it makes a more compelling argument against passive investing.
The first four chapters outline various challenges for the modern investor: demographic changes in the United States, the role that the Federal Reserve has played in the bond market, Morningstar’s rating system, inconsistent fund manager performance, high fees, and so on. Erickson uses these examples to conclude that modern portfolio theory simply will not work in the future and that exchange-traded funds (ETFs) have created an opportunity, an “investment renaissance.” Instead of passively holding a portfolio with a specific asset allocation (e.g., 80% stocks/20% bonds), Erickson proposes altering the asset allocation and the composition of the sectors within the stock allocation to obtain better results than those of the traditional passively managed portfolio of index funds.
To prove his point, Erickson back tested a portfolio comprising either the S&P 500 Index or the Ibbotson Associates SBBI Long-Term Government Bond Index. Each month, he altered the portfolio’s asset allocation on the basis of how each index performed during the previous month. If the S&P 500 was up more than the bond index, he would buy the S&P 500; if bonds performed better in the previous month, he would buy the bond index. Erickson discovered that simply buying the asset class that was up the previous month and shedding the one that was down resulted in roughly the same long-term return as that of the S&P 500—but with considerably less risk. Erickson concludes that his newly constructed portfolio was operating outside the efficient frontier that Markowitz graphed to show the relationship between risk/return and a portfolio’s allocation of stocks and bonds.
Erickson back tested a second portfolio, still based on two asset classes, but instead of holding the S&P 500, he used ETFs that represented the nine major sectors of the S&P 500. This approach allowed him to alter the portfolio’s sector weightings on the basis of the previous month’s performance (i.e., he could overweight technology, underweight utilities, etc.). He also adjusted the portfolio so that instead of being composed solely of stocks or bonds, it could have various combinations of the two. As in the first backtest, he holds up the second portfolio to claim that he was able to create a portfolio that existed outside Markowitz’s efficient frontier, yielded a superior return, and had a lower standard deviation.
The case that Erickson makes for asset rotation is impressive. His attempt to discredit Markowitz’s work, however, is less convincing. He claims that the portfolios he constructed existed above the efficient frontier by providing a superior return with lower risk. He adds, “We believe our work has dispelled this widely regarded investment tenet [MPT] as nothing more than a myth.” Curiously, Erickson does not explore the holding period of the various ETFs that are rotated monthly nor how the short-term betas of these asset classes may differ from their historical betas. If one holds an asset that outperforms the S&P 500 for one month, can one conclude that the asset has a beta of less than 1.0 for that period? The problem with using beta to predict future returns has been well explored by Gerard Hoberg and Ivo Welch.1 In their 2009 study on noise in stock returns, Hoberg and Welch concluded that market beta often contains a backward-looking aspect that has a negative influence on predicting future stock returns. They also observed that “momentum predicts future stock returns primarily because it picks up a forward statistic.” It would appear that Erickson has done more to validate the work of Hoberg and Welch than to diminish the work of Markowitz.
Although Erickson’s argument heralding the demise of MPT seems riddled with contradictions (the book’s flap indicates that Erickson uses traditional modern portfolio theory in the funds that he manages at Renaissance Capital Management), Asset Rotation does offer a compelling argument for active management. Erickson demonstrates that by using ETFs and asset rotation, one can sometimes achieve a return superior to that of a passively managed fund that relies on MPT and index funds. This remarkable claim is well supported by Erickson’s fine work. For that reason alone, Asset Rotation constitutes a robust argument for active management and may indeed be a harbinger of an “investment renaissance” and the end of passive management.