ISSUE

The issue of this question concerns financial management and applied statistics in portfolio management, i.e. risk management. Much of the issue turns on the Modern Portfolio Theory (MPT) by Harry Markowitz.

LITTLE ADVANCEMENT IN RESEARCH ON FINANCE THEORY

The fact that we have been using these “drivers” for the past 50 years is a prima facie evidence showing that there has been little innovation in research in finance. It is unfortunate that with the EU debacle, off-and-on/come-and-go financial crisis in the US, and other regional financial troubles, i.e. Asian Financial crisis of 1995-97, no new and ground breaking theories in financial management had been put forth. When it comes to portfolio management theory, Markowits’s MPT seems to dominate the field despite the changing market condition. The market condition that exists today no long resembles that of Markowitz time of the early 1950s.

PORTFOLIO THEORY & CAPITAL MARKET LINE

The portfolio theory proposed by Markowitz states that “the higher the risk, the higher the return” on a portfolio. This relationship is non-linear and is marginalized as the risk keeps increasing and the increased returns starts to decrease. No maximum risk or maximum returns is defined. Where positively curve asymptotic curve touches (tangent) with the Capital Market Line (CML), an efficient frontier of the portfolio is indicated. The CML formulation follows:

R(p) = I.rf + (R.m – I.rf) sigma(p) / sigma(m)

… where:

R(p) = Expected return of the portfolio;

R.m = return on the market portfolio;

I.rf = risk free rate of interest;

Sigma(m) = standard deviation of market portfolio; and

Sigma(p) = standard deviation of portfolio

There is a problem here. What if the risk free rate (I.rf) > R.m?

One can argue that a risk free cannot exceed the market rate in a given market, i.e. bank rate always be lower that the stock market return. From 1950s – 1990s, that may be true. With borderless trade and capital movement, this assumption becomes unreasonable. Assume that the US stock market yields 5% and a foreign bank, say Kanh bank in Mongolia gives a risk free rate of 15%. Assume further that the stock market in the US, through the working of the Law of large Number for the sake of our argument has a sigma of 1.0 and that the manager is so efficient that he construct the portfolio in such a manner that the return therein also is normally distributed N(0,1)---these assumptions are ideal----not ad absurdum. The working of CML follows:

R(p) = I.rf + (R.m – I.rf) sigma(p) / sigma(m)

R(p) = 15% + (5% - 15%)

=15%-10%

=5%

Now, the result is ludicrous because 15% from a bank in Mongolia is not in the US market from which all assumption of the equation is based. The assumption that the efficient frontier is the tangency when CML touches the return frontier curve does not work well in the so-called “global financial market”---a market that we live in today. In the market of Markowits in 1952, it may have worked. The 15% is a point in space, not on the CML or the Y-intercept of CML.

FAULTY ASSUMPTION OF EFFIECIENT FRONTIER

MPT assumes that the market is a single market and that all participants in the market have the same information. This assumption begins to break down in the financial world of today. Despite the availability and access to information via electronic sources, investors are still operating with imperfect information. Moreover, the free flow of capital and hence the accessibility to investment market throughout the world also shows the weakness of Markowitz’s MPT. For instance, the efficient frontier curves assumes the behavior of the relationship of risk and return within one (single) market, i.e. the US market or the EU market. This definition of “system” is a closed one and, therefore, is not at all “efficient.” If the stock market in the US yields an average return of 5% and the risk free rate is 2.5%, the Capital market Line (CML) and the efficient frontier line would be tangent according to these two pieces of information, say the Y-intercept of CML would cross the Y-axis (returns %) at 2.5%. At the same time a government-guaranteed bank in Mongolia offers a risk free rate for a time deposit at 15%* per annum at Kanh Bank or 10% with banks in the Lao PDR’s BCEL,** Markowits portfolio theory begins to crumble in light of “global financial market.” While the CML according to the US market would still retain a Y-intercept at 2.5% return while 15% and 10% examples would be two separate points outside of the so-called efficient frontier. The definition of omega (sample space) in MPT would not work well in today's global financial market.

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* https://www.khanbank.com/

** http://bcel.com.la/(A(Ngh1czRMzwEkAAAAMDE2ODczYjUtNWY0Ny00NjQ4LTk5OTMtYWYxMjMxYTI0MGM1mg0nSTOxzz5ASNuJiYjXVDIGPS41)S(y0ehlhdzgfcllhq2df3i03na))/en/InterestRate.aspx

REFERENCES

(1) Markowitz, H.M. and E. van Dijk (March–April 2003). "Single-Period Mean-Variance Analysis in a Changing World". Financial Analysts Journal 59 (2): 30–44.

doi:10.2469/faj.v59.n2.2512.

(2) Markowitz, H.M. (September–October 2005). "Market Efficiency: A Theoretical Distinction and So What?". Financial Analysts Journal 61 (5): 17–30. doi:10.2469/faj.v61.n5.2752.

(3) Markowitz, H.M. (2009). Harry Markowitz: Selected Works. World Scientific-Nobel Laureate Series: Vol. 1. Hackensack, New Jersey: World Scientific. p. 716. ISBN 978-981-283-364-8.

It depends on the value drivers you are referring to. Lately, there is something called ESG (environmental, social, governance) factors. Through my research, I have been getting mixed conclusions as to whether considering ESG actually leads to better financial returns. Different sets of data suggest a different conclusions.

If value drivers refer to value stocks, i.e. stocks with lower price-to-book than average, then yes these stocks tend to perform better than the average over time.

Best regards