Why the success of model portfolios and the paradox of Schrodinger’s cat have a lot in common
By Allan Lane, Algo-Chain – According to a recent article in the Wall Street Journal, the data provider Broadridge Financial Solutions estimates that model portfolios in the US held over USD4 trillion of assets as of September 2020, and to this we can safely add another USD1 trillion if we include the UK.
Yet, if you speak to an institutional investor this is an alien world that they do not inhabit. Just pause for a moment on that point, can it really be true that there is a USD5 trillion financial industry that the ‘professionals’ have very little to do with?
In short, the answer is yes, and to see why one needs to simply realise that by their very design, model portfolios are fleet of foot which is in stark contrast to the feet of clay that so many institutional firms display as they are hemmed in by regulation and red tape. Model portfolios do not constitute a legal fund wrapper, instead just think of them as a loose form of baskets of funds and stocks.
How would Erwin Schrödinger have managed his portfolio risk?
If ever there was a year when the notion of the fear of missing out had some meaning, 2020 was that year. Just look at the basic facts, the digital currency ethereum, as of 1/12/20, is up 358 per cent year-to-date in USD terms, whereas the electric car company Tesla is up 667 per cent. We are not talking fringe activity here, since March 2019 the Swiss Regulator has allowed investors to access ethereum via 21 Shares’ ethereum ETP, which is listed on the Six Swiss Exchange. Likewise, the buzz on the street is the imminent inclusion of Tesla into the S&P 500.
As a result, those discretionary fund managers who did not have exposure to those assets will almost certainly be further down the league table as compared to those that did. However, the conservative nature of the model portfolio industry doesn’t sit comfortably with the idea of adding crypto currencies as a tactical investment opportunity. On that basis, how should a model portfolio manager go about their business as the old school world of investing inches ever closer to the utopian panacea where every asset class is digitised? I might add that even a small allocation to cryptos, such as a 3 per cent allocation, would have given the portfolio a boost in performance and most likely would provide diversification in the future.
It turns out that the mathematical framework on which Quantum Mechanics was founded has a lot in common with the way the stock markets can be modelled and understood. For this reason, it shouldn’t be so surprising that one can learn quite a lot from the ideas and thinking style of the world’s greatest quantum physicists, and non more so than the parable of Schrödinger’s cat. In a famous thought experiment, which involved a cat that was left in a sealed box where a radioactive substance had been added, the question of how to deal with uncertain outcomes became the topic of much debate. Without further information, the super-position principle of quantum mechanics allows for the possibility that at any one time the cat can be both dead and alive. It is only after the fact when the container is opened would an observer obviously see that the cat is either dead or alive, not both!
Likewise, when an investment manager builds a portfolio, each of the selected stocks or ETFs may go down as well as up in value and it is only when someone makes a measurement of the portfolio, can one say for sure what actually happened. There is no paradox here, just simply the real-world problem of how to manage the risks associated with all possible outcomes that might happen in the future. At the risk of stating the obvious, any investor who stakes too much on Tesla could lose more than the person with a smaller percentage allocation.
One often hears many professionals talking about capturing the risk premia associated with any asset class, say large cap stocks, or the higher risk premia that come with small cap stocks, but very rarely are risk rated model portfolios presented in this fashion. In essence, it is the idea of constructing a suite of portfolios that have an increasing level of ‘composite risk premia’ that makes this one of the most powerful ideas in portfolio theory, yet I have a niggling suspicion not too many of those same professionals are fully appreciative of how well these portfolios deliver the goods.
If you don’t know whether the cat will be alive or dead when you next look at your portfolio, at least know in advance how much it will bounce when the markets turn volatile. I suspect the reason so many active managers fail to beat their benchmark is because they don’t treat portfolios as a statistical ensemble of random variables, but instead try to forecast too much about the cat’s future state.
As a Portfolio Manager, what would Richard Feynman have done differently?
In modern folklore, Richard Feynman became famous as the person who uncovered why the space shuttle blew up, but for many years before that he was synonymous with the notion of thinking outside the box. There are many stories involving this Nobel Prize winning physicist, but none better than the time when working at Los Alamos he discovered a hole in the security fence and counted how many times he could leave through that hole before the guards at the front gate became suspicious. He had a big dislike for those that could not think for themselves and too often believed what they were told.
And so, it is with investing. How many times do we hear of a portfolio manager boasting that they follow the Markowitz Model and weight their assets along the efficient frontier, yet never question whether this model truly works in practice? Why worry about the fine details of the weights of your assets in the portfolio if you have not selected the right ones in the first place.
I suspect Feynman would have loved the idea of constructing model portfolios along the lines of a Core/Satellite framework. Providing one is able to establish what the overall risk rating of the portfolio is, particularly if you were to use the satellite concept to incorporate a very small allocation to ethereum, then one should have a good estimate of the potential risk premia that this tactical portfolio will deliver over time. What is more, according to the Feynman Path Integral approach to calculating outcome probabilities, if you stay with your risk rated portfolio long enough, it will deliver what it says on the tin.
What would Paul Dirac have made of risk rated core/satellite portfolios?
As Britain’s most famous theoretical physicist who predicted anti-matter, it is hard to portray the level to which Dirac was held in high esteem by those who knew him. In truth though, it was his prowess in problem solving that left even the brightest of his contemporaries in the shade.
The best anecdote that shows this ability dates back to the time when a group of theoretical physicists, including Neils Bohr and Werner Heisenberg, the founding fathers of quantum mechanics, used to go hiking and they set themselves puzzles as they walked through the Alps. One of those puzzles proved impossibly hard to solve and it had stumped all of the greatest quantum physicists for some considerable time. Yet one day Dirac came up with a complete solution that solved the problem once and for all and it was ‘Game Over’.
When it came to the puzzle of investment management, the US based ETF commentator, Tom Lydon, once remarked that by using ETFs as the building bricks in a model portfolio, it was essentially game over. A view that over time I have come to agree with, particularly as more news filtered through that many active managers failed to deliver on their promises during the great sell-off of 2020.
As the growth of the ETF industry shows no sign of abating, it is not unreasonable to ask if the fun has gone out of investing on the back of the commoditisation of the fund management industry. If that is true, then have we already reached the game over stage? Speak to many fund managers about the impact of ETFs on the investment landscape and you might well reach that same conclusion, but with an increasing number of managers using alternative investments as a source of returns, then it could well be that we are on the cusp of a new era of investing. Either way, I am 100 percent confident that risk rated model portfolios, built on a core/satellite basis, will soon become the new norm.