Princeton Prof Shares An Essential Portfolio Theory
“Rebalancing is an option that allows investors to achieve additional gain, vis-à-vis a static portfolio of buy-and-hold. The long-term investor takes advantage of the natural dynamics of markets.”
John Mulvey has spent a lot of time – practically 30 years at Princeton - thinking about risk, and those musings could have big implications for your portfolio. Apart from being a part of Princeton’s Operations Research and Financial Engineering Department, Mulvey helped found that university’s Bendheim Center for Finance, giving the school – which does not have a business school – an “interdisciplinary center for support of activities in finance,” offering a Master’s degree and undergraduate certificate in finance.
And even though Mulvey has been an academic for nearly three decades, he has a wealth of experience on the practical side of the financial sector. His resume includes work with former PIMCO parent Pacific Mutual, American Express and actuarial firm Towers Perrin‘s Tillinghast unit.
More recently, Mulvey has had a hand in Rydex Investments’ Essential Portfolio Theory as author of the white paper. EPT seeks to apply certain institutional strategies to individual portfolios, updating Henry Markowitz‘s Modern Portfolio Theory by encouraging “true” diversification, using, to the extent possible, alternatives, alternatives to market capitalization weighting and rules-based rebalancing, among other tenets.
Mulvey spoke with InstitutionalInvestor.com‘s Jonathan Shazar about EPT, the perils of ignoring his advice and 1,000 future scenarios. This is an excerpt from their conversation.
InstitutionalInvestor.com: What is financial optimization?
John Mulvey: Optimization involves the search for the best compromise among competing goals. An investor might accept greater risk today, for example, in order to achieve higher performance over time.
II.com: Who is it for?
JM: I work with large institutional investors, such as a multi-strategy hedge fund, reinsurance and insurance companies and pension trusts. Optimization techniques can be applied to global financial institutions, not only in a centralized manner, as you would see in most pension plans, but also in decentralized settings, where independent companies are owned by a financial conglomerate.
II.com: What are those techniques? What does financial optimization entail?
JM: I’ve spent almost 40 years working on these issues. We focus on scenarios that harm the organization, while searching for a compromise strategy. Instead of assuming constant correlations, we develop a scenario analysis of the enterprise; we project how individual divisions, assets and liabilities will fare under the scenarios.
In the Towers Perrin/Tillinghast case, we employ 500 to over 1,000 scenarios that represent paths for the future economic environment and the return of asset categories. It’s an anticipatory approach. By its nature, the world is uncertain, so we analyze assets and liabilities across multiple scenarios to see what will happen to the organization – pension plan or insurance company. If interest rates rise across the world, in one scenario, what is the impact on each division, and by implication, what is the impact on the full organization?
II.com: And for individual investors?
JM: Individuals must address events that threaten their financial health. Risk is not a general concept; it’s specific to the individual investor. The notion that short-term volatility automatically translates into risk is invalid for many individuals and institutions.
II.com: I guess that’s where Essential Portfolio Theory comes in. How does it work?
JM: It takes successful techniques from the institutional world and brings those ideas, as best we can, to individuals. For example, pension plans link asset decisions to their liabilities. New instruments and technologies give individual investors greater abilities to tailor investment strategies to their unique circumstances. Investors in tax deferred accounts, especially, get an opportunity to rebalance their portfolio. We consider rebalancing decisions within our asset-liability framework.
II.com: EPT emphasizes rebalancing. Why is it so important?
JM: Rebalancing is an option that allows investors to achieve additional gain, vis-à-vis a static portfolio of buy-and-hold. The long-term investor takes advantage of the natural dynamics of markets.
A simple example is the Equal Weight Standard & Poor’s 500. A cap-weighted S&P 500 is equivalent to a buy and hold strategy to some degree. Rebalancing the portfolio ought to achieve higher returns over time, and equal weight is one type of rebalancing. Rebalancing allows you to confront the decisions of risk and reward each period in a consistent fashion.
II.com: You’ve mentioned pension funds using financial optimization, and a lot of private pension funds are going belly-up lately. How has a scenario-based system helped those funds that have used it?
JM: Check out the book by Rusty Olson called The School of Hard Knocks, describing Kodak’s use of the Towers Perrin system to help them weather the 2000-2003 period. They looked at multiple scenarios under differing assumptions, and they realized that zero-coupon government bonds would provide protection under economic downturns. Accordingly, they increased allocation to those assets. The anticipatory analysis will often pinpoint assets and strategies which can protect the organization, and that’s the essential part. It’s difficult to do this in a purely judgmental manner; you need judgment plus anticipatory models. Investors suffered because of their inability to hold assets that protected them under stressful conditions.
Of course, we can’t guarantee that companies performing asset-liability studies will be sensible in the end. They may argue that their traders can beat a government bond index by active management to achieve a risk premium. Pension administrators would say: We can achieve 50 or 75 basis points higher than the government index, so why do we want a government index?
II.com: I’ll bet a lot of them regret that decision.
JM: Well, yes. Some of them are trying to catch up by moving into alternative investments.
Certain institutions have benefited greatly by the expanding set of opportunities, such leading universities – Harvard, Yale, and Princeton. Recently, Stanford University surged ahead partially due to its investments in alternative assets. Private investments offer more opportunities due to a number of factors, including barrier to entry. Even Princeton has difficulty. Andy Golden, who manages the Princeton endowment, gave a lecture in my class on Princeton’s approach; he mentioned that Princeton cannot invest in some of the top venture capital opportunities, because they didn’t start as early as Yale University.
II.com: Much of the hedge fund world had a year to forget in 2005. Does that make investment in p.e. and VC that much more important?
JM: The hedge fund world has a wide range of opportunities. Average performance is a poor indicator of the performance of individual hedge funds. Some hedge funds have achieved 20% to over 40% for many years, so it’s dangerous to assume that the average return is representative of the opportunities in the hedge fund world.