Morningstar has a rich history of publishing research aimed at helping institutional allocators make better informed decisions, and that sits very well alongside the firm’s better-known services targeted at wealth managers and individuals.
Thomas Idzorek, Chief Investment Officer for Morningstar’s Retirement division, which provides planning and investment management services, talked through his thinking on the current state of capital markets from his last 20 years as an institutional practitioner and author of academic financial research at Morningstar.
Notably, he examines why it’s time for new investment and asset-allocation paradigms to be embraced, including moving beyond the limitations of the much-used Capital Asset Pricing Model from the 1960s. He explains why he thinks the current push into private markets should be viewed cautiously , but also presents an opportunity for market experts to make a real difference to investment outcomes.
His full interview is below.
How Morningstar research serves institutional investors
Institutional Investor: Many people are aware of Morningstar’s tools for individual investors and advisors, but are less familiar with Morningstar’s services for institutional investors whose needs can be much more complex. I know that you are associated with cutting edge research. Can you start by telling us a bit about your role and history at Morningstar?
Thomas Idzorek: Absolutely. I’m the Chief Investment Officer for Morningstar Retirement. My primary responsibility is overseeing our retirement managed accounts services, which provide ongoing, personalized planning and investment management services to over 2 million individuals.
I came to Morningstar via their acquisition of Ibbotson Associates back in 2006, which was founded by Yale professor Roger Ibbotson. I’m far from neutral on this, but I’d say Ibbotson Associates was the leading authority on asset allocation and capital market assumptions. The Ibbotson study on stocks, bonds, bills and inflation (SBBI) is famous amongst advisors and institutional investors. That historical time series data started in 1926, so we are on the cusp of the 100-year anniversary. This data meant that, for the first time, people were able to look at the long-term history of those major asset classes. This changed the way allocators made decisions, helping to bring Harry Markowitz’s Modern Portfolio Theory into use by a large number of institutional investors. This enabled investors to start making asset allocation decisions based on the distribution of returns, the variability of returns, and how the returns of different asset classes relate to each other.
A new paradigm for asset allocation
Institutional Investor: There was an interesting interview of Nobel Prize Winner Gene Fama by the Financial Times’ Robin Wigglesworth in 2024. Fama says, “A lot of big paradigms came in the 1960s and ’70s. But there’s no new options pricing theory, capital asset pricing model or efficient market hypothesis. People are now basically working on the details. But it’s time for a big jump forward.” What’s your take?
Thomas Idzorek: I remember reading that, and it evoked a number of emotions and thoughts.
At times, I too feel as if there haven’t been any recent major breakthroughs in terms of financial economic theory. Even when there are advances in theory, they don’t seem to catch on with practitioners. A notable exception is behavioral economics, which of course led to multiple Nobel prizes and certainly has changed the profession. (I note that Morningstar has a fantastic Behavioral Science team led by Ryan Murphy.)
Returning to Fama’s points, I’d like to think the work we do is at the forefront of advancing financial economic theory with the hope of changing how practitioners practice. Here, I’m thinking about the work that I’ve done with my former Morningstar colleague Paul Kaplan on combining lifecycle finance lifecycle models (sometimes called the lifecycle hypothesis) with Modern Portfolio Theory or mean-variance optimization. These are two of the most important theories in financial economics.
The lifecycle hypothesis tells investors how to allocate assets through time. It has been advanced by numerous Nobel Prize winners, including Milton Friedman, Franco Modigliani, Paul Samuelson, and others. Modern Portfolio Theory is primarily the work of another Nobel Prize winner, Harry Markowitz. It tells investors how to allocate at a specific moment in time. These two ideas have co-existed for 75 years, but have never been integrated in a meaningful way until our 2024 CFA Institute Research Foundation book: Lifetime Financial Advice: A Personalized Optimal Multilevel Approach.
In addition to this, I’d like to think that the work that I’ve done with Paul and Roger on the Popularity Asset Pricing Model (PAPM), could and should replace the Capital Asset Pricing Model (CAPM) of the 1960s.
From one perspective, it looks like we are just working on the details per Fama, but I think those details seem meaningful.
Asset Allocation: Moving from CAPM to PAPM
Institutional Investor: Sometimes working on the details can lead to a big jump ahead in practice. Can you elaborate on PAPM?
Thomas Idzorek: In many finance textbooks, the CAPM is a critical chapter with behavioral finance covered separately. In another book also published by the CFA Institute Research Foundation, Popularity: A Bridge between Classical and Behavioral Finance, we introduced the PAPM.
The PAPM improves upon the CAPM by removing two very unrealistic assumptions. First, in the PAPM, investors can have different opinions on expected returns. Second, unlike the CAPM, the PAPM assumes that investors can have a wide variety of non-financial preferences that influence how investors form portfolios, all of which drive asset prices.
Institutional Investor: Can you provide an example?
Thomas Idzorek: We think of securities as bundles of characteristics. Some characteristics are liked or loved by many investors, such as liquidity, safety, great ratings, high growth, powerful brands, etc. Other characteristics are disliked or shunned by many investors, such as downside risk, taxation, sin or vice industries, polluters, etc. If the characteristics of a security are popular with investors, all else equal, that security will be expensive (popular) and the expected returns will be lower. In this manner, the PAPM helps identify which characteristics will likely produce long-term return premiums. We wrote an article on likely long term return premia for the 50th anniversary edition of the Journal of Portfolio Management (“Domesticating the Factor Zoo with Economic Theory”).
The growing, and changing, role of alternative investments
Institutional Investor: Today’s institutional and retail portfolios are more complex than they were twenty years ago, particularly when you factor in private markets and other alternative investments. Does the conventional approach to asset allocation need to change to accommodate these new realities?
Thomas Idzorek: In alternatives, I think it's imperative to distinguish between an alternative asset class where there's an inherent non-skill-based systematic return, and a skill-based manager attempting to add value.
For setting asset allocation policy with alternative asset classes, we have developed an expanded form of mean-variance optimization that we call ‘Net Worth Optimization,’ which incorporates financial assets, funding sources, and the liability – we think it is more holistic and robust than what some people refer to as a ‘total portfolio approach.’.
For determining how much to allocate to managers, including alternative managers, we have developed alpha-tracking error optimization methods that incorporate additional investor preferences under PAPM.
A critical characteristic of alternative investments is liquidity, and different investors have different needs or preferences for liquidity.
We’ve observed that investors tend to overestimate time horizons, overestimate risk tolerance & risk capacity, and underestimate their need for liquidity. Net worth optimization can help institutional investors with all three of these challenges. There’s a good example in the United States, if you're a university endowment or foundation at this moment where grant funding has diminished and operating costs are increasing, you're thinking, we might need to tap into our portfolio right away, i.e. your time horizon is short and your need for liquidity is high.
Institutional Investor: One of the biggest industry changes today is alternative assets entering the retail/wealth space. As a leading authority on asset allocations, how are you thinking about this? Is the wealth and retail industry equipped to handle the illiquidity and complexity?
Thomas Idzorek: We’ve conducted in depth asset allocation studies looking at commodities, precious metals, direct real estate, infrastructure, venture capital, private equities, and thought deeply about how investors incorporate all that into a strategic asset allocation,
It’s fair to say retail investors may not fully understand those investment classes, so it’s wonderful to have expertise in the different alternative investments to help those investors make an informed decision around asset allocation and investment specifics. It is definitely helpful when a professional is assisting that investor.
But how important are those alternative assets for creating a diversified portfolio? It depends. Sometimes it helps; sometimes it’s not that important. If we go back to Modern Portfolio Theory: when you take your core, conventional asset classes and build an efficient frontier, you get one set of risk and return trade-offs. As you expand that opportunity set to include more asset classes including alternatives, you can shift the risk/return trade-off to be more favorable. But as you introduce more and more distinct asset classes – a 10th, 11th, 12th asset class, for example – the marginal benefit can be quite small.
