CIOs Assess the Legacy of Harry Markowitz

Economist Harry Markowitz, the pioneering father of modern portfolio theory, died last week at age 95. His insights won him the Nobel Prize. They also informed a host of financial professionals on how to construct investments, by harnessing diversification to get the best returns relative to the amount of risk they take.

Six chief investment officers weighed in on Markowitz and his contribution to the world of finance. Charles Van Vleet, CIO of pension investments at Textron, for instance, lauded MPT as the “bedrock to all investing.” But he noted that the theory was far from infallible, saying, “I have also learned the downside of being over diversified.”

“The theory starts with the seemingly basic yet profound insight that portfolio managers should consider their investments as an integrated portfolio,” said Jase Auby, CIO of the Texas Teachers’ Retirement System. “No model is perfect, but MPT provides an essential baseline for all portfolio managers. Mr. Markowitz’ legacy is immense.”

Marcus Frampton, CIO of the Alaska Permanent Fund, recalled that Markowitz had great humility. “He quipped that, in spite of developing the world’s most sophisticated asset allocation theory, he places his own investable assets simply at 50% bonds and 50% stocks,” Frampton said.

Another lesson from the celebrated economist that Frampton learned was that “world events can play out in unexpected ways. Sometimes an investor should calculate the optimal amount of leverage in a portfolio, but then go unlevered and hold a little extra cash. This is because markets can play out in ways not captured by models.”

MPT is based on the efficient market hypothesis, which holds that investors behave rationally and are well-informed. Markowitz taught the investing community about “the importance of viewing risk at the portfolio level and the practical steps to use for volatilities and correlations,” said Matt Clark, state investment officer for the South Dakota Investment Council.

But there are limits to MPT, Clark said: “Markets can depart at times from those assumed behavior patterns. Most impactful may be the tendency toward fat adverse tails for stocks and tendency for correlations to increase during a crisis.”

MPT got criticized in the wake of the 2008-09 financial crisis because it proved not to be the umbrella some were convinced it would be. In fairness, when almost every asset class except Treasuries was tanking, diversification cannot work as advertised.

Mark Baumgartner, CIO of the Carnegie Corporation of New York, agreed that MPT does not ensure that investors’ assumptions are correct. Nonetheless, he added, “the beauty of MPT is that it can be used not just for beta portfolio design, but also alpha portfolio design. Given today’s lower real return expectations, there is necessarily an increased focus on not just finding alpha, but also consistency of alpha generation.”

On a similar note, Britt Harris, CEO and president of the University of Texas/Texas A&M University Investment Management Company, pointed out that “data has not proven to be as effective a measure of expected outcomes of various individual stocks, or portfolios.”

That said, Markowitz’s theory led to the creation of index funds, which have been a great boon, Harris added. “We may have forgotten that before his time the world did not get the concept that there were interactions between stocks that actually lowered the total aggregated risks of your total holdings, so a collection of stocks could provide your target.”

Summing up, Baumgartner declared, “RIP Harry Markowitz. Glad we had him with us for 95 years. His influence will live on.”