Investment industry ‘must embrace new theory of investing’

An overreliance on modern portfolio theory, which assumes away the effect investors can have on the market, has led to asset managers not adequately fulfilling their purpose, according to a new paper.

Managers are ignoring “systems-level risks to investing, such as government actions, diversity issues and climate change”, authors Jim Hawley and Jon Lukomnik wrote in the report, ‘The Purpose of Asset Management’, published today.

Lukomnik is a former deputy comptroller for the City of New York and investment adviser to the city’s pension funds, while Hawley is head of applied research at TruValue Labs and a professor emeritus at St Mary’s College of California.

The asset management industry had a twin purpose, the authors said: to provide a reasonable, risk-adjusted return to clients by efficiently allocating capital to improve the economy and society.

According to Hawley and Lukomnik, however, the way in which the industry had adopted modern portfolio theory (MPT) – both consciously and inadvertently – combined with the industry’s current business models had created a tendency for asset managers to pursue strategies that diverged from this purpose.

There were misalignments between the incentives of the industry and the investors who were its ultimate clients, they said: complexity, multiple and opaque fees, and short-termism.

“Our clear recommendation is to unify this potential to affect real world risk under a common banner that could be called ‘systems-level investing’.”

Jon Lukomnik

The main remedy, according to the authors, was for asset managers to focus on changing the systemic risk/return of the market. This was not about a wholesale abandoning of modern portfolio theory, they said, but about adding “systems-level” considerations to security selection and portfolio construction.

“Using a systems-based approach alongside modern portfolio theory has the power to evolve the asset management industry and realign its interests with its customers,” said Lukomnik. “Our clear recommendation is to unify this potential to affect real-world risk under a common banner that could be called ‘systems-level investing’. This will benefit not only the performance of the industry and its customers, but society more generally.”

The paper is the second in a series about the purpose of finance, facilitated by Pension Insurance Corporation (PIC), an insurer of defined benefit pension funds.

Tracy Blackwell, CEO of PIC, said: “We believe profoundly in the importance of the finance industry. But asset management, like other parts of the finance industry, must demonstrate that it fulfils a clear purpose. As Hawley and Lukomnik argue, for that to happen, we have work to do.”

Industry reactions 

In addition to arguing for a new intellectual paradigm for investing, the authors also recommended measures such as a simple fee statement – equivalent to the nutrition labels on prepared food – and a ‘do-no-harm’ pledge similar to the medical profession’s Hippocratic Oath.

According to PIC, the paper generated “considerable interest”. A summary of stakeholder responses said they suggested “profound differences in perspective as to the problems within the asset management industry”.

It relayed that “the industry challenges the argument that modern portfolio theory contributes to short termism and is responsible for… reliance on index benchmark approaches”. 

Short-termism was not inherent to MPT but was mostly driven by regulation, behavioural biases, and other factors, according to PIC’s summary. For further progress to be made on some aspects, asset managers felt asset owners needed to lead.

Andreas Utermann, CEO of Allianz Global Investors, was one of the most critical of Hawley and Lukomnik: “The argument that MPT is (mostly) to blame for many of the ills that befall our industry, and in particular that it drives short termism and is responsible for (over-)reliance on index benchmark approaches, is tenuous,” he wrote.

His and other stakeholders’ responses were included in the paper. 

It was “not clear” how MPT contributed to systemic factors being neglected in investment decision-making, added Utermann, and the paper “leaves the reader wondering what ‘systems theory’ is meant to be, other than the implications that it is somehow ‘superior’ to MPT”.

“The idea that one can improve ‘beta returns’ is the most fanciful of all,” wrote Utermann. “Directing capital towards certain sectors/activities may have great societal (system) benefits but will likely lead to lower beta returns in those sectors as capital is ‘wasted’ from an efficient capital market perspective.”

Gavin Ralston, head of official institutions at Schroders, questioned whether it was up to asset managers to move away from a model based on modern portfolio theory.

“We would welcome the industry moving further in this direction, but it needs to be led by the asset owners,” he said.

‘The Purpose of Asset Management’ can be found here .