MPT and the Fiduciary Wars – Part 3

This post deals with arguments against MPT from the legal side of the debate, in particular with respect to Fiduciary responsibility. 

As discussed in previous posts, the issue of Fiduciary responsibility is being pushed to the fore in retail financial services and the issue of what is and what is not prudent investment practise to satisfy fiduciary type obligations is important.  My viewpoint for the last 2 decades has been that MPT ignores key market risks and that these key market risks do need to be managed. 

My thread in this respect has been helped by a blog post on the Psy-Fi blog which alerted me to the existence of a growing  body of criticism from the legal profession.

The following provides excerpts from two articlesreports, the first a 2010 article, “Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine” by Stewart E Stark in the Cornell Law review:

“….trust law’s implementation of modern portfolio theory appears to have left many trust beneficiaries worse off than if trust law had retained traditional principles of trust investing. This fact suggests that it is time to reassess the recent “revolution” in trust law doctrine.”

“….decline in the value of a broad spectrum of investments does not cast doubt on the wisdom of diversification; recent market experience, however, does suggest rethinking the principle that every investment, in the right context, is a prudent investment.

“..modern trust law implemented no legal rules to provide trustees with appropriate incentives to consider market risks. …by abrogating the duty not to delegate, modern trust law has reduced the incentive for trustees to make careful investment decisions, and this reduced incentive undoubtedly has resulted in uncompensated losses for trust beneficiaries.

the changes to trust law, in the aggregate, effectively reduced the liability of banks—institutions with significant political power—and other trustees for breaches of the duty of care with respect to trust investments.

….Academics embraced the lessons of modern portfolio theory and sought to integrate those decisions into trust law.  Practicing lawyers, banks, and trust companies, all eager to generate higher returns for their trust clients, supported the changes

…. the first premise—that riskier investments will generate a higher expected return—depends more on investor psychology than it does on mathematical formulae or inevitable economic truth. ….The second premise— that diversification reduces risk without reducing expected return—is mathematically true assuming there exists a reliable mechanism for ascertaining the risk and expected return of individual investments…. Although many proponents of modern portfolio theory relied on market price as a mechanism for identifying risk and return, recent scholarship and market gyrations undermine the hypothesis that market price accurately reflects risk or expected return. Finally, the third premise—that a portfolio optimally deals with market risk by adjusting the percentage of high-risk, high-return investments—remains a sensible strategy in the face of market uncertainty.

“.. How, ….., do investors measure the risk of market decline? Modern portfolio theory tends to minimize that risk. Although it informs of the risks associated with common stocks, it also emphasizes that the expected return on common stocks typically will be higher than the expected return on other investments…

..what is critical is that a key assumption….that investments in common stock pay a risk premium that reflects market risk—is dependent on ECMH. In the absence of ECMH, it would be possible for investors as a group to underestimate the risks of market decline…“

“…Modern portfolio theory started with a mathematical insight that remains as true today…..The mathematics, however, say nothing about how to determine risk and expected return.  Modern portfolio theory dealt with that gap by looking at historical data that revealed larger returns on equity investments and by explaining that data with the intuitively appealing idea that investors are generally risk averse and therefore demand a “risk premium” for investing in stocks. As a result, equities were essential for a portfolio that sought to maximize return; the only reason to temper investment in equities would be to reduce market risk. Moreover, the ECMH essentially made it unnecessary to focus on which equities belong in a trust portfolio because market prices would reflect the best available information about future return.

Recent scholarship and recent events suggest that faith in both the superior performance of equities and in the ECMH has been excessive. ….. Finally, the notion that any investment can be a prudent trust investment requires Herculean faith in the ECMH—faith not borne out by market data.

…to the extent that modern portfolio theory underestimates particular investment risks, the doctrinal structure magnifies the risk to trust beneficiaries ..

The reformers who drafted the Restatement (Third) and the UPIA took on a serious problem that badly needed a solution. The solution that they devised relied on and promoted academic theories with impeccable pedigrees; the theories generated Nobel Prizes for their proponents. The solution appeared to promise better returns and less risk for trust beneficiaries who were the principal victims of the straitjacket placed on trustees by traditional trust doctrine. And the solution— coincidentally or not—appeared to benefit banks and trust companies by reducing their exposure to liability for imprudent investments.

Unfortunately, like many of the investments made by trustees under the new regime, the doctrinal solution proved too good to be true. The academic theory needs revision, the beneficiaries need additional protection, and even the banks may discover that the new regime leaves them exposed to liability..

And the following are excerpts from a report from the  Hauser Center for Non-profit Organizations at Harvard University: “THE TIME HAS COME FOR A SUSTAINABLE
THEORY OF FIDUCIARY DUTY IN INVESTMENT”

However, in spite of this seemingly crystal clear responsibility of the trustee, as well as three decades of adherence to what was considered the scientific law of investment, MPT, the meaning of the concept of fiduciary duty in the investment context is in ferment today. 

….[m]any assumptions underlying the way economists, policymakers, and regulators have traditionally viewed pension systems no longer apply.  Given the link between financial theory and fiduciary duty in investment, if the critics of MPT are correct, the foundation for the operative definition of fiduciary duty in investment must be re-examined as well.

The mighty revolution in investment theory, Modern Portfolio Theory, which was seemingly an ―end of history‖ moment, has proven to be far from perfect in practice

Lydenberg further argues that the chase for more and more return, the holy grail of MPT, has led to ―increasing systemic risk through the increase of the supply of, and demand for, risky products.‖

MPT has given trustees, financial advisors, and their lawyers a false sense of security.  Peter L. Bernstein, the foremost chronicler of the investment theory of MPT has written, ―Perhaps the most remarkable feature of these ideas is the indomitable power of their influence on investment decisions, even though the theories failed to survive a batter of empirical testing.   As John Bogle has argued, slavish adherence to the theory is inappropriate as the touchstone in any analysis of the proper exercise by a trustee of fiduciary duty in investment:

Finally, the argument can be made that adherence to MPT does more harm than good and, in fact, betrays beneficiaries.  In light of the enormity of the bank bailout of 2008 and the continuing large compensation paid to bank executives, academics have begun to argue that investing in such banks is a violation of the fiduciary duty of a pension fund trustee.

….blind adherence to MPT no longer appears to be sufficient in fulfilling a trustee‘s true investment duties to beneficiaries in the real world of the marketplace.  Current conceptions of fiduciary duty need to reflect this reality.

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