Is Modern Portfolio Theory Valid in Today’s Economy?

The ideal portfolio for any investor would be low risk with a high return. Unfortunately, investing isn’t that simple.

The best known solution to the risk/reward equation is modern portfolio theory (MPT). This theory suggests that a variety of investments, when combined, bring greater returns without increasing risk.  MTP was introduced in 1952, by Harry Markowitz, and made the assumption that investors did not want to take risks. While innate investor risk aversion remains, some question whether the MPT remains a valid theory in today’s market.

The basis for the MPT is portfolio diversification.  MPT has been questioned recently due to seemingly repetitive financial crises.  There are those who believe that due to the unknown factors in today’s uncertain economy, a new theory needs to be developed to handle the current investment environment.

However, there are many factors that make the MPT as valid today as it was in 1952, according to Paul Pfleiderer, in his article Is Modern Portfolio Theory Dead? Come On.  The basic fact of investing is that investors are rewarded for taking higher risks. However, not all risk is rewarded, such as risks that can be diversified away by holding bundles of investments. When an investor holds large quantities of high risk stock, they face diminished return given their risk. However, a portfolio that is diversified is based on several holdings with risk. The fluctuation of one stock does not have the same affect. MPT focuses on building a diversified portfolio, which works well in an uncertain environment, such as today’s economy.

Accredited investors and institutions are increasingly further diversifying into alternative assets, including private companies, hedge funds, venture capital, and real assets. Alternative assets generally demonstrate very low correlations with traditional assets. These assets are also generally less liquid. Investors who include alternative assets in their portfolio seek long-term wealth appreciation without the regular fluctuations of the public stock market.

Interested in adding alternative assets into your investment portfolio? Sign up for Grolio now to be notified when we launch later this summer.

Why Invest in Alternative Assets?

When thinking about their investment portfolios, most investors think of traditional assets – stocks, bonds, and mutual funds. The last decade has proven that traditional assets are not as safe or sure as once thought. Although seemingly separate and independent, returns for these asset classes are too highly correlated; as one experienced difficulties, so too did the others. Investors found that their portfolios were not as diversified as they had thought.

This is where alternative investing comes in. Alternative investments cover a wide range of instruments with two things in common; they are not traditional and their performance is not linked to the returns of traditional assets. As Investopedia notes, “Alternative assets come in many varieties, but a common thread is their low correlation coefficients with both equities and fixed income.” A low correlation means that when the traditional investments are experiencing difficulties it will not affect or have very little effect on your alternative investments.

Hence the increase in interest in, and dollars flowing into, alternative assets. They provide a “measurable degree of independence from systematic market risk factors.” Instead of having the appearance of diversity, your portfolio will in fact offer a free lunch – both higher returns and lower risk.

Historically, investing in alternative assets was generally limited to endowments, pension funds, and family offices managing investments for a wealthy family. Only these groups had the manpower and experience to identify appropriate investments for their portfolios. Minimum investments were also out of reach for all but institutions and the highest net worth investors.

Grofolio’s mission is to provide greater access access to alternative investments. Grofolio makes it easier and more efficient for all accredited investors to find, search, sort, and filter alternative investments to identify the best fits for their portfolio. Grofolio also offers the chance to interact with other potential investors.

Contact us to learn more about how you can benefit from alternative investing and true portfolio diversification.

Asset Correlation Matrix

The table below highlights the importance of portfolio diversification. By diversifying across traditional and alternative asset classes, investors earn a free lunch – higher returns without greater risk.

A correlation of 1.00 means assets move in perfect tandem. When one increases by 10%, so does the other. A 0.00 correlation indicates no return relationship between asset classes.

The correlation matrix below reflects Yale University Investments Office’s assumptions about future interrelationships.

	U.S. Equity	U.S. Bonds	Developed Equity	Emerging Equity	Absolute Return	Private Equity	Real Assets	Cash
U.S. Equity	1.00
U.S. Bonds	0.40	1.00
Developed Equity	0.70	0.25	1.00
Emerging Equity	0.60	0.20	0.75	1.00
Absolute Return	0.30	0.15	0.25	0.20	1.00
Private Equity	0.70	0.15	0.60	0.25	0.20	1.00
Real Assets	0.20	0.20	0.10	0.15	0.15	0.30	1.00
Cash	0.10	0.50	0.00	0.00	0.35	0.00	0.30	1.00

Source: Pioneering Portfolio Management, An Unconventional Approach To Institutional Investment, David F. Swensen, 2009

Regulation D Rule 506 – A Primer

In the United States, selling securities generally requires registering with the United States Securities and Exchange Commission (SEC), in accordance with the Securities Act of 1933. There are qualifications that exempt a fundraiser from having to register with the SEC, which are outlined in Regulation D of that Act.

Regulation D Rule 506 provides a “safe harbor” under Section 4(2) of the Securities Act. An issuer using the Rule 506 exemption can raise an unlimited amount of funds. The purpose of this exemption is to aid small businesses and entities that may not be able to afford the registration fees of the SEC. In order to be in compliance with Section 4(2) exemption, the following standards must be upheld:

• The offering must be “private“; the fundraiser cannot use general solicitation, or advertising, to attract potential investors.
• The fundraiser may sell securities to an unlimited number of accredited investors.
• Issuers may also sell securities to up to 35 non-accredited, “sophisticated” investors. These investors must have credentials that enable them to properly evaluate the merits and risks of the potential investment. Due to the incremental effort of ensuring sophistication, many issuers forego the opportunity to sell to non-accredited investors.
• The company or fundraising entity must make itself available to answer questions from prospective buyers.
• The issuer chooses what information they provide to prospective investors, provided it does not violate the antifraud prohibitions of federal securities laws.
• The financial statement requirements for financial documents are the same as for Rule 505 of Regulation D.
• Investors receive “restricted securities” which cannot be resold for at least a year without registering them.

Using a Rule 506 exemption does not completely eliminate documentation to the SEC; a “Form D” – a brief summary of the names and addresses of the company’s owners and stock promoters – must be filed after their first sale closes.  Unlike registered securities, the Form D is a simple document with minimal disclosures.

For accredited investors, Grofolio is your digital market for finding private placements to diversify your portfolio. Please contact us to learn more about Reg D Rule 506 offerings or alternative assets.

A “Free Lunch” – Portfolio Diversification

Diversification is an investment portfolio risk management technique that mixes a broad range of investment securities within a portfolio. The rationale is that an investment portfolio containing different types of assets will yield higher returns and pose a lower risk than any individual investment.

Modern Portfolio Theory pioneer and Nobel Prize in Economics winner Harry Markowitz said “diversification is the only free lunch”. The ‘free lunch’, or benefit achieved without a cost, is higher returns without greater risk. Studies have shown that maintaining a well-diversified portfolio across a broad range of asset classes will provide the most cost-effective level of risk reduction.

Diversification works to smooth out unsystematic risk in a portfolio. As a result, the positive performance of some investments will neutralize the negative performance of others. It’s important to understand, however, that the benefits of portfolio diversification only if the securities in the portfolio are uncorrelated. If investments in a portfolio are too closely correlated, their performance will tend to track each other; a portfolio of highly correlated investments increases risk with no increase in expected return.

A truly diversified portfolio should contain multiple assets classes. Depending on the portfolio’s objectives, diversification could include both traditional assets and alternatives investments.

Traditional Assets:

• Domestic publicly traded equities
• Bonds
• Cash equivalents

Alternative Investments:

• Domestic private equities (e.g., investments in early-stage stage companies, hedge funds, private equity funds)
• Foreign equities
• Real property

In the past mutual funds provided some opportunity for the individual investor to benefit from holding diversified investments. Now, Grofolio makes it easy for all accredited investors can take advantage of the same kinds of investment opportunities previously available only to wealthy individual and institutional investors.

If you’re looking for ways to diversify your portfolio by investing in truly non-correlated alternative asset classes, please contact us today.

The Yale Endowment Model: Once Considered ‘Radical,’ Now Recognized as Ideal For Creating Long-Term Appreciation

Back in the 1980’s, the die was cast for endowments funds to consider a non-traditional approach to managing their assets. It was then that the manager of the Yale endowment, David Swenson, moved over half of the assets he was overseeing into classes of assets considered to be “alternative,” a move that would make him legendary.

In addition to a heavy equity bias, the Yale model included illiquid alternative assets classes, which many at the time viewed as a “radical” investment approach. The Yale endowment’s portfolio included private equity, including venture capital and leveraged buyout participation, hedge funds, and real assets.

How did Mr. Swenson do? Over a twenty year period (July 1987 – June 2007) the Yale endowment registered an annualized return of 15.6 percent, which was 4.8 percent above the return of the Standard & Poor’s 500 stock index during that time period. More importantly, the endowment fund experienced less volatility, and its success spurred public and business pension fund managers to follow the money by embracing what might have been a shunned component to most portfolios — illiquid, alternative asset classes.

Launching soon, Grolio will offer investors pre-vetted alternative investments. Grolio knows the importance of accommodating investors with a sensible selection that matches an array of risk/reward profiles.

Creating long-term wealth appreciation is the goal behind the alternative investment strategy. The Grolio portal is designed to help clients achieve true portfolio diversification, reducing the hot-blooded volatility pervasive in the public markets.

Want to learn more about this long-term investment strategy that can add growth income to your investment portfolio? Contact us today.