Why Hasn't the Investment Industry Moved Beyond the Mean-Variance Framework?

Jim Kaffen

Tue Sep 17 2024

The world of finance is often at the forefront of technological innovation, but when it comes to investment strategy, the industry lags behind. Despite significant advancements in portfolio theory, many investment practices remain anchored in outdated models.

The mean-variance framework, introduced by Harry Markowitz in the 1950s, continues to dominate, even though Post-Modern Portfolio Theory (PMPT), behavioral finance, and downside risk optimization offer more robust and flexible solutions.

The Origins of Modern Portfolio Theory

In the 1950s, Harry Markowitz revolutionized investment thinking with his development of Modern Portfolio Theory (MPT). This framework introduced the concept of diversification as a way to minimize risk while maximizing returns. Markowitz’s mean-variance model became the cornerstone of portfolio management by quantifying risk (through variance) and expected returns. The basic principle: balancing risk and reward through diversification.

The CAPM Era

The 1960s saw the introduction of the Capital Asset Pricing Model (CAPM) by Bill Sharpe, along with the Sharpe Ratio. CAPM provided a way to measure risk-adjusted returns based on the relationship between the performance of an individual asset and the overall market (beta). The Sharpe Ratio, on the other hand, was designed to measure the return per unit of risk. Both models had a tremendous impact on portfolio construction, but they weren’t without limitations.

From Downside Risk to Minimal Acceptable Return

In the 1970s, Peter Fishburn introduced a new perspective on risk management with his focus on downside risk—the risk of losing money or not achieving a certain level of return. His concept of Minimal Acceptable Return (MAR) underscored the idea that investors should be primarily concerned with returns that fall below a specific threshold, as opposed to the broader volatility of returns. This more practical understanding of risk resonated with investors who were far more worried about losing money than achieving slightly lower-than-expected gains.

Sortino's Desired Target Return: A Similar Focus

In the 1980s, Frank Sortino expanded on Fishburn’s ideas by introducing the Desired Target Return (DTR). While Fishburn’s MAR focused on setting a minimum acceptable return, Sortino’s work led to the development of the Sortino Ratio, which measures performance by penalizing only downside risk—returns that fall short of the minimum acceptable return, not relative to a desired target. This distinction is critical, as the Upside Potential Ratio, which Sortino also developed, specifically measures performance relative to a target, penalizing only returns below the desired target.

The Role of Behavioral Finance

The late 1990s and early 2000s saw the rise of Behavioral Finance, led by Daniel Kahneman and Amos Tversky, who identified systematic biases in how investors make decisions. Their research revealed that real-world investors often behave irrationally, deviating from the assumptions of rational behavior in traditional models like CAPM and MPT. This line of thought highlighted how emotions and cognitive biases impact financial decisions, challenging the notion that investors always act in their best financial interest.

At the same time, academics like Eugene Fama provided empirical evidence that CAPM often failed to hold up under scrutiny. Even Bill Sharpe, one of the architects of CAPM, eventually distanced himself from the model, stating that both CAPM and the mean-variance framework were ill-suited for individual investors.

Why Haven’t These Innovations Been More Widely Adopted?

Despite these advances in theory, the investment industry remains slow to embrace these new approaches. One clear example of the reluctance to change comes from Bill Sharpe and Frank Sortino themselves. In a 2005 Wall Street Journal article, both expressed disappointment with how their names had become attached to their respective ratios, particularly criticizing the misuse of these metrics by hedge funds. They pointed out how these ratios, originally designed to measure risk accurately, had been distorted into marketing tools, misrepresenting the actual risk involved in portfolios.

This example illustrates how deeply ingrained traditional metrics are in both the financial world and academic institutions. Even though Sharpe and Sortino disavowed these tools, their ratios continue to be taught in universities as fundamental components of finance education. The reliance on outdated models not only misrepresents modern portfolio risks but also perpetuates a culture resistant to adopting more relevant frameworks like PMPT or downside risk optimization. Furthermore, the industry's dependence on historical data and backtesting, which favor established models like the Sharpe Ratio and CAPM, reinforces this inertia. While these models fail to fully account for the complexities of today’s markets and investor behavior, they remain popular due to their familiarity and simplicity. This institutional inertia makes it difficult for newer, more adaptive strategies, like Target Rate Funds (TRFs), to gain traction, even though they offer more customized and realistic approaches to managing risk and return.

The Future of Investment Theory: Post-Modern Portfolio Theory and Target Rate Funds

While the investment industry has been slow to adopt newer approaches, tools and insights from Post-Modern Portfolio Theory are becoming increasingly relevant. PMPT shifts the focus from overall volatility to downside risk, aligning investment strategies with real-world concerns about losing money. By prioritizing desired target returns and minimal acceptable returns, PMPT offers a more nuanced approach to managing portfolios in an unpredictable market.

Real-World Impact: Comparing Target Date Funds to Target Rate Funds

A key example of the industry’s reluctance to change is the ongoing dominance of Target Date Funds (TDFs) over more flexible alternatives like Target Rate Funds (TRFs). TDFs follow a one-size-fits-all approach, where asset allocation is adjusted solely based on an investor’s age. As investors approach retirement, TDFs mechanically shift toward safer, less volatile assets such as bonds, assuming this reduction in risk is universally beneficial.

However, this strategy overlooks individual variations in financial goals and specific return objectives. What happens if an investor needs a higher rate of return to meet future liabilities, such as retirement income? Or what if market conditions change and the default glide path no longer makes sense?

In contrast, Target Rate Funds (TRFs) focus on the rate of return needed to meet future financial obligations, rather than relying on age-based allocation. TRFs define a target return for each participant based on their unique circumstances and adjust the portfolio accordingly. This approach offers greater flexibility and adaptability, aligning investments with each investor’s personal goals rather than imposing a one-size-fits-all strategy.

TRFs aim to achieve a return above a defined threshold, akin to Sortino’s Desired Target Return, and provide a more tailored solution. By removing the rigidity of TDFs, TRFs can better respond to changes in market conditions and individual needs, giving investors more control over their retirement planning.

A Stronger Call to Action: Moving Forward

The investment industry needs to embrace these newer, more adaptive strategies to meet the real-world needs of today’s investors. By focusing on achieving specific financial goals and managing downside risk, advisors and plan sponsors can create more personalized, effective portfolios. The rise of tools like Target Rate Funds and downside risk frameworks like PMPT offer the potential for a better, more flexible approach to managing risk in an uncertain world. It’s time for both the financial industry and academic institutions to move beyond outdated models and embrace solutions that truly serve the needs of investors. The adoption of frameworks like PMPT and the widespread implementation of Target Rate Funds could mark the beginning of a new era of investment optimization, one that prioritizes personal goals over abstract risk measures.