Attack on MPT and Soft Dollars


New York – A new research paper finds that modern portfolio theory has little correlation with actual asset management practices, and condemns what it sees as excess trading by managers to generate commissions to pay for research.

In “Economists’ Hubris – The Case of Equity Asset Management” released the end of April, Shahin Shojai, global head of strategic research at Capco in London, and George Feiger, chief executive of Contango Capital Advisors, along Rajesh Kumar, an academic at the Institute of Management Technology, evaluate academic contributions to asset management and find them wanting.

“In reality we find that few, if any, of the portfolio management companies even try to look for the efficient portfolios in the way that theory tells us. If one looks at the institutional asset management market we find that most use different methodologies to describe a mechanism that is nothing more than a glorified stock picking process. They can call it a top-down or bottom-up asset allocation policy, or whatever impressive name that their marketing departments can generate, but at the end of the day, most portfolio managers rely on their own gut instincts and the recommendations of sell-side analysts.”

The authors assert that performance evaluation methodologies based on modern portfolio theory are unable to compare managers’ performances in a way that is useful to investors.  Risk adjusted returns are meaningless, and used by mediocre managers to justify mediocre returns.  “If one accepts that argument, then all that matters is how well a manager performs and investors should not be accused of stupidity for using raw returns data for deciding who manages their assets.”

How would they evaluate manager performances?  “[T]he best way to assess the performance of a manager is to compare them against themselves. This idea, called inertia, was suggested to one of the authors during a meeting with Lord Myners a number of years back, when he had finished compiling his report on the U.K. asset management industry [Myners (2001)]. According to Lord Myners, inertia basically compared an asset manager‘s end of year performance against making absolutely no changes to the portfolio during that year.”

One of the benefits of using inertia to measure performance would be the reduction of ‘excessive trading’: “By incorporating the inertia concept, portfolio managers who are unable to generate genuine alphas might be prevented from using trading revenues to make up for performance related income shortfalls, since they would find that they are also paying for them indirectly. Finally, it might put an end to the use of excessive trades in return for soft commissions.”

“The fact that managers know that they can only benefit from trading excessively means that they might end up making trades that they might otherwise have not had they also been forced to pay part of that fee themselves. This situation becomes exacerbated for managers who are simply unable to produce genuine alpha.”

The paper attacks the current model of manager compensation, and the use of soft dollar commissions.  “The current model, with the serious accusations that many of these trades are made for soft commissions, per the Myners report, or to get access to IPOs, or free research whose benefit is highly questionable, cannot be allowed to continue. Investors must be protected and if academic analyses cannot help them do that then may be its time to reassess how money managers are compensated, and a simple tool would be to compare them to themselves. In this case, one really does not need to use risk measures that even academics find to be of little benefit.”

This new paper is the fourth in the “Economists’ Hubris” series. Previous articles examined whether academic contributions in the areas of mergers and acquisitions, asset pricing and enterprise-wide risk management systems were of practical use.


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