The Limits of Investment Theory

Publication info: Dow Jones Institutional News ; New York [New York]14 Apr 2018.

ProQuest document link

FULL TEXT
by Steven D. Bleiberg

More than 40 years ago, Tom Wolfe gently skewered the multidecade ascendancy of art theory in The Painted
Word, a book triggered by the following statement in a 1974 New York Times review of an exhibition of realist
painters by the art critic Hilton Kramer: "Realism does not lack its partisans, but it does rather conspicuously lack a
persuasive theory....[T]o lack a persuasive theory is to lack something crucial..." In other words (Wolfe's words),
"without a theory, I can't see a painting."
Studying finance in business school the year after the book's publication, I was struck by the similarities between
what Wolfe described in the world of art and what was then happening in the world of finance. Modern portfolio
theory, or MPT -- a body of work developed in the 1950s and '60s that asserts we can quantify the relationship
between risk and return, and concludes that active investment management is fruitless because markets
efficiently price in all relevant information -- was beginning to dominate investment thinking. And yet, investing
isn't a theoretical exercise, any more than viewing a work of art.
Investors' devotion to modern portfolio theory has only strengthened over time, with the rise of passive investing
and the struggles of active managers. Many investors now think it's a waste of time to try to understand anything
about the companies in which they invest. MPT tells them to just buy the index and ignore company details. But
the pre-MPT view of the world still holds valuable insights. To illustrate, let's consider three questions, and contrast
the pre- and post-MPT answers.
What is a stock? Fifty years ago, the answer was simple: Shares represent ownership of a business. Then MPT
came along and told us that individual stocks were really just a statistical cog in a portfolio, of interest only for
their expected return and volatility. The main thing that mattered was a stock's level of "systematic risk," or how its
behavior over time related to the behavior of the overall market, a relationship captured by a statistic called beta.
The "stock specific" risk of an individual stock could be diversified away by holding many stocks. Later, MPT broke
this systematic risk down into multiple factor risks beyond the original beta -- factors such as company size,
valuation, growth, leverage, and more. Today, when looking back at a stock's return, we attribute that performance
to its factor exposures, and show how the various "factor returns" drove the stock.
But this is getting things precisely backward. As an investor from 1968 could tell us, stocks do well or poorly
because the underlying businesses do well or poorly. After the fact, we can use stock returns to derive a set of
factor returns, but it is a mistake to view the factor returns as if they have an independent existence, driving the
returns of individual stocks as if in a vacuum.
Why have stocks performed better than bonds? Modern investment analysis focuses on something called the
"equity risk premium," or ERP, the margin by which stocks are expected to outperform bonds. To read most
analyses of the ERP, you would think it is a mysterious force of nature, like gravity. But there is no mystery. Our
1968 investor knew that every company, regardless of industry, is trying to do the same thing: take a dollar of
capital and, net of the cost of that capital, turn it into something more than a dollar. That is by definition how a
company grows the value of its business.
Over time, companies have been able to do just that, and the long-term appreciation in the stock market reflects

PDF GENERATED BY SEARCH.PROQUEST.COM Page 1 of 3

(and has been well correlated with) the return on invested capital that businesses have earned. Bonds, by their
nature, don't offer the kind of upside participation in the value of a business that equities do. The fact that equities
are more volatile than bonds is just a function of the range of outcomes that each type of security offers.
What is the role of an index? Fifty years ago, an index was just a measure of overall market performance. But under
MPT, an index represents the optimal portfolio. To reach that conclusion, one has to assume that we all agree on
how to define and measure risk, which is unrealistic. The logic of indexing ignores the fact that not all businesses
are worth owning, and simply says "buy them all."
What's more, the use of indexing has had unintended consequences on the behavior of asset owners and asset
managers; it changes the focus of both away from "which businesses are good businesses worth owning?" to
"how do we look relative to the index?" Focusing on the second question makes it less likely that you will
successfully answer the first.
MPT is an elegant body of theory that has contributed greatly to our understanding of investing. But it is a model
of the way the world works, not a description of the real world. The relationship between risk and return isn't rigidly
quantifiable; it might be better thought of as another of the many "trade-offs" that economists study.
Ultimately, equity investors are buying into actual businesses and would be better served by seeking to understand
them: Do they have competitive advantages that enable them to earn good returns on invested capital? Are those
advantages sustainable?
Thinking about stocks this way -- as real businesses, rather than aggregates of return and volatility statistics -- is
something many investors have lost sight of since the rise of MPT. In a world where so many people aren't even
bothering to try to understand those businesses, the opportunities for those who make the effort are even greater.
--
Steven D. Bleiberg is a portfolio manager at Epoch Investment Partners in New York. This essay is adapted from
"The Limits of Theory," a white paper published this month by Epoch and available at eipny.com.

To subscribe to Barron's, visit http://www.barrons.com/subscribe

(END)
April 14, 2018 06:00 ET (10:00 GMT)

DETAILS

Subject: Theory; Investments; Stock exchanges; Volatility

Location: New York

People: Wolfe, Tom

Company / organization: Name: New York Times Co; NAICS: 511110, 511120, 515112, 515120

Publication title: Dow Jones Institutional News; New York

Publication year: 2018

Publication date: Apr 14, 2018

Publisher: Dow Jones &Company Inc

Place of publication: New York

PDF GENERATED BY SEARCH.PROQUEST.COM Page 2 of 3

 Country of publication: United States, New York

Publication subject: Business And Economics

Source type: Wire Feeds

Language of publication: English

Document type: News

ProQuest document ID: 2024919063

Document URL: https://search.proquest.com/docview/2024919063?accountid=31259

Copyright: Copyright Dow Jones &Company Inc Apr 14, 2018

Last updated: 2018-04-15

Database: ProQuest Central

Database copyright  2019 ProQuest LLC. All rights reserved.

Terms and Conditions Contact ProQuest

PDF GENERATED BY SEARCH.PROQUEST.COM Page 3 of 3