Modern Portfolio Theory Ignores Crucial Systemic Risk, Author Says

The world—and the stock market—was in a very different place when economist Harry Markowitz won a Nobel Prize for his Modern Portfolio Theory nearly 60 years ago. His pioneering work, which quickly became canon, posits that investors could build an efficient, diversified, and risk-appropriate portfolio by considering how each investment’s risk and return profile affects the portfolio as a whole.

Decades later, the risks are very different, and a new paper challenges the limitations of Modern Portfolio Theory (MPT). Jon Lukomnik runs Sinclair Capital, a boutique consultancy focused on corporate governance. He formerly served as investment adviser for New York City’s pension fund, and has repeatedly been named one of the 100 most influential people in U.S. corporate governance by the National Association of Corporate Directors. Lukomnik and James P. Hawley, senior ESG advisor at Factset, recently published Moving Beyond Modern Portfolio Theory, which argues that MPT, with its narrow-minded focus on diversification, subjects investors to systemic risks. We caught up with Lukomnik to discuss the problems with MPT. Read the following edited excerpts for more.

Barron’s: Where are we with Modern Portfolio Theory?

Lukomnik: Everyone thinks of MPT as diversification, but we trace it back to Miguel de Cervantes in 1690 writing in Don Quixote to not put all your eggs in one basket. Harry Markowitz gave us the math and rationale behind diversification. A host of enabling theories have sprung up around MPT, which allow the math to work without taking into account the complexities of the real world. Efficient market hypothesis, in its strong version, says that all knowledge is known and acted upon rationally by the market, and even in its weak version, that the market will tend towards rationality based on knowledge. “Random Walk” theory says you can’t predict things at the next toss of the coin. All of them are intuitive, logical, and self-contained, but they’re wrong. Daniel Kahneman won a Nobel Prize for proving we’re not rational: In fact, we’re loss-averse. If the market were random walking, we wouldn’t have contagion. And you can’t be loss-averse unless you know what price you paid for a stock. Momentum strategies are path dependent. MPT isn’t the be-all and end-all.

Your book provides yet another critique.

MPT says diversification works on idiosyncratic risk: Company A outperforms Company B. But it doesn’t work on systemic risk, which is risk to a real-world system, such as climate change, or systematic risk, which is non-diversifiable risk in the capital markets, often caused by a systemic risk in the real world.

So MPT provides us a tool to deal with what matters least. An obvious example was the global financial crisis, where people tried to diversify poorly underwritten loans but weren’t dealing with the real-world issue that underwriting standards had declined. Eventually the risk metastasizes, and we’ve got a global financial crisis. So what we say is, look, you can’t diversify systematic risks. If you go back to the real world and try to deal with climate change, or with the growth of antimicrobial resistant superbugs, you can mitigate the real-world risks to the environmental, social, and financial systems that cause systematic non-diversifiable risk to the capital markets. Our book is a finance book that ultimately winds up with looking at the reasons that we should care about climate change or gender diversity or any of those issues from a risk and return perspective. You can create huge value by decreasing risk in the real world that affects the capital markets, because the capital markets re-rate, and you can create huge wealth. And then you can apply MPT to a higher-performing capital market.


Tell about what you call beta activism.

People are aware of traditional activism—when Trian Fund Management or Bill Ackman goes after a company that’s poorly performing and tries to turn it around. Beta activism tries to deal with systematic risk in the real world. It uses stewardship, proxy voting, organization and policy inputs to try to deal with real world systemic risks that people are afraid will spill over into the capital markets. So what various [investors] do about climate change—it’s not targeting an individual firm, it’s beta activism. Trillions of dollars of assets under management signed the Principles for Responsible Investing. Climate Action 100 has the largest investors in the world dealing with climate change: Those investors have been very active in pushing governments to adopt climate change mitigation strategies. When we first started the book, we thought we were going to detail all the beta activist campaigns. The number has exploded. For example, Domini Impact Investments works on deforestation. There was a very successful intervention on mining safety led by the AP funds of Sweden after the Vale mine collapse that cut $19 billion out from their market cap.

What does the asset management industry need to do?

Two things. Pay attention to the health of the market generally, not just how well your portfolio did against the market. Second, professionalize things other than trading and portfolio construction. I’ll give you an example. New York City has something called Proxy Access, a way of nominating directors for public companies in the U.S. Three economists, including a Securities and Exchange Commission economist, found that [this system] added 53 basis points of excess return a year. We glorify traders and portfolio managers. Yet we do not pay stewardship people, nor do we give them the attention.

Environmental, social, and governance investing has become a force in the financial markets. Why is it so important?


There are different strains of ESG—socially responsible investing, ESG integration, sustainability, impact investing. Directionally, and in terms of force and magnitude, it is this massive, somewhat undisciplined force rolling in one direction. In the last three to five years, there’s a recognition that value and risk are created in the real world, and they’re priced into the capital markets. If I were a private equity investor, or owned a small business, I’d be concerned about creating value and minimizing risk by dealing with these real world issues. Why, as the public market investor, have we arbitrarily sealed them off and somehow said that they’re not legitimate investing? From a societal view, reuniting capital markets with the real-world,, with intentionality, is attractive.

What’s your advice to individual investors and advisors that want to protect against systemic risk?

Pay attention to what your asset manager is doing. Many publish sustainability or impact or stewardship reports. How real are they? What issues do you care about? This is not simple. Sometimes environmental or social issues collide. Carbon tax without any mitigation is great for the environment, but it’s really bad for income inequality. And communicate. I have been on a mutual fund board for 15 years. Do you know how many letters I’ve gotten from end-use investors in that time? Zero. Let your asset manager know if you disagree with something they’re doing. And if you’re an advisor, be abreast of the issue. If you’re an individual, ask your advisor what they are doing about ESG issues. What strain of ESG is the advisor following? How involved do they get?

Finally, what’s in your personal portfolio?

I actually pick individual stocks myself. I own a lot of municipal bonds. People forget about them but they have infrastructure and green aspects to them. I own

Invesco Water Resources ETF




Cisco Systems




Henry Schein

(HSIC), among others.

Thanks, Jon.

Write to Leslie P. Norton at [email protected]