Link: https://www.barrons.com/articles/the-li ... 1523636363The Limits of Modern Portfolio Theory by Steven D. Bleiberg in Barron's
It now dominates investing—and as a result, many equity investors no longer understand the companies they own.
I found this to be an interesting way of rethinking the role of indexes over time. What does it mean that we are now focusing on performance of an index, or relative to an index, or based on factors of large groups of stocks, rather than the underlying businesses?
Basically, we thought about stocks as shares of businesses.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" ... and beta.
So by focusing on performance as a function of the factors, not a business, we maybe lose sight of the real picture.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.
More and more, in addition to the index tracking the market, the market (or at least: its participants) tracks the index.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.”
Now, as a passive investor, I'm not going to go about asking what businesses are worth owning, just interested in others' thoughts.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"