Modern Portfolio Theory and Multi Asset
Investment – Did Markowitz get it wrong?
Presentation by David Smith Chartered FSCI Head of Portfolio
Management CI, Kleinwort Benson Jersey
The Basis of the Theory

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize a portfolios expected return for a
given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the
proportions of various assets

MPT models an asset's return as a normally distributed function, defines risk as the standard deviation of return of that
asset, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted
combination of the assets' returns

MPT seeks to reduce the total variance of the portfolio return. Which expressed in mathematical terms is the standard
deviation of the investment squared

This theory gives rise to the concept of Multi Asset Investment which through the allocation to various non correlated
asset classes provide the optimum risk return profile to match the investors objectives
© Kleinwort Benson, 0411 2631, page 2
Strategic Asset Allocation Study
Security selection
4.6%
Other 2.1%

Gary Brinson, (founder of Brinson Partners, Inc.), Brian
Singer and Gilbert Beebower published a groundbreaking
study in the Financial Analysts Journal, May – June 1991

Bottom Line: According to this study, asset
allocation – America’s most admired but least practiced
investment discipline – accounts for 91.5% of the variation
in portfolio returns
Market timing 1.8%
Asset allocation policy
91.5%
Conclusion: Strategic asset allocation can reduce portfolio risk while stabilising returns
Source: Brinson et al (1991). Notes: Brinson, G.P., Hood, L.R. and beebower, G.L., “Determinants of Portfolio Performance II: An Update”, Financial Analysts Journal, May / June 1991.
PB 29/03/11
© Kleinwort Benson, 0411 2631, page 3
Why strategic asset allocation is key

Two decades of academic studies have shown that strategic asset allocation (SAA) accounts for most of the variation in
portfolio returns

Tactical asset allocation (TAA) has less impact on portfolio returns – this includes, stock or investment selection,
market-timing and the ability for a manager to over / underweight
Brinson (1986)1
Brinson (1991)
Ibbotson (Mutual)2
Ibbotson (Pension)
% return due to SAA
94%
92%
81%
88%
% return due to TAA
6%
8%
19%
12%
1. Brinson, G., Hood, R., Beebower, G. “Determinants of portfolio performance II: An update”. Financial Analyst Journal. Jul / Aug 1991.
2. Ibbotson R. and Kaplan P. “Does asset allocation policy explain 40, 90 or 100% of Performance“. Financial Analyst Journal. Jan / Feb 2000.
© Kleinwort Benson, 0411 2631, page 4
SAA in practice

David Swensen, Yale University’s Chief Investment Officer, is responsible for more than US$16.7 billion in endowment
assets

For the last 20 years Yale Endowment generated returns of 13.1% per annum, a record unequalled among institutional
investors

Yale’s portfolio is structured using strategic asset allocation

Risk needs to be allocated in a way that maximises expected returns

Risk is necessary to drive returns

Appetite for risk is, more often than not, set by each investor

The purpose of risk management is not to minimise risk but rather to monitor the levels and sources of risk to make sure
they match expectations

By spreading the investment among different assets, we trade the “best” returns we would get if we timed the market
perfectly for stability and risk management
Source: Yale university Investments office, 2010 annual report.
© Kleinwort Benson, 0411 2631, page 5
Asset class diversification
Year v
Rank
1
2
3
4
5
6
7
8
9
10
11
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Emerging /
Emerging /
Asia Pacific ex
Emerging /
UK
Emerging /
Commodities UK real estate Commodities
Japan equity
Private equity
other equity
other equity
Japan equity
other equity
Government
other equity
49.8%
3.9%
32.1%
63.1%
39.4%
44.7%
33.2%
37.8%
13.6%
85.3%
36.3%
UK
UK
Asia Pacific ex
Emerging /
Emerging /
Asia Pacific ex
Asia Pacific ex
UK real estate
UK real estate
Hedge funds
UK real estate
Government
Government
Japan equity
other equity
other equity
Japan equity
Japan equity
18.6%
3.1%
9.5%
48.7%
23.9%
43.7%
31.9%
37.2%
-21.4%
73.7%
19.1%
UK
Asia Pacific ex
Emerging /
Hedge funds UK real estate Private equity
Private equity Europe equity Commodities UK real estate Private equity
Government
Japan equity
other equity
9.0%
2.8%
1.2%
35.4%
23.0%
35.3%
22.0%
32.7%
-24.1%
35.6%
18.9%
Asia Pacific ex
Asia Pacific ex
Hedge funds
Hedge funds
US equity
Commodities Europe equity UK real estate Hedge funds
UK equity
UK equity
Japan equity
Japan equity
4.1%
-2.4%
1.0%
29.1%
17.3%
28.3%
21.7%
10.3%
-29.9%
30.1%
18.4%
Emerging /
Asia Pacific ex
Europe equity
Japan equity
Private equity Commodities
UK equity
US equity
US equity
Europe equity
US equity
other equity
Japan equity
-0.8%
-10.2%
-5.1%
23.0%
15.6%
25.6%
16.8%
6.0%
-37.1%
29.8%
15.4%
Emerging /
UK equity
US equity
UK equity
Europe equity UK real estate
US equity
Europe equity Europe equity
US equity
UK equity
other equity
-5.9%
-12.0%
-7.1%
20.9%
13.6%
24.0%
15.3%
5.9%
-42.2%
27.1%
14.5%
US equity
UK equity
Japan equity
Commodities
UK equity
UK equity
Private equity
UK equity
Japan equity
Commodities
-12.5%
Emerging /
other equity
-18.8%
-13.3%
-18.6%
20.7%
12.8%
11.3%
-42.5%
13.5%
9.6%
Europe equity
UK equity
Europe equity
Japan equity
Commodities
UK real estate
Commodities
-17.8%
-22.7%
19.5%
10.9%
13.5%
Japan equity
Japan equity
US equity
UK real estate
US equity
Hedge funds
-19.7%
-18.8%
-22.7%
18.8%
10.7%
22.0%
Asia Pacific ex
Japan equity
21.0%
UK
Government
8.0%
Private equity
Private equity
Private equity
Hedge funds
Hedge funds
Hedge funds
-25.6%
11.6%
UK
Government
2.1%
6.9%
UK
Government
6.6%
7.5%
7.3%
UK
Government
0.5%
US equity
Commodities
Japan equity
5.7%
-15.1%
-10.1%
-29.3%
-22.6%
Asia Pacific ex
Commodities
Japan equity
-30.0%
-31.9%
Europe equity
-32.0%
Europe equity
10.4%
5.3%
UK
Government
4.7%
Japan equity
UK real estate
-6.7%
-46.5%
Asia Pacific ex
Japan equity
-51.6%
11.5%
9.0%
UK
Government
7.3%
Private equity
Private equity
Japan equity
Hedge funds
-7.1%
-53.0%
Emerging /
other equity
-53.7%
9.3%
UK
Government
-0.8%
5.5%
Hedge funds

No one asset class tends to
outperform others consistently

Asset classes have fluctuating returns
and correlations over different time
horizons

It is therefore critical to diversify and
adapt your portfolio to the dynamic
investment climate
Japan equity
0.7%
Source: Lipper hindsight, HFR Website and Kleinwort Benson
Note: Historical performance data from Lipper Hindsight & Hedge Fund Research Website. All data quoted in local currency from Dec 1989 to Dec 2010.
PB 29/03/11
© Kleinwort Benson, page 6
Correlation of asset classes

Asset classes with a lower correlation to one another will have more risk diversification benefits within a portfolio than those
with a higher correlation to one another
UK
Emerging
Corporate
Government
Market
bonds
bonds
bonds
UK
inflation
linked
bonds
UK equity US equity
Europe
equity
Japan
equity
Asia
Emerging /
Pacific ex
other
Japan
equity
equity
Hedge
funds
UK real
estate
UK private
Commodities
equity
UK Government bonds
1.00
-
-
-
-
-
-
-
-
-
-
-
-
-
Corporate bonds
-0.00
1.00
-
-
-
-
-
-
-
-
-
-
-
-
Emerging Market bonds
0.13
0.49
1.00
-
-
-
-
-
-
-
-
-
-
-
UK inflation linked bonds
0.68
0.28
0.18
1.00
-
-
-
-
-
-
-
-
-
-
UK equity
0.18
0.54
0.43
0.30
1.00
-
-
-
-
-
-
-
-
-
US equity
0.04
0.59
0.50
0.18
0.77
1.00
-
-
-
-
-
-
-
-
Europe equity
0.02
0.55
0.44
0.17
0.84
0.78
1.00
-
-
-
-
-
-
-
Japan equity
-0.06
0.41
0.40
0.08
0.50
0.47
0.54
1.00
-
-
-
-
-
-
Asia Pacific ex Japan equity
0.04
0.57
0.53
0.19
0.67
0.68
0.65
0.51
1.00
-
-
-
-
-
Emerging / other equity
-0.02
0.56
0.75
0.13
0.63
0.64
0.64
0.50
0.72
1.00
-
-
-
-
Hedge funds
0.00
0.47
0.45
0.18
0.51
0.52
0.56
0.41
0.58
0.64
1.00
-
-
-
UK real estate
0.07
0.57
0.34
0.29
0.60
0.56
0.57
0.35
0.49
0.47
0.37
1.00
-
-
UK private equity
-0.00
0.60
0.37
0.22
0.69
0.67
0.69
0.50
0.62
0.57
0.57
0.63
1.00
-
Commodities
-0.13
0.18
0.09
0.09
0.12
0.13
0.05
0.20
0.23
0.25
0.36
0.13
0.22
1.00
Source: Lipper hindsight, HFR Website and Kleinwort Benson. Index data is taken from Dec 1989 to Feb 2011 total returns. Past performance is indicative and no guarantee of future returns
PB 29/03/11
© Kleinwort Benson, 0411 2631, page 7
“In theory it will work in practice but in practice theory
never works.” Anon.

With these factors in mind the question then has to be asked, “What went wrong during the events of 2008 and can we be
assured this will not happen again?”

2008 in itself and the performance of markets will hopefully not be repeated

The credit fuelled asset bubble that was the US housing market burst and the fallout was felt globally by the financial
institutions that had bankrolled it and investors which had purchased structured investments based on it

As the casualty toll rose events came to a head with the collapse of a major US financial institution and the possible
collapse of the entire global financial system

As fear spread correlation between asset classes, geographic regions and stocks rose with widespread panic selling driving
down asset prices
© Kleinwort Benson, 0411 2631, page 8
“In theory it will work in practice but in practice theory
never works.” Anon.

Hedge Funds previously thought of as the beneficiaries of such a market found themselves subject to sanctions and
constrictions on trading strategies from which they may have benefited

Together with this they were hit by a raft of redemptions as investors fled to quality

This forced selling of assets only led to the momentum of the downward spiral

At the height of the crisis US T bills were trading at a premium. Effectively investors were paying for the “privilege” of lending
to the US government

So with Multi Asset portfolios not able to protect as much as investors had perhaps expected was the theory debunked?
© Kleinwort Benson, 0411 2631, page 9
What are the other options?

Whilst it is true to say that Multi Asset portfolios and funds suffered drawdowns in 2008 the level of these was dependant on
amongst other things the underlying risk profile of the strategy itself, the style of management and the overall strategic
focus. In fact there were many and varied factors which could have been taken into account

In addition to this Multi Asset strategies were not the only ones to suffer. All in all few managers came out of the events of
2008 unscathed

So in the absence of the adoption of a well diversified portfolio spread across different asset classes what other options
could we adopt?
1)
Concentrated Stock Selection
2)
Concentrated Asset Selection
3)
Market Timing
© Kleinwort Benson, 0411 2631, page 10
Concentrated Stock Selection
1.
Buy a couple of FTSE100 Stocks?
If an investor had bought the best performing stock in the FTSE 100 on January 1st 2008 by December 2008 they would
have made over 59% on a total return basis.
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 11
Concentrated Stock Selection
1.
Buy a couple of FTSE100 Stocks?
If however they had picked the worst performing stock in the FTSE 100 over the same time period they would have on a
total return basis lost over 85%.
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 12
Concentrated Stock Selection
1.
Buy a couple of FTSE100 Stocks?
During 2008 the Index itself on a total return basis lost just over 28%.
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 13
Concentrated Stock Selection
1.
Buy a couple of FTSE100 Stocks?
The best performing stock in the FTSE 100 for 2010 had an annualised standard deviation of returns of over 71% with the
worst performing stock having an annualised standard deviation of returns of over 98%.
The index itself however had an annualised standard deviation of returns of just over 37%.
This would then appear to point towards the thinking that picking the right stocks pays off well, but pick the wrong stocks
and you will suffer. Additionally the volatility of individual stocks can be considerably higher than that of a diversified group.
© Kleinwort Benson, 0411 2631, page 14
Concentrated Asset Selection
2.
Hold just one asset class?
The following three graphs show the Total Return enjoyed by equities and bonds over the past 10, 5 and 2 years using the
FTSE All World Total Return GBP Index as a proxy for Equities and the FTSE Actuaries All Stocks Total Return Index as a
proxy for Government Bonds.
© Kleinwort Benson, 0411 2631, page 15
Jan 2000 to Dec 2010
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 16
Jan 2000 to Dec 2010

During this period the clear winner is Bonds with a total return of 82.25% versus just 30.09% for Equities

So investors would have been better holding Bonds over the past 10 years, but what if they had commenced investment 5
years ago?
© Kleinwort Benson, 0411 2631, page 17
Jan 2005 to Dec 2010
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 18
Jan 2005 to Dec 2010

This time the table are reversed with Bonds returning only 36.75% total return and Equities returning 65.22% total return

Finally looking at the past 2 years alone
© Kleinwort Benson, 0411 2631, page 19
Jan 2008 to Dec 2010
Source: Bloomberg. All data quoted in GBP.
© Kleinwort Benson, 0411 2631, page 20
Jan 2008 to Dec 2010

Over the past 2 years recovering from the lows felt during 2008 Equities have returned 39.11% total return versus only
5.95% total return for Bonds

Does this then mean that Equities are the clear winner over Bonds or vice versa?

Before such a conclusion can be reached, if ever, other factors have to be taken into account such as:
1.
2.
3.
Risk as measured by standard deviation of returns of the underlying asset class
Income requirements and reinvestment risk
Capital Growth requirements and investment time horizon
© Kleinwort Benson, 0411 2631, page 21
Individual Investors Choice

As you would imagine the answers to these questions will be individual to each and every investor and their personal
circumstances

It is therefore highly unlikely any investor would choose full investment into one sole asset class to the exclusion of another

Each asset class brings its own attributes to the blend which is put together to create an investors model or strategy

The asset classes included in this blend when using a Multi Asset approach is merely wider than that of a Traditional
approach, (Equities, Bonds and Cash), aiming to produce comparible returns within a less volatile environment
© Kleinwort Benson, 0411 2631, page 22
What are the other options?
3.
Disinvest to cash on market down turns?

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost
in corrections themselves” - Peter Lynch

“Only liars manage to always be out during bad times and in during good times” - Bernard Baruch

“It must be apparent to intelligent investors that if anyone possessed the ability to do so [forecast the immediate trend of
stock prices] consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his
stock market guesses to the general public” - David L. Babson & Company

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two"
- Warren Buffet
© Kleinwort Benson, 0411 2631, page 23
What are the other options?
“Maybe I should disinvest to cash until thing settle down or get better?”
“Maybe I should move into Gold or Bonds or ??????”

Markets create wealth and it is often human behavioural responses that tend to destroy wealth

Cumulative inflation together with fees and costs will over time erode wealth

Markets react to information and it is not possible to consistently forecast both the flow of information and the reaction of
markets

As an investment manager helping clients maintain their investment strategy in line with their objectives is key
© Kleinwort Benson, 0411 2631, page 24
Market timing – FTSE 100
12.00%
 Many investors believe that timing a market is possible
however the graph to the left shows the dramatic effects of
mis-timing a market. The second bar shows the return
when only the 50 highest returning days of the FTSE 100
were missed.
10.0%
10.00%
8.00%
 The FTSE 100 has returned an annualised 10.0% p.a.
6.00%
between December 1983 to February 2011. This period
contains 6,868 trading days, were an investor to be out of
the market for the 50 best trading days (i.e. 0.7% of the
period) then the return is dramatically reduced to -2.4% p.a.
4.00%
2.00%
 It is during periods of unforeseen stress that some of the
0.00%
greatest single day returns can be seen alongside some
severe losses, as demonstrated in the table below
-2.00%
-2.4%
-4.00%
FTSE 100 CR since 1984
FTSE 100 CR since 1984 ex 50 best trading
days
Source: Annualised historical performance data from Bloomberg. All data quoted in local
currency from Dec 1983 to Feb 2011.
1
2
3
4
5
6
7
8
9
10
24/11/2008
19/09/2008
13/10/2008
29/10/2008
21/10/1987
08/12/2008
13/03/2003
10/04/1992
20/10/2008
17/10/2008
9.8%
8.8%
8.3%
8.1%
7.9%
6.2%
6.1%
5.6%
5.4%
5.2%
20/10/1987
19/10/1987
10/10/2008
06/10/2008
15/10/2008
26/10/1987
11/09/2001
06/11/2008
22/10/1987
21/01/2008
-12.2%
-10.8%
-8.8%
-7.9%
-7.2%
-6.2%
-5.7%
-5.7%
-5.7%
-5.5%
PB 29/03/11
© Kleinwort Benson, 0411 2631, page 25
Market timing – S&P 500
12.00%
 Many investors believe that timing a market is possible
10.9%
however the graph to the left shows the dramatic effects of
mis-timing a market. The second bar shows the return
when only the 100 highest returning days of the S&P 500
were missed.
10.00%
 The S&P 500 has returned an annualised 10.9% p.a.
8.00%
between December 1949 to February 2011. This period
contains 15,292 trading days, were an investor to be out of
the market for the 100 best trading days (i.e. 0.7% of the
period) then the return is dramatically reduced to 0.6% p.a.
6.00%
 It is during periods of unforeseen stress that some of the
4.00%
greatest single day returns can be seen alongside some
severe losses, as demonstrated in the table below
2.00%
0.6%
0.00%
S&P 500 CR since 1950
S&P 500 CR since 1950 ex 100 best trading
days
Source: Annualised historical performance data from Bloomberg. All data quoted in local
currency from Dec 1949 to Feb 2011.
1
2
3
4
5
6
7
8
9
10
13/10/2008
28/10/2008
21/10/1987
23/03/2009
13/11/2008
24/11/2008
10/03/2009
21/11/2008
24/07/2002
30/09/2008
11.6%
10.8%
9.1%
7.1%
6.9%
6.5%
6.4%
6.3%
5.7%
5.4%
19/10/1987
15/10/2008
01/12/2008
29/09/2008
26/10/1987
09/10/2008
27/10/1997
31/08/1998
08/01/1988
20/11/2008
-20.5%
-9.0%
-8.9%
-8.8%
-8.3%
-7.6%
-6.9%
-6.8%
-6.8%
-6.7%
PB 29/03/11
© Kleinwort Benson, 0411 2631, page 26
So where to turn?

Based on the options available Modern Portfolio Theory and the concept of risk reduction through diversification appears to
offer the greatest possibility of less volatile returns over the longer term

However in order for this to be accepted we as investors need to:

Refocus on longer term objectives over short term wins

Accept that whilst a well diversified portfolio will aim to reduce losses on market downturns, there will inevitably be a
degree of losses

Focus our clients on what meets there needs and objectives and not on others

In order to make this possible we need to have a process for matching each clients needs and objectives to a suitable
strategy

We need to then maintain regular contact with our clients ensuring the strategy remains suitable in ever changing times
© Kleinwort Benson, 0411 2631, page 27
How can this be achieved?

As stated throughout this presentation suitability of strategy and the ongoing communication between client and manager
ensuring its relevance is key

Risk profiling questionnaires used throughout the industry offer an opportunity for the investor to separate heart and mind
issues if used correctly

The results produced can then be used as a basis for conversation between manager and client to fine tune and finalise the
chosen strategy

Over the longer term a portfolio managed in line with a clients changing requirements should be able to produce the desired
returns within a suitable risk profile
© Kleinwort Benson, 0411 2631, page 28
Company details and investment risk warnings
Kleinwort Benson is the brand name of Kleinwort Benson (Channel Islands) Investment Management Limited which is a
company incorporated in Jersey with the company number 13270. Registered Office Kleinwort Benson House Wests Centre St
Helier Jersey JE4 8PQ. It is regulated by the Guernsey Financial Services Commission to conduct investment business and is
also regulated by the Jersey Financial Services Commission. Telephone calls may be recorded.
Kleinwort Benson is the brand name for Kleinwort Benson (Channel Islands) Limited which is regulated by the Guernsey
Financial Services Commission. Kleinwort Benson is a participant in the Guernsey Banking Deposit Compensation Scheme. The
Scheme offers protection for ‘qualifying deposits’ up to £50,000.00 subject to certain limitations. The maximum total amount of
compensation is capped at £100,000,000.00 in any 5 year period. Full details are available on the Scheme’s website
www.dcs.gg or on request. Kleinwort Benson is also authorised and regulated by the UK Financial Services Authority in respect
of UK regulated mortgage activities, and its firm reference number is 310344. Registered Office Dorey Court Admiral Park St
Peter Port Guernsey GY1 3BG Telephone number +44 (0) 1481 727111. Telephone calls may be recorded.
The value of investments and income from them may fall as well as rise and the investor may not get back the amount invested.
Past performance does not guarantee future performance. Fluctuations in exchange rate may cause the value of foreign
investments to fall or rise. The levels and bases of, and relief from taxation may change. The value of tax relief will depend on
individual circumstances. This document is for information purposes only and does not constitute the provision of Investment
advice or management services.
© Kleinwort Benson, 0411 2631, page 29