*As seen on Forbes.

James Tobin showed us all how to mix the super-efficient equity portfolio with the zero risk asset to form a portfolio that would meet anybody’s need for liquidity or risk tolerance. Tobin defined the super-efficient portfolio as having highest return per unit of risk possible, but he didn’t have any idea what that portfolio might look like.  The answer eluded economists for quite some time.


The first really good crack at the problem happened when Harry Markowitz asked Bill Sharpe to simplify the math for Modern Portfolio Theory (MPT). As Sharpe considered the problem it occurred to him that if MPT were true one of the implications was that stock prices and performance would be directly related to risk or volatility relative to the market. This was the critical insight that led to Capital Asset Pricing Model (CAP-M).

Under CAP-M equity investors should expect to receive a risk free return, plus market return, plus or minus the variation of the volatility of the stock relative to the entire market (Beta). The entire market had a Beta of one.

It followed that the super-efficient portfolio was the market. This perception in turn led to the demand for and creation of index funds. At the time, the market was pretty much only the S&P 500, but gradually the definition expanded to the entire global market.

In the event that a portfolio’s performance due to superior skill and cunning of the manager through stock selection or market timing exceeded the market return, the amount of the excess return was attributed to “Alpha”.

CAP-M was such a great theory that along with Markowitz, Sharpe was awarded the Nobel Prize in Economics. Just a nagging little problem: Over time though the data didn’t match the theory. Folks that invested in small stocks or value stocks seemed to get outsized returns relative to what should have been expected. An entire cottage industry of economics sprang up to justify the variations. Everything from moon cycles to expansion of the money supply were proposed to reconcile the discrepancies. But, nothing explained the outliers satisfactorily.

Alpha rears its ugly head

Meanwhile, managers that invested in small and value stocks claimed to have generated Alpha when in fact they just happened to have picked a sweet spot in the market. Then they usually failed to deliver all that they should have while they generated additional risk, cost and tax inefficiencies through their efforts. Somehow, against all the mountain of evidence, the idea of Alpha refuses to die.

Multi Factor Models replace CAP-M

CAP-M is a single factor explanation of market returns and pricing. It assumes that investors only consider volatility when they make investment decisions. But, it turns out that other risk factors influence stock pricing. Those include size, value and profitability. When those are factored in to the performance of a manager, Alpha almost invariably disappears and reliably turns negative.

Overweighting your portfolio to favor stocks small, value, or more profitable companies opens up the possibility of beating the global market indexes without making decisions on individual securities or market timing. You can just let a computer sort on the risk factors to create a portfolio.

Each of these factors beings its own set of risks to the portfolio. For instance, small companies may underperform the broad market for years at a time. So, the portfolio won’t always “beat the market”. There is no free lunch and small companies are not an arbitrage opportunity. You can’t sell large companies short to use the proceeds to buy small companies and make a steady risk free profit.

Investors Face Choices

Under CAP-M investors just had to buy the global equity portfolio and forget it. They could expect to get the market return. That was a simple clean and elegant solution, and it’s not a bad one. However, now investors that want more must decide how much if any to overweight their portfolios to capture extra performance. So, instead of a single sharp point on the risk-reward spectrum, investors now must pick a point in a hazy cloud. No one can know exactly what the dominant portfolio will be. We can all meet in a bar fifty years from now to see exactly the right point was.  Until then the search for the superefficient portfolio remains elusive.

Even though we expect additional long term return over the global market index, simply sorting on risk factors can’t be called Alpha. We are not selecting individual securities or deciding whether we want to be in or out of the market. Once you understand the real risk factors that shape the market, skill and cunning through “active management” doesn’t add value.

Smart Beta

Recently marketing folks coined the term “Smart Beta” to describe a more academic and rigorous approach to portfolio selection that overweights on those risk factors. It sounds sexy, but it’s hardly new. Investment advisors that have followed the research as it evolved in financial economics have been generating long term additional returns for over 20 years. The story isn’t over. New research is constantly improving our insight in to what drives returns in the market. So, our ability to deliver additional returns without significantly higher risk will continue to improve.