Guest Opinion: Burning Down Markowitz’s House
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Dr. Jimmie Lenz
“Watch out, you might get what you’re after” was an anthem sung by a frantic David Byrne in the Talking Heads classic, Burning Down the House. When the song was released in the mid-1980s, Wall Street was also in a frantic mode of its own. In the ensuing decade, it began providing its clients with more technology to better access markets and more products to replicate the strategies being employed by institutional investors. The result? Retail investors — both large and small — embraced new innovations and strategies with a “Do It Yourself” mentality. Fast forward (which was what you did with your Talking Heads cassette) and you have a myriad of passive indices available for investment, robo applications, legions of portfolio tools and content platforms that encourage self-sufficiency in portfolio construction.
Nothing happens in a vacuum, and I believe the today’s market dynamics reflect this DIY mentality. Consider this: Since 2000, the number of listed equities in the US has decreased by 46%, or about 3% on average per year. At the same time, we have seen a surge in correlation of asset performance. If a life in finance has taught me anything, it’s that there are very few coincidences; if that theory holds true, a connection likely exists between these two phenomena.
The serial correlation of assets has a number of implications that investors should be aware of, including the way risk and reward is quantified and assessed. While the decline in the number of listed stocks has been reported in several studies and a number of conclusions have been raised (including concerns around regulatory pressures and cost) the effect of this changing landscape seems to have other implications. Specifically, there has been a proliferation of alternatives beyond single stocks for investors to gain equity exposure. The most obvious of these are mutual funds and exchange traded funds.
To provide some relative perspective on these alternatives, consider that according to the World Bank and ICI, since 1995, the number of mutual funds has increased by about 4% and the number of ETFs has seen a staggering increase of 56%. How has the number of mutual funds and ETFs translated into actual asset growth? Since 2005, the market capitalization of listed equities has risen by 4% per year on average, mutual fund assets have risen by 10%, and ETFs have surged by over 17%.
How have correlations responded during this period of hypergrowth in ETFs and mutual funds? According to a report from Blackrock, from 1980-1989, the correlation of US to international stocks was about .47. More recently, from 2010-2015, this correlation has risen to .88. Perhaps even more telling is the correlation of bonds to stocks. In fact, during the period of 2006 to 2015, Blackrock compared a portfolio of 60% stocks and 40% bonds to one comprised entirely of stocks. In that scenario, the correlation was .99.
Of course, the excessively low interest rates that followed from the financial crisis may be a factor in rising correlations. But it’s important to remember that while low rates and regulatory changes may have created the backdrop for greater passive investment, demand from individuals seeking “baskets” of securities started rising long before our current rate and regulatory environment.
Today, the “basketization” of investment products shows little sign of slowing down. In fact, the baskets of securities available for investment now eclipse the actual number of the securities themselves. Given this reality, should traditional models for measuring how stocks behave be utilized? Has the basketing of investment products merely amplified or been the driving cause of tighter correlations? These are questions that have engaged academics and resulted in papers that attempt to address the questions. The findings of one paper by Leippold, Su, and Ziegler (2016) found that their “model predicts that demand shocks to ETFs and futures lead to stronger price comovement for both index stocks and non-index stocks.” That’s an academic way of saying that as ETFs and futures use increases, so does the correlation of ALL stock. The universe of mutual funds, those that specifically set out to mirror indices and those that “closet track” a benchmark, would only seem to exacerbate the issue of correlation. To put a global perspective on this, consider that there are over 100,000 open ended funds available that can use US stocks in indexing strategies vs. approximately 4,300 individually listed US stocks.
As passive and index strategies continue to grow in popularity, it would seem that a more correlated environment is to be expected. Moreover, if the surge in ETFs continues while the total number of individual stocks keeps shrinking, there is little doubt that the effects of this dynamic will have a major impact on how markets behave. Again, nothing occurs in a vacuum. The ability to continue to utilize tried and true methods, like the diversification techniques made famous by leading thinkers such as Harry Markowitz, may need to be reevaluated and modified to address current realities. However, thanks to our ability to leverage data and machine learning in ways that were inconceivable in 1952 (when he wrote his famed essay), Markowitz’ theories may be born anew. And just as David Byrne sang, “fighting fire with fire,” perhaps using powerful technology to realize the benefits of portfolio theory may be the solution to preventing the house from burning down.
Dr. Jimmie Lenz is an experienced executive, lecturer and scholar in the field of banking and capital markets. Starting his career as an equity trader over 25 years ago, he has held a number of senior management roles within the finance community and has numerous pending patents. (All views in this article are his own).
