The lost decade of financial fundamentalism

Strolling past Regent's Park mosque during the late 1990s on my way to lectures at nearby London Business School, I would wonder which inspired the greatest devotion among disciples and converts: the teachings of Islam or financial theory; Allah or Mammon?

Entering the hallowed halls of LBS, I was shocked by the financial fundamentalism of yesteryear's professors, schooling future generations of investment managers in banks, fund houses and pension schemes.

Coming from a liberal-minded journalistic background, sparring with retail and institutional fund managers, I was used to discussing performance, stock selection and asset diversification.

Despite the increasing force of quantitative methodology encroaching into the investment world, there was space for those who saw investment as art rather than science. Conviction-based gurus such as Templeton's Mark Mobius and Berkshire Hathaway's Warren Buffett ruled the roost.

Yet the atmosphere inside the spotless rooms of LBS was more restrained, homogeneous and anachronistic. The mantras and unquestioned certainties felt more Soviet Russia than Tony Blair's Cool Britannia. Any dreams of students with creative pretensions of discovering innovative future firms were stifled by an orthodoxy dating back to the 1950s.

The heroes worshipped in this intellectual citadel included academics such as Harry Markowitz, introducer of "modern" portfolio theory to the investment world in 1952; and Barr Rosenberg, who put theory into practice, selling "Barr's bionic betas" to the investment community.

These characters became famous for their innovative models. Yet their teachings eventually became the status quo, with innovators discouraged from replacing the old texts.

It took a global crisis in 2008, the worst since the 1930s Depression, for heretics to emerge and question Mr Markowitz's beliefs that risk and return were intrinsically linked and that diversification led to superior performance.

Despite widespread portfolio losses, most institutions still clung to these scientific methods to determine the composition of optimised asset portfolios.

Amin Rajan, another finance professor and advocate of the controversial "multi-boutique" fund house model, has always been suspicious of MPT and its associated school of rational expectations, which had emerged from the University of Chicago. As an economist in the UK Treasury of the 1970s, one of his tasks was to model the influence of massive IMF loans to the UK, using Chicago principles. He found this almost impossible.

On leaving the Treasury, he road-tested the concepts and again found them wanting. When he wrote critically about them in an investment context, he came up against a wall of business-schooled opprobrium.

"The amount of hate mail I received was breathtaking," recalls Mr Rajan, founder of Create, a consultancy.

Having surveyed 140 of the most prominent papers and articles on the topic, he concluded there was no evidence to support the widely held theories. In fact, applicants for the equity component of the investment management programme are still encouraged on the LBS website to "gain broader knowledge of modern portfolio theory and its applications".

The early 2000s are described as the investment industry's "lost decade" by fellow unbeliever, Pascal Blanque, chief investment officer at Amundi, the fund house, in Paris. He describes a worrying era when investors found buy-and-hold strategies no longer worked, where age-old correlations between bonds and equities became irrelevant and the ability of diversified portfolios to rescue investors became almost defunct.

MPT, it seems, only worked when most investment was domestic, when cash and fixed income dominated portfolios and when there was no co-ordination of economic and monetary policy between governments and central banks.

Of all the bullets fired into the still-wriggling corpse of MPT, the most damaging seemed to be the quantitative easing volleys. "Investing has always been an art," says Mr Rajan. "If anything, it is more an art now than in the past, largely because markets are now driven by politics rather than economics."

In the less prescriptive asset management world to which we are moving, the old theories may evolve from concrete models to useful concepts, with clients' needs, risk tolerance and investment preferences coming first.

Benefiting from the opportunity to broaden portfolios beyond standard offers to include property, private equity and hedge funds, banks are beginning to see an investment world with no boundaries when it comes to diversification. Clients shackled for so long by financial fundamentalism may at last be set free.

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