Wednesday, 31 October 2012

Modern Portfolio Theory alive and well at the ECB

The last few months must have been agonising for the ECB; it is hard to imagine the pressure they must have been under. I therefore applaud the choice of action taken in the midst of a potential crisis. Of course this announcement does not come without risk, and it will clearly upset some of the core, but I’m sure history will look back on the decision as the right one…

To whom am I referring? Mario Draghi, the President of the European Central Bank? A good guess, but no. Whilst the conditional agreement to become ‘buyer of last resort’ has brought the eurozone back from the brink of financial disintegration, and deserves some modest back patting, I am, of course, referring to the England Cricket Board and its decision to reinstate Kevin Pietersen.

Why is this relevant? Well I have made the logical assumption that the England Cricket Board’s decision making process is a sporting interpretation of Modern Portfolio Theory (MPT). The basic principles of MPT tell us that we should not assume the addition of a more volatile asset (KP) will increase the risk of a portfolio (the team). The asset's inclusion must also be dependent on the correlation of its performance in relation to the existing portfolio. In that respect we can observe that Pietersen’s batting performance (good) versus that of the rest of the team (bad) is often negatively correlated. The team, therefore, is better balanced as a result of Pietersen’s more volatile but less correlated contribution.

However, could Ian Bell, the ‘exquisite rapier’ who sits alongside Pietersen in the middle order, have shouldered the burden of the exiled Proteus? Well, despite some impressive form with the bat, I’m sure the ECB will have again used MPT to conclude this would have been a risky strategy. The reason – Ian Bell’s performances have a high correlation with the rest of the team. Put another way, Bell will score well when the team is in the ascendancy but, when starved of runs, will typically surrender his wicket without much of a contribution. In that respect, whilst a valuable part of the team, Ian Bell is a poor diversifier of performance.

The key to delivering consistent performance, therefore, is balance; achieved by having different parts of your portfolio that can respond positively to less favourable outcomes. If we can appreciate this concept, then we can begin to understand how portfolios are constructed. And we can also understand why the ECB had little choice but to recall (or text) Kevin Pietersen.

Despite this sound theory, many portfolios employing this approach have succumbed to the chaos of financial markets. Classic errors include wrongly classifying an asset as lowly correlated and another is to assume that correlations remain stable. In my next blog I will discuss both these issues further.
Ben Gutteridge
Head of Fund Research

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