Modern Portfolio Theory |

Modern portfolio theory (MPT) is a concept developed by Harry Markowitz, first published in the Journal of Finance in 1952. At the time it was highly revolutionary and has since changed the way investors view the framework for portfolio construction. Before MPT was introduced, investors viewed portfolios on a security-by-security basis and evaluated the risk reward pay of of each individual investment.

The theory behind MPT includes the concept of diversification that shows if securities in a portfolio have low correlations, then the investor may be able to achieve a given level of return with reduced risk as defined by standard deviation.

MPT assumes investors are rational and therefore always want higher return for a given level of risk or lower risk for a given return target. An investor may use MPT to build model portfolios by assuming returns, standard deviations, and correlations.

Some investors use historical numbers and others use expected values based on their beliefs of future performance. Figure 1 is an illustration that shows the efficient frontier, which is the set of portfolios that has the maximum return for each given level of risk.

One of the results of MPT shows the market is efficient over long periods of time, which means on average a manager cannot consistently beat the market. However, MPT also assumes a portfolio of assets. If this is the case, we must consider whether hedge funds are portfolios of assets to determine if MPT holds.

As described by Park, hedge funds are not like mutual funds because when they eliminate market risk by taking of setting long and short positions the asset base is canceling out. Park concludes hedge funds are more like companies that can produce positive profits all the time and that there is a very powerful diversification effect from adding additional hedge funds into a portfolio.

In fact he shows that similar to equity portfolios where most have between 50 and 100 stocks for diversification, fund of hedge fund portfolios should include at least 50 funds to realize full diversification benefits. Further, Park (2001) concludes hedge funds as an asset class that appear to have stock-like returns with bond-like risk and little correlation to both stocks and bonds.

MPT predicts that a sufficiently diversified portfolio of hedge funds should be included in a traditional portfolio of stocks and bonds. However, one must not forget the underlying assumption of a normal return distribution for modeling portfolios under MPT and that hedge fund returns may exhibit significant skewness and kurtosis.

Lastly, Figure 2 is an exhibit that shows how the efficient frontier shifts up from the addition of hedge funds to a portfolio of stocks, bonds, and cash. This demonstrates that by adding hedge funds to a traditional asset mix an investor can achieve a higher return for a given risk level or reduce risk for a given return target.