Chancery Lane CEO: Modern portfolio theory doesn’t work for income investors

MPT is is wrongly incorporated into most offerings directed at retail clients in the UK, writes Doug Brodie

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By Doug Brodie, CEO of Chancery Lane

Most advisers or managers try to give retail investors secure long-term income through Modern Portfolio Theory (MPT). The essence of this theory is that there is no gain to be had in investment without risk, but that this risk can be contained within limits via asset diversification.

In the portfolio’s simplest form, the gains – and therefore the risks – come from equities, while the containment – the main source of income – is provided by bonds. The proportions are dependant on the taste of the investor and whether they have an appetite for return or security.

But the inventor of the MPT himself, Nobel-prize-winning economist Harry Markowitz,  acknowledged that this was never intended for running an individual’s portfolio, but to be applied to open-ended, undated, mutual funds with daily cashflows seeking to grow in value.

He said: “The investing institution I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or mutual fund.”

If the inventor himself ignored MPT for his own pension, advisers and income seekers would be wise not to ignore him.

In spite of this, virtually all investment theory directed at the UK retail market continues to be some restatement or rehash of MPT based on analysis commissioned by institutional investors for funds, not people. This is frequently then re-badged by the marketing departments of fund management firms to suit their own ends when soliciting new money.

We argue that MPT has become a less appropriate strategy in recent years, but nowhere is this more apparent than when seeking to generate long-term income. The primary objective here is certainty of income, not capital growth. This need is invariably for income that arrives in investors’ bank accounts with the same regularity as their monthly bills. Most income investors are retirees who need to replace a monthly pay cheque.

However, fund managers usually have different objectives. They may have a remit to provide an income – which allows their fund to be marketed to income seekers – but they have less explicit goals that might not benefit the end investor.  

The reality is that competition for assets often makes maintaining and growing capital an equally important objective because it improves a manager’s position in fund league tables. And of course, more assets and higher values mean increased ad valorem fees for managers.

There is clearly some dissonance between what income-seekers need and how the industry goes about meeting that need. The main risk to a fund manager is that their returns fall below the benchmark and peer group – the risk to a retiree is that the expected income is not delivered.

Essentially, MPT reduces volatility by combining assets whose values move differently to each other. This approach can work with a long-term, open-ended pension fund or scheme with continuously variable cashflows, but not for an income investor who’s timescale is finite and expenses have a fixed baseline.

The biggest difference between a pension scheme and a typical income investor is that the former has monthly cashflows coming in from both investors and employers. For the income seeker, every penny of income being paid out has to be generated by their pension or income pot, which is often their sole source of investment income.

An investment consultant can afford to get it wrong when advising a DB scheme because there is no harm done to the scheme retirees when the employer is legally obliged to sign blank cheques to meet any shortfall.

This is not so with individual income investors. Not only do they have their regular monthly income switched off, but they must also be cashflow income investors as well – a task hard enough for most advisers, never mind their end clients.

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