It is not every day you attend a presentation where the speaker tells a room full of some of the most experienced investment professionals in Australia that what they are doing is utterly useless.
But at the recent Australian Superannuation Investment Conference on the Gold Coast that is exactly what happened.
Controversial economist Steve Keen, author of the book Debunking Economics, told portfolio managers the model they relied on was not supported by long-term data.
Keen was particularly critical of the capital asset pricing model (CAPM), a model used widely for portfolio construction. "Anyone that does CAPM-style investing is fooling themselves," he said.
"If you look at the long term, you simply can't swallow that [efficient market hypothesis] stuff anymore. Anyone that uses CAPM, change it."
He pointed out to a somewhat bemused but also animated audience that not even Harry Markowitz, the economist on whose work CAPM is based, believed in the model.
In a recent video interview with Research Affiliates chief executive Rob Arnott, Markowitz confirmed those views. The CAPM model was developed using a number of assumptions, including that you could borrow all you want at the risk-free rate. "Well, they found out that you can't borrow all you want at the risk free rate," Markowitz said.
And when that assumption was replaced by real-world restrictions on borrowing, some of the conclusions reached under CAPM no longer held true, he said. "In the face of the empirical problems with the implications of the model, we should be cognisant of the consequences of varying its convenient but unrealistic assumptions," he said.
"In particular, we should be cognisant of what more realistic assumptions concerning investment constraints imply about how we should invest, value assets, and adjust for risk."
But this didn't mean diversification didn't work, he argued. In fact, the global financial crisis illustrated that different asset classes produced vastly different returns, he said. "People say in a crisis all asset classes lose money and, therefore, diversification has failed. That is not quite true, but people say that," he said.
"The S&P 500 went down 38 per cent, corporate bonds went down 5 per cent, emerging markets went down 50 per cent or more, so it depends on the beta.
"If your portfolio was high on the [mean-variance] frontier and so essentially you had a high beta, you got hit. If you had a lot of bonds and relatively little equity, you got less hit.
"So it was a good example why you should pay attention to the mean-variance frontier."
Keen said the main problem with CAPM was the assumption that higher volatility would produce higher returns in the long term, when in fact that assumption was false.
A better model would be to focus on the book-to-market ratio, a ratio used to determine the value of a company by comparing the accounting value to the market capitalisation of a company.
"Your best option is to go to the book-to-market ratio; a high book-to-market ratio, low volatility, that is the proposition," Keen said.
I'm not sure if anyone went to the office that night to overhaul their investment strategy, but as with all good presentations, it provided plenty of food for thought.
