Markowitz, MPT, and Market Efficiency

Modern Portfolio Theory (MPT) is rooted in the mean-variance analysis research performed by Harry Markowitz conducted to allocate assets through a portfolio optimization process.

The portfolio concepts presented in section I trace their roots to Markowitz groundbreaking work.

The Efficient Market Hypothesis (EMH) contents that the market correctly prices all securities.

MPT argues that all investors should hold the same portfolio of diversified securities correctly priced by the efficient market.

The conclusion of MPT would argue for passive management of investor portfolios.

• With this in mind, some portfolio managers have consistently out-returned a recognized market index over time.

• Further, sometimes asset mispricings are correctly identified by portfolio managers and these anomalies have been exploited to generate excess returns above the market index benchmark. These issues can serve as a foundation for justifying active portfolio management over passive management.

CAPM assumes that investors face no restrictions on lending and (more importantly) borrowing at the risk free rate, as well as the ability to short sell.

In reality these limitations frequently exist.  Any investor can lend at the risk free rate buy purchasing a bond deemed as having extremely low risk.

Investors lack the ability to command the low borrowing rates of say the US, Japanese, or German sovereign governments (which would be the proxies for a risk free rate, despite a total risk free nature).

Many investors cannot short sell (even some big institutional types, such as pensions).

Those investors who can short sell could opt to borrow at their cost and sell short some of the portfolio.

Ultimately, with a spread between the lending (lower) and borrowing (higher) rates imposed on investor reality and restrictions on short selling, the market can exhibit inefficiencies.

Inefficiency causes a distortion in the linear nature of the relationship between expected returns and beta.