Beyond Portfolio Theory: The Next Frontier

Logically, investment theory's next frontier is to put into practice the rich set of tools that academia has bestowed on the investment community—starting with Harry Markowitz's seminal article on portfolio selection in 1952. Or is it? In fact, the next frontier lies beyond simply engineering the implementation of new investment decision tools. The time has come to integrate the powerful insights offered by information theory and principal–agent theory into a holistic, comprehensive theory of investing. Only such an expanded theory offers any material hope of improving the economic prospects of the millions of clients/beneficiaries of today's mutual funds, pension funds, endowments, and foundations. The broad consensus among finance and investment academics is that investment theory’s next frontier consists of putting into practice the rich set of tools that academia has bestowed on the investment community since 1952. Without doubt, the academic community can be proud of its intellectual achievements in proposing the concepts of modern portfolio theory and extending them to add: the consideration of multiple horizons, the use of long-term inflation-linked bonds as the natural reference point for assessing the reward and risk of alternative investment strategies, the integration of investment-related rewards and risks with other considerations, such as real property, and the recognition that investment returns have time-variant predictive components, so strategic asset allocation must be dynamic. These four extensions of “old” portfolio theory are major advances in investment theory, but that reality does not logically make the “engineering of systems” to incorporate the extensions into practice the next frontier for investment theory. Before we settle on what investment theory’s next frontier really is, we need to consider two additional (related) bodies of thought—information theory and principal–agent theory: Information theory addresses the question of whether economic actors (e.g., buyers and sellers of investment-related services) are in equivalent positions, from an information perspective, as they make decisions. Principal–agent theory addresses the question of whether or not the economic interests of principals (e.g., individuals) and agents making decisions on their behalf (e.g., investment managers) are aligned. The market for investment services is a classic illustration of informational asymmetry—with sellers having much information and buyers having little. The acute informational asymmetry of the financial services market leads logically to principal–agent considerations. In a world where the clients/beneficiaries of various financial service organizations (e.g., pension funds, mutual funds, endowment funds) are millions of remote, faceless individuals, will the boards and managers of the organizations and those they hire serve the interests of the beneficiaries, or will they use their power to serve their own interests? Because of these characteristics of today’s investment world, we need more than simply the reengineering of investment decision systems. We must integrate into our new models the profound issues raised by (1) information asymmetry and (2) the fact that millions of ultimate beneficiaries at the bottom of the financial food chain depend on a mosaic of intermediary (agent) organizations to provide products and services that truly serve the beneficiaries’ interests. This article explores what investment theory would look like if it integrated old portfolio theory not only with the post-1952 technical offerings of academia but also with the economic concepts of asymmetrical information and misalignment of economic interests—that is, integrative investment theory. It would recognize that Client/beneficiary value creation = f(A, G, R, IB, FE);that is, client/beneficiary value creation is a function of the successful integration of five value drivers: A = agency issues, G = governance, R = risk issues, IB = investment beliefs, and FE = financial engineering. Despite evolutionary fits and starts over the past five decades, integrative investment theory is inevitable. Why? Because its broad adoption will produce better financial outcomes for millions of “ordinary” people. They will not be denied.