This theory helped guide the asset management industry that burgeoned over the next half-century by balancing considerations of market risk and expected return.
Over the generally booming markets of recent decades — notwithstanding the equities shocks of 2000 and 2008 — MPT has helped fund managers around the world maximise potential returns for their investors.
But some market practitioners are coming to realise the shortcomings of thinking in binary risk-return terms. Markowitz omitted a crucial third element, says Pascal Blanqué, chief investment officer at France’s Amundi: liquidity.
“Financial markets,” he wrote in a recent report, “seem more and more a bigger house with smaller exit doors. The ability to transact in any meaningful size . . . has in some ways diminished across all asset classes and that would be exacerbated in case of market turmoil.” And that, he believes, fundamentally undermines traditional risk-return expectations.
It is a timely observation. Last week in the UK one of the country’s best-known stockpickers, Neil Woodford, saw his principal fund all but implode as investors responded to a period of underperformance with unsustainable requests to withdraw their money.
Mr Woodford, many of whose holdings were in illiquid or unlisted companies, triggered an emergency clause in the fund’s articles, barring redemptions. The fund’s army of retail investors are now trapped inside the fund, as the value of its underlying holdings continues to slump.
The story has attracted vast coverage in the media, due to a combination of Mr Woodford’s colourful persona and his widespread popularity, first as a fund manager at Invesco Perpetual and then at the helm of his own group, Woodford Investment Management.
But amid the populist attention, the broader relevance of Woodford’s implosion has been generally dismissed. The consensus view seems to be that he was an idiosyncratic manager whose plight holds no lessons for others.
This is a dangerously smug view to take. As Mr Blanqué’s analysis suggests, the way in which Woodford has been undone by illiquid investments should be a cautionary tale for the whole asset management sector, both in the UK and globally.
The Amundi commentary was focused principally on emerging markets risk where investor nervousness has intensified of late but that analysis, equally, should resonate more generically.
Indeed, Bank of England governor Mark Carney made the link explicit in a speech last week that highlighted the danger of the mismatch between instant-access funds and illiquid underlying investments.
“More than $30tn of global assets are held in investment funds that promise daily liquidity to investors despite investing in potentially illiquid underlying assets, such as [emerging market] debt,” Mr Carney said. “We have recently seen analogous situations in the UK.”
A freeze-up in emerging market debt liquidity would not only hurt end investors trapped in funds that could not liquidate. It could also cause economic mayhem given the emerging markets’ growing reliance on bond rather than bank finance.
The proportion of emerging market finance provided by banks has shrunk by a third in the past decade, while the share of market-based funding has doubled.
The shift — welcome for the added diversity but concerning given its potentially destructive volatility — was triggered in part by banks’ retrenchment from lending as a result of more stringent post-2008 regulations.
There is another thread linking today’s nascent market liquidity concerns with 2008.
Liquidity, or the lack of it, was the buzzword behind the 2007-8 financial crisis, when the availability of liquid funding for banks from Lehman Brothers to Northern Rock dried up, sending markets and the global banking system into meltdown.
Banks are no longer the centre of concern, but corporate debt is. Today, it is less the ability of banks to finance themselves by selling bonds that is at issue, and more the market’s appetite to keep buying crporate bonds and shares at ultra-high prices after a years-long boom.
Growing illiquidity in racier assets, from emerging market bonds to high-yield western names, could freeze funds across the asset management sector, causing meaningful damage to end investors — both private individuals directly and the pension funds we count on for retirement.
Be warned: Neil Woodford could well be the canary in the coal mine.