The Failure of Traditional Portfolio Management For Long-Only and Hedge Fund Portfolios (Mean-Variance; Normal Distributions, Black Litterman)

Abstract

Modern Portfolio Theory, introduced by Markowitz in 1952, is still used extensively as a tool for portfolio management of traditional, as well as alternative investments. Rather than selecting an asset based on its expected risk‐return profile, it considers how assets in a portfolio move in tandem. The fundamental concept is that of diversification. Given two assets, as long as there is less than perfectly positive correlation, the portfolio’s overall risk can be reduced. Although many of the model’s failings have been widely discussed, insufficient attention has been paid to the implications of constantly changing correlations. This paper is divided into two sections. The first section summarises the model’s key assumptions and limitations for managing traditional or alternative investment portfolios. Using data from 1999‐2010, we demonstrate that currency, commodity and equity returns are increasingly failing to follow a normal distribution. The second section (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1964388) tackles a less widely published topic: that of constantly changing correlations, as well as the impact of the time period under observation.