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The Inefficient Market Advantage

Davide Accomazzo
Davide Accomazzo, adjunct professor of finance

For decades Wall Street has pushed forward an investment agenda based on the academic research initiated in the 1960s by Prof. Markowitz, the now notorious Market Portfolio Theory (MPT) and the Efficient Frontier. While the historical investment context in which MPT  developed was indeed lacking some sort of scientific support to analyze risk and performances, the answer provided by the theory—mean-variance optimized portfolios—ended up overlooking the real fabric of the markets and therefore failed investors once the going got tough.

Markets are not efficient because market participants—much to the chagrin of MPT followers—are not fully rational agents. But more sadly, markets are inefficient also because of massive asymmetrical information and manipulation of markets structure by better positioned economic agents. So if markets are not efficient, how do we take advantage of anomalies and, more importantly, how do we protect our portfolios from those frequent and damaging grey and black swans?

Of course there is not one answer; the proper approach is a function of the individual investor’s resources, interest, risk profile, and time.  An interesting portfolio management approach that is sophisticated yet relatively simple and low maintenance is the “Core-Satellite” construction. In its most

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simplistic form, an investor would allocate a larger percentage of his/her funds to a beta replication instrument like a passively managed index ETF or a mix of subsectors ETFs (the core).  This portion of the portfolio would be beta driven but also cost-effective from an implementation point of view; there will be no high management fees, almost inexistent transaction/slippage costs, and low taxes.  The satellite (a smaller percentage of the total of the portfolio) would be dedicated to alpha seeking strategies or in other words skill-based, uncorrelated investment programs.  This portion would be actively managed, priced accordingly and with an uncorrelated and/or higher expected rate of return.

In today’s environment of generally low rates of returns across all traditional asset classes and with beta having largely disappointed all investors, a more complex approach to core-satellite is due.  I like to create a core that is low-cost and essentially multi-beta driven with an additional embedded risk-management mechanism in place and a satellite that is truly defined by superior skills and that can possibly lower my systematic risk.

Years ago I came across a study by Mebane Faber[1] that utilized the 10-month moving average as a buy/sell filter for a portfolio of five major asset classes: Domestic Equities, International Equities, Real Estate, Commodities, and Bonds.  This approach works very well and easily for the construction of a cost-efficient, multi-beta driven, yet actively managed core.  Based on the data of the study, the risk adjusted combined results were quite attractive.

Utilizing ETFs, the investor can tailor a multi-beta core at low cost by choosing different subsectors (from more traditional strategic allocations to more refined and personalized ones) and utilize the 10-month moving average as the risk filter that will liquidate any segment of the core that falls below the moving average.

The satellite could then be built by investing in skill-based, uncorrelated to the core strategies, like managed futures.  Managed Futures, usually structured as Commodity Trading Advisors (CTA), operate strategies based on futures and options in diversified global markets such as commodities, market indexes, interest rates, and metals.  Including a precious metal strategy in your satellite should also help lower the systematic risk of the overall portfolio, since gold is estimated to be a zero-beta asset with generally no covariance with traditional asset classes.

In conclusion, the difficult and often dislocating investment environment of these past 10 years is probably going to continue; the investment universe is hardly as rational and prone to exact modeling as MPT leads one to believe. The world is messy and a more pro-active approach is needed to build portfolios that can withstand the stress of our times.

[1] Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation,” Journal of Wealth Management, 2007.

Author of the article
Davide Accomazzo, Adjunct Professor of Finance
Davide Accomazzo, Adjunct Professor of Finance
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