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By misapplying MPT, plan sponsors ignore alpha
What happens when a portfolio with an AIMR-compliant 20-year track record that routinely ranks in the top decile for fixed income pops up to the top of fixed-income search screens?
Once institutional investors or their consultants realize the investment strategy is a private one, they generally make an equally quick decision to discard it from the search process. The fact that the portfolio might be a good way to make money is typically regarded as, at best, a curiosity, because most fixed-income searches require that only public-market strategies that can be modeled and evaluated against public-market benchmarks should be considered for investment.
This public-market bias is the standard technique used by modern portfolio theory-based processes to create risk controls. That is, institutional investors look to carefully and precisely describe a benchmark and search for managers to beat it.
The Prudential Insurance Co. of America started a commingled fund called PRIVEST for a handful of pension funds more than 20 years ago. The portfolio invests in private placements and nothing else except for a very small portion in bonds - and continually ranks in the top decile for fixed-income portfolios.
Because of investors' reliance on Modern Portfolio Theory, however, more than a decade has gone by without any pension fund...