In December of 2006, which is almost 17 years ago, I wrote the original version of this short paper titled “Markowitz Bites Back: The Failure of CAPM, Compression of Risky Asset Spreads and Paths Back to Normalcy”. It was influenced by a simple yet elegant publication by Harry Markowitz, the founder of modern portfolio theory (“Market Efficiency: A Theoretical Distinction and So What?” Financial Analysts Journal, Vol. 61, No. 5, pp 17-30, 2005).
At that time, I was at PIMCO, and we were witnessing the precursor to one of the largest bubbles and busts in financial history which came to be known as the GFC (Global Financial Crisis). The plethora of implicitly levered “synthetic credit” products imploded in a spectacular fashion, and took down Bear Stearns, Lehman Brothers and many global financial institutions. For those who were able to foresee the dynamics and events and position defensively, the next two decades were more profitable, both personally and financially, as opportunities abounded in the debris of the global financial crisis.
17 years later, with the current boom in index ETFs and retail options trading, are we setting up for another meltdown? What does Markowitz’s framework say?
The full note on this important topic can be downloaded at this link: LTA Thinking – Markowitz Bites Back…Again