Once considered the bastion of investment standards, modern portfolio theory (MPT) has been assailed recently as the weak link in asset management and the root cause of investor losses in the economic recession of 2008 and 2009. As stock markets plunged worldwide and investment portfolios took it on the chin, revisionists sought to expound on what they deemed were the inherent flaws of the deeply entrenched MPT. In short, the theory became the scapegoat for the failure of diversification.

Modern portfolio theory allows for the hypothetical combination of a given set of asset classes that yields an optimal portfolio. Optimal in this context is defined as a portfolio at each level of expected return that carries the lowest possible expected risk. In practice, advisors refer to these structuring of portfolios as "strategic asset allocations."

So elegant is this solution for portfolio construction that it spawned a sub-industry within investment management. But as with any theoretical construct, the proof is in the pudding. It turns out that few practitioners made good products with the recipe, as evidenced by countless published articles about why advisors failed or why diversification failed.

Drilling down

A little insight into how MPT is supposed to work goes a long way in supporting such headlines. The good news is that there is a way for advisors to embrace traditional MPT, while also moving forward with greater confidence in their ability to prepare portfolios for the next onset of market turmoil that we know will eventually come.

As with all theories, MPT requires assumptions that limit its applicability to our real, multiple-market universe. Perhaps the most limiting of the assumptions is that the expected returns and corresponding risk for each asset class may pertain only to one period. That is, we must estimate these inputs for a single investment horizon, and then use the MPT to construct optimal portfolios based on specific levels of risk tolerance. These inputs are often referred to as capital market expectations and they are notoriously difficult to estimate.

Implementation of MPT is also hobbled by the fact that the single-period assumption implies a buy-and- hold investment strategy. That is: Estimate the capital market expectations, construct the optimal portfolios, select the appropriate risk level, buy accordingly and hold until the end of the investment horizon.

Clearly, this approach is problematic in an environment in which asset-class, risk-and-return dynamics are in constant flux. As a result, many firms will alter their inputs periodically and adjust the portfolio allocations. Such actions, of course, violate the underpinnings of the framework. This ongoing adjustment is really a form of tactical asset allocation-though the strict adherents to MPT and the buy-and-hold approach would never admit to such blasphemy! That's because by its very nature, tactical asset allocation involves the consideration of shifting market events-a move that is inconsistent with the fundamentals of MPT.

Connecting the dots

So is there a fine line between strategic and tactical asset allocation? MPT and strategic asset allocation are based on optimal risk-and-return trade-offs and diversification. But the trade-offs are dynamic and need constant monitoring.

The monitoring identifies potential opportunities that advisors tactically try to exploit through time, without giving up the diversification benefits of a multi-asset class portfolio.

For instance, if the risk/reward ratio is not optimal for, say, stocks, then a reallocation to bonds may be in order. This may ultimately manage the investor's risk exposure through time and possibly lead to better risk-adjusted return results. Arguably, this process is every bit consistent with the main concepts underlying MPT. The tactical response simply bridges the chasm between reality and the model.

In general, multi-asset class products with a tactical approach are managed based on continuous monitoring of the risk-adjusted return potential of equities relative to fixed income. For example, one approach might manage risk through independent modeling of each equity allocation. The modeling results determine the allocation to a particular equity class, over or under what's suggested by the strategic asset allocation. If the risk-adjusted return is unattractive, the tactical manager reduces the equity allocation and allocates more to fixed income, and vice versa. Over time, this process could actually reduce the overall risk of portfolios relative to the strategic asset allocation and improve the returns as well.

Many MPT adherents would argue that this tactical asset allocation process violates the tenets of the theory, but the periodic adjustment to capital market expectations is in itself a tactical approach. Managers who embrace this idea are simply merging theory with reality. Plus, other advancements in the investment world make this approach more possible to implement.