Saturday, September 13, 2008


All theories have a shelf life in the quickly evolving world of investing. The constant dialectic process ensures new theories challenge the old and the better theory survives until a new challenger comes along. Our analysis shows that the Modern Portfolio Theory may well have been trumped by a new challenger!

The Modern Portfolio Theory (MPT) has been a mainstay of the investment management business for some time. It provides a theoretical underpinning for how an investment portfolio should be constructed. It has been considered a “core” investment principle and is part of the curriculum for investment courses taught in our business schools, the CFA program and also in the Canadian Securities Course. While not everybody agrees wholeheartedly with all aspects of the theory, most acknowledge the relevance of the thought process. In short it is mainstream.

Investopedia offers a nice short definition of MPT.
"According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.

In an analysis of the investment portfolios of individual or “retail” investors, you would expect to find significant evidence of MPT in a review of the portfolio construction. However, inexplicably many portfolio show little evidence of the application of MPT, with portfolios lying well off the efficient frontier.

No theory is “static” in the fast changing world of investing. I believe that a new theory needs to be develop that can adequately explain this phenomenon in portfolio construction at the retail level. Hence, I unveil the “Modern Commission Theory” or MCT.

MCT, while not taught in the CSC courses or found in any investment textbooks, appears to be the chief operating theory guiding many of the financial advisors in the retail investment industry. It is a concept learned strictly through mentorship and on the job experience, with no text books available. The fact that the theory has been adopted by so many sales advisors is due to the enlightened self interest that is so inherent in the theory and rampant in the industry.
The definition of MCT is as follows:
“According to the theory it is possible as an advisor, for each client , to construct an optimized portfolio of securities such that commissions can be maximized for any given set of investment objectives, account size and investment knowledge”

While it requires a strict discipline and a great deal of research and knowledge, a maximum commission opportunity is available for every security type and asset class. Portfolios utilizing the MCT strive to attain the efficient commission frontier; where no further fees can be derived without increasing the time spent with a client!
In its highest and purest form of application the fees and commissions are opaque and can only be determined and measured with the highest level of investigation and analysis. Fees and commissions at the top level should be buried in complex terminology and where possible inserted deeply into the most complex prospectus.
Under the broad theory of MCT, there appear to be a number of principles uncovered that are used with great effectiveness by advisors as they strive for the optimal MCT portfolios.

1.The most complex products with the most confusing and opaque fee and commission structures should be sold by advisors to the least knowledgeable investors. As such investors with limited knowledge should be sold Principal Protected Notes (PPN), Guaranteed Minimum Withdrawal Benefits (GMWB) variable annuities, and other financially engineered products, wherever possible. Let’s face it stocks, bonds, and preferred shares are getting to be too well understood.

2 Wherever possible the wealth should be shared through the use of managed products. Rather than manage a portfolio directly as old world stock brokers and advisors did, you should sub-contract the portfolio wherever possible. Managed solutions such as funds of funds and wrap accounts do a nice job of layering fees. We call it the “team approach”.

3.Intergenerational investing is important. Where possible DSC accounts should have 10% a year removed from the initial fund and reinvested in another DSC fund (the son). The following year you repeat the process and create the third layer or grandson of the original DSC. Who says diversification can’t be profitable for all.

4. Structured products should be the mainstay of an optimized MCT strategy. By their very nature they are sexy, confusing, and best of all they provide great opportunity to increase fees and hide costs and risks.

A word of caution however is worth noting. As with all new theories, some of the dinosaurs are not on side (did I say’ buy and hold’, value, GAARP) and more seriously a few rogue advisors are promoting a counter theory.

Beware the “indexers”! Clearly unaware of the personal satisfaction built into the MCT, they preach low fees and greater diversification. I caution you because opening the door even slightly to index funds will knock you off the maximum commission frontier line. In fact a whole portfolio of index funds may actually cause the portfolio to spontaneously combust and burn up all the fee gains driven through diligent application of the MCT.

Similarly beware the fee based and fee only advisors for they can also erode the key principals of MCT unless corrective commission tactics are embedded in the processes.

Fortunately the indexers are few and the commissions are many. I am convinced the MCT will prevail,after all, haven’t we been able to maintain the worlds highest MER’s inspite of all those annoying investor advocates! Stay the course and MCT shall emerge as the accepted theory by all self aware advisors!

As with all new theories, the idea has not been fully explored to date. But we are just at the start of a great new world of structured commissions…er products that promise to take advisors and their companies to a new revenue high.

Like the original works of MPT by Markowitz,was expanded on by William Sharpe and Merton Miller who all eventually shared a Nobel Prize: I believe that the theory of MCT will be expanded on in years to come and if nominated for the Nobel Prize, I would honorably accept it. I would also be remiss if I did not acknowledge the efforts of my predecessors for their pioneer work on the theory. Special acknowledgement to P.T. Barnum and his work on the “One is born every day” theory!

Note* The above article may contain traces of sarcasm and a heavy dose of reality.



Anonymous said...

well said Mike

too sad and too true
(from a former investment salesperson who tried to change the system for the better and was chewed up and spit out for the effort)
Keep writing, I copied some of the highlights with credit to you on

also see for a good site for research further to your writing

larry elford

Anonymous said...

Great article! Loved it from the subject to the end. Unfortunately, you are right... MCT is still king in most of our society.