Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 47

Standing on the shoulders of giants

This little journey through fund analysis history provides some background to modern portfolio analysis and reporting techniques. Although the work of these pioneers in our industry is up to 60 years old, it is still taught in universities and finance courses as the foundation of modern funds management.

Portfolio diversification

In 1990, William F. Sharpe was awarded the Nobel Prize in Economics, along with Harry Markowitz and Merton Miller “for their pioneering work in the theory of financial economics”. Markowitz, often referred to as the father of Modern Portfolio Theory, did not invent the idea of portfolio diversification, which can be traced back to Shakespearean times (see The Merchant of Venice, Act I, Scene I). His key contribution was the idea that while risk can be reduced through diversification, it cannot be completely eliminated. In his seminal 1952 paper 'Portfolio Selection', he was the first to formulate a mathematical model for the diversification of investments. This model demonstrated that what was important was not the riskiness of any individual investment, but rather the contribution that the asset made to the risk of the overall portfolio.

Sharpe built upon this foundation to develop the Capital Asset Pricing Model (CAPM) in 1964. This model utilised a linear regression approach with Beta as a measure of the sensitivity of an asset's return to the return of the market and Alpha as a measure of the excess return for the risk incurred. Both parameters were used to calculate a fair-value rate of return of a risky asset.

Like all good ideas in finance, it wasn't long before others contributed to improvements. Indeed, Sharpe was not alone in formulating such ideas as Jack Treynor, John Lintner and Jan Mossin had independently come to similar conclusions. In 1972 Fischer Black (of Black-Scholes option-pricing fame) improved the CAPM model and it became widely used as a model for pricing individual securities. Later the Black-Litterman model was introduced which incorporated an investor’s subjective views on the market trends which may influence return levels.

Attribution analysis

In 1988, William Sharpe took the ideas to the next level in the article 'Determining a Fund’s Effective Asset Mix'. In this article, Sharpe introduced the idea of ‘attribution analysis’, later dubbed returns-based style analysis (RBSA). In the CAPM model, we can look at the return of an asset with respect to the return of the market. If we consider that any single index is a representation of the 'market' for this 'style' of investment, we can thus calculate exposure to this market. If we then use a number of indices to represent different markets, we can assess the exposure to various markets based on the returns of our portfolio. From here, we can assemble a 'style portfolio' being a portfolio of our indices, weighted by the exposure we have determined that we have to each. The style portfolio will usually not explain 100% of the fund returns (as the fund might hold a mix of assets in each market different to that of each index), however a well-fitted style portfolio should explain the returns to a high level.

The immediate practical applications for this model were obvious, as it allowed an investor to analyse a fund’s underlying exposures. If the underlying holdings are unknown, this can help the investor understand what the fund is doing and where it is exposed. If on the other hand the holdings are known, the analysis can uncover ‘hidden’ exposures (for example the share prices of an Australian company that imports food could be exposed to the Brazilian market).

In 2002, Michael Markov developed and patented a new version of RBSA called ‘Dynamic Style Analysis’. This innovation was designed to improve the capture of changing weights in the portfolio (i.e. a fund will generally not have static holdings throughout the year, but will rebalance the portfolio in response to market conditions). Such changing asset weights add a further level of complexity to the style analysis, as we now have to explain not only which exposures are present in the portfolio, but also how these exposures have changed over time.

Building on past research

Although research continues in the development of new modelling techniques, such research is often based on the work done by those mentioned above. We now have available to us some sophisticated tools to gain an understanding of funds for which we do not have full disclosure of holdings, to perform due diligence of funds we are considering investing in, to break funds down to their component exposures and even to identify hidden exposures in portfolios.

In the words of Sir Isaac Newton, “If I have seen further it is by standing on the shoulders of giants.”

 

Joe Maisano is a Director and Dr. Alex Radchik is a Project Consultant at Trading Technology Australia (TTA). TTA is the Australian representative of Markov Processes International, the developers of MPI Stylus Pro™.

 

  •   31 January 2014
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

Datacenters are the new shale oil

banner

Most viewed in recent weeks

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

Meg on SMSFs: What do we think about reversionary pensions these days?

Reversionary pensions have long been a staple of SMSF estate planning, but are they still the best option? Meg Heffron revisits a once-clear favourite and asks whether changing super rules have shifted the balance.

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

How does the 4% rule stack up?

The 4% rule has long been retirement's gold standard. But after a difficult period for investors, fresh analysis suggests a more conservative approach may significantly improve the chances of making savings last.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

Latest Updates

Exchange traded products

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Taxation

Will investors be better or worse off under new housing tax changes?

Housing tax reforms have sparked warnings of market turmoil and promises of greater fairness. But after modelling nearly two decades of property data, the results suggest winners and losers may not be who many investors expect.

Retirement

Three considerations before reshaping your legacy plan

Many retirees hope to leave a legacy. Proposed trust tax reforms could force families to rethink. The question is not how much to leave behind, but whether today's inheritance plans will still make sense as circumstances change.

Investment strategies

Why experienced investors still get markets wrong

Retirement is approaching. Markets are noisy. And every headline seems to demand action. The biggest investment risk isn't fear, greed or market volatility, it often arrives disguised as research and sensible risk management.

Shares

Why pay more for less?

Conditions were stacked in favour of professional investors in 2026. Most still fell short, raising questions about where investors should look for value. Meanwhile, an alternative strategy continued to make its case.

Investment strategies

Bleeding air out of the bubble

Equity valuations have fallen sharply over the past year, yet investors have largely been spared the volatility and losses that typically accompany a de-rating. What explains this unusually orderly reset? Here are five key drivers.

Strategy

Has AI gone rogue?

We worry about AI becoming conscious. But what if consciousness isn't the issue? The more unsettling possibility is a machine capable of pursuing objectives relentlessly, without motives, emotions, or awareness of any kind.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.