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™.

 


 

Leave a Comment:

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 628 with weekend update

Australian investors have been pouring money into US stocks this year, just as they start to underperform the rest of the world. Is this a sign of things to come? This looks at 50 years of data to see what happens next.

  • 11 September 2025
Exchange traded products

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Retirement

We need a better scheme to help superannuation victims

The Compensation Scheme of Last Resort fails families hit by First Guardian and Shield losses, as well as advisers who are being wrongly blamed for the saga. It’s time for a fair, faster, universal super levy solution.

Investment strategies

5 charts every retiree must see…

Retirement can be daunting for Australians facing financial uncertainty. Understand your goals, longevity challenges, inflation impacts, market risks, and components of retirement income with these crucial charts.

Economy

How bread vs rice moulded history

Does a country's staple crop decide elements of its destiny? The second order effects of being a wheat or rice growing country could explain big differences in culture, societal norms and economic development.

Investment strategies

Small caps are catching fire - for good reason

Small caps just crashed the party like John McClane did in the movie, Die Hard - August delivered explosive gains. With valuations at historic lows, long-term investors could be set for a sequel worth watching.

Defensive growth for an age of deglobalisation, debt and disorder

Today’s new world order appears likely to lead to a lower return, higher risk investment environment. But this asset class looks especially well placed to survive, thrive, and deliver attractive returns to investors.

Economy

Will we choose a four-day working week?

The allure of a four-day week reflects a yearning for more balance in our lives. Yet the reliability of studies touting a lift in productivity is questionable and society may not be ready for such a shift anyway.

Sponsors

Alliances

© 2025 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.