Rethinking Investment Portfolios in the Era of Tokenization

For decades, investment portfolios have depended on the academic idea of efficient markets, rooted in Eugene Fama’s theory from the 1960s, leading to the modern portfolio theory. This has facilitated the rise of index funds, which have become the go-to strategy for managing pensions and retirement accounts.

As we enter a new era of digital finance, tokenized assets present an opportunity to expand investment possibilities that traditional models often overlook.

The Genesis of Modern Portfolio Theory

Index fund investing was not accidental. In the early 1970s, Burton Malkiel promoted index funds in his 1973 book, “A Random Walk Down Wall Street.” This idea was later implemented by John Bogle with the launch of the Vanguard S&P 500 fund in 1975.

This strategy, emphasizing broad diversification and minimal trading, has gained global acceptance, despite questions about the rationality of investors, as explored by behavioral psychologists like Daniel Kahneman and Amos Tversky in books like “Thinking, Fast and Slow.”

Economists later merged concepts of efficient markets with irrational behaviors, leading to the notion of “pretty good markets”. Though prices aggregate knowledge over time, significant daily variances exist, creating opportunities for astute investors. Index funds thrive as consistent exploitation of these opportunities is challenging due to costs.

Regulatory frameworks enforce a reliance on proven strategies, resulting in fund managers committing their portfolios predominantly to long-established, reliable assets like government bonds and passive equity funds.

Consequently, acceptable investments hinge more on data history, reliability, and transparency than purely on potential returns. Index funds are a prime example of this phenomenon.

In this context, exploring novel opportunities entails significant caution. New asset classes often lack the historical data necessary for inclusion in fiduciary portfolios, as most portfolio theory centers around U.S. equities and government bonds. Although each has expanded to include additional index funds and bonds from other economies, it’s still a small segment of global assets where investments are constrained by regulatory and data limits. However, this landscape is shifting.

Tokenization: Expanding the Universe of Investable Assets

Tokenization and on-chain transactions provide a scalable method for housing various assets. They facilitate transparent and comparable data on asset values. By digitizing real-world assets, such as Thai real estate or Nigerian oil leases into blockchain tokens, we can establish the continuous pricing data typical of a narrow asset set.

For instance, question arises: how much Thai real estate should comprise a diversified retirement portfolio? Current models lack reliable pricing data, but tokenization could implement a daily market for such assets, allowing evaluation against metrics like U.S. equities. In due time, this would redefine the static, index-driven investment approach.

The Implications for Global Finance

Currently, alternative investment strategies – anything outside stock or bond indices – make up a mere 15-20% of many funds. A data-driven shift in investment options could open up the remaining 80% for exploration.

Envision a future where truly diversified portfolios are unrestricted by traditional equity and debt markets. Tokenization could grant both individual investors and large institutions access to previously sidelined asset classes and geographies due to data inadequacy or illiquidity. The core principles of modern portfolio theory would evolve, incorporating a broader spectrum of risk-return profiles.

As tokenized assets accumulate performance histories, fiduciaries favoring traditional bonds and index funds may need to reassess their strategies. The “pretty good market hypothesis” won’t be discarded; its definition of “efficiency” may significantly broaden. A richer dataset might enable more nuanced risk evaluations, yielding portfolios that more accurately reflect global value.

A Measured but Inevitable Shift

This transformation will not be instantaneous. Changes are likely to materialize over about a decade, with a need for a comprehensive portfolio of tokenized assets and a 5-7 year timeframe to develop continuous data trails. However, swift shifts could follow the emergence of reliable data, aided by AI advancements.

Historically, change tends to be gradual, with fund managers and consumers often slow to adapt to new information. It took 40 years for pension fund investors to shift from a model heavily reliant on bonds in the 1950s to a mostly equity index fund model in the 1990s, while index funds took about 30 years to gain dominance as the optimal equity investment choice.

In an age of AI-driven automated investment solutions, the transition could potentially accelerate. With hundreds of trillions of dollars in assets managed, even a slight shift in allocation strategies can result in significant impacts. To explore the future role of digital assets in portfolios, join us at the upcoming EY Global Blockchain Summit, April 1-3.