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Black-Litterman Approach

Time diversification

Half or half

allocation, the CAPM and investing

SAPM [Econ F412/FIN F313]

Ramana Sonti

BITS Pilani, Hyderabad Campus

Term II, 2014-15

1/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Agenda

Example

2 Using the CAPM

4

5

2/48

Factor models

Single index model

Estimating CAPM parameters

Application: Markowitz optimization

Market risk premium

Empirical evidence

The equity premium puzzle

Black-Litterman Approach

Time diversification

True or false?

Resolution

Optimal investment mix and age

Half or half

The puzzle

Evaluation

Lecture 6: Practical Matters - Asset allocation, the CAPM and investing

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

Accepts as inputs: expected returns and variance covariance matrix

Big Problem: Using historical returns to estimate inputs is fraught

Illustration

Monthly data on 8 equity market MSCI indices Nov 1998 through

Sep 2008 (119 months) from Datastream

Canada

Germany

Hong Kong

India

Japan

Singapore

United Kingdom

United States

3/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

Every month, use 12 month (or 60 month) historical average returns

Regress realized returns on expected returns as follows:

If averages are any good (unbiased) as estimates of expected returns,

Results for India and the USA

j

T (j = 1)

R2

India

12 months

60 months

0.451

0.494

-2.12

-0.99

0.028

0.016

USA

12 months

60 months

0.283

-0.946

-2.27

-2.42

0.008

0.023

Problem 2: Estimation using finite samples brings with it estimation error

4/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

With (the first) 60 months of data, calculate historical mean vector

0 and VC matrix

Use these inputs to calculate 25 portfolios on the efficient frontier

Minimum exp. return portfolio: global minimum variance portfolio

Maximum exp. return portfolio: maximum expected return asset

23 intermediate portfolios

5/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

Mean return

0.040

0.045

0.050

0.055

Standard deviation

6/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

Return data are generated from unknown distribution

The 60 months of historical data represent only one possible sample

path

Assuming sample moments as the true moments leads to estimation

error

Exploratory framework: Resampling

0

Step 1: Generate historical mean vector

0 and VC matrix

Step 2: For trial i, draw a sample of T = 60 returns for N = 8 assets

0

from a multivariate normal distribution: N

0 ,

i . Use these inputs to form 25

Step 3: Estimate new inputs

i and

efficient frontier portfolios

Step 4: Evaluate the mean and variance of these 25 portfolios with

0

the original optimization inputs:

0 and

Step 5: Repeat Steps 2 through 4 for say, 500 trials

optimal allocations

7/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

0.020

Resampling: Results

0.010

0.005

0.000

Mean return

0.015

0.005

0.04

0.05

0.06

0.07

0.08

0.09

Standard deviation

8/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example

0.005

0.000

0.005

Mean return

0.010

0.015

0.040

0.045

0.050

0.055

0.060

0.065

Standard deviation

9/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Factor models

Factor models are useful ways of summarizing

the returns of each security

the relationship between returns of different securities

Note that this is merely a way of breaking down returns, where F

represents unanticipated shocks to the only risk factor

In English, the above equation says that any return over and above

the expected return on a given security could be from one of two

sources

the impact of unanticipated macro events through the factor, in proportion to

the securitys factor sensitivity, i F

Here we have assumed that GDP growth, GDPG is the only risk factor affecting all

stocks. Notice that the factor F has been defined as GDPG E (GDPG ): the

unanticipated component of the macro risk factor

eI is the company specific part of Infosys return next quarter

10/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Factor models

Multi-factor models

Multi-factor models posit more than one factor, and are written as

Note that Fj represent unanticipated shocks to the the j th factor

Any return over and above the expected return on a given security

the impact of unanticipated macro events through each of the

factors, in proportion to the securitys factor sensitivities, i,j Fj

unanticipated idiosyncratic or company specific events, ei

Note that E (Fj ) = 0 for all factors j , and

For example, we might write for Infosys stocks next quarter:

Here we have assumed that in addition to GDP growth, GDPG ,

there is one more macro factor, inflation, INF affecting all stocks

11/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Factor models

Asset pricing refers to models that relate expected return and risk

(factor betas)

For instance, the most general asset pricing model called the

E (ri ) = rf + i,1 1 + + i,K K

i,j is the sensitivity of asset is return to factor j

1 through K are called the factor risk premiums, i.e., the excess

associated with the particular factor

As another example, the Capital Asset Pricing Model (CAPM), says

Here the market is the only factor, so 1 = E (rm ) rf , a.k.a. the

12/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

While using a single factor model, we need to take a stand on what

the factor is. Following from the CAPM logic, one might choose the

return on a market index as the only macro factor

A related model which is very popularly used is the single index

model ri rf = i + i (rm rf ) + i , where E (i ) = 0

Here, rm represents the return on an index, such as the BSE Sensex

Why is the single index model a valid single factor model?

Taking expectations on both sides, we have

E (ri ) rf = i + i [E (rm ) rf ]

Subtracting the second equation from the first, we have

ri E (ri ) = i [rm E (rm )] + i , which is a clearly a single factor

model

This single index model was first used to model security returns by

William Sharpe (of CAPM fame), and is also called the diagonal

model

13/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

There are three fundamental assumptions of the single index model,

E (i ) = 0: the idiosyncratic part of the security return is

unpredictable

Cov (i , rm ) = 0: the idiosyncratic part of the security return is

Cov (i , j ) = 0 for all i 6= j: the idiosyncratic return of one security

Using the first two assumptions, we already deduced that

i = 0 for all securities, if the CAPM is true,

2

i2 = i2 m

+ 2i ,i.e., total risk is the sum of systematic risk and

idiosyncratic risk

What about the covariance between the returns of two assets, i and

j?

Cov (ri , rj ) = Cov (i + i (rm rf ) + i , j + j (rm rf ) + j )

2

which reduces to Cov (ri , rj ) = i j m

after using the last two

assumptions above

14/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Consider a Markowitz portfolio allocation exercise with N = 50

following parameters as inputs

N = 50 estimates of expected returns

N = 50 estimates of variances

N(N 1)/2 = 1225 estimates of covariances

Besides, another problem is that expected returns are notoriously

The single index model helps us get around this problem. From the

N = 50 estimates of betas

N = 50 estimates of idiosyncratic (firm specific) variances

1 estimate for the variance of the factor (index)

If we use the CAPM for expected return, we can use the betas,

provided we have an estimated market risk premium

15/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Consider monthly return data on 10 Indian stocks from 1999:01 through 2007:12

Let us estimate alpha and beta using the single index model for each stock

Typically use 5 years (60 months) of data: Parameter stationarity

Why monthly data? Bid-ask bounce and non-synchronous data at daily intervals

excess returns, with the characteristic line superimposed

0.6

0.5

0.4

0.3

0.2

0.1

0.0

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

-0.1

0.05

0.10

0.15

0.20

-0.2

-0.3

-0.4

Index excess returns

How do we read

i , i and i,t from this graph?

16/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Consider estimating the beta of Reliance Energy stock

T = 60 months of return data from 1999:01 through 2003:12

Use COSPI index as the market portfolio proxy

Use NSE MIBOR data as risk-free rate proxy

How do we decompose the variance of Reliance Energy?

Total risk of the stock is Var (ri rf ) = 0.0176

Systematic risk is i2 Var (rm rf ) = 0.0052

Idiosyncratic volatility must be 0.0176 0.0052 = 0.0124

In practice, we estimate idiosyncratic volatility by dividing the SSR

by T 2 (here, 58). this estimate yields 0.7349/58 = 0.0127

R-squared is the explained proportion of stock return variance,

0.0052/0.0176 = 0.2936

How could we use the CAPM to predict the expected return next

Assuming rf will remain at 0.4% (monthly), and E (rm ) rf is 1.25%

0.4 + 0.79(1.25) = 1.39%

17/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Note that Merrill Lynch uses 60 months of data with the S&P 500

index as the U.S. market index proxy, and runs the regression:

ri,t = ai + bi rm,t + ei,t

Their estimate

of alpha is related to our alpha estimate as:

ai =

i + 1 i rf , where rf is the average risk-free rate over the

sample period

The beta estimates of both regressions are the same

Adjusted beta: Merrill obtains adjusted betas as

Intuition: Nudging estimated beta towards one; think about

Statistics: Estimation error

18/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Fundamental betas

Can betas estimated from historical data be used as predictors of future beta?

Note that historical beta is an unbiased estimator of the true historical beta

averaged over past periods. Whether this is a good predictor of the future

depends on whether the change in the true beta from past average to the future

value is zero or not

Firm reduced leverage very recently; estimated historical average will be higher than

current firm beta, i.e., the fundamentals of the firm have changed during the

estimation period

A firms beta tends to drift about an industry norm. A good predictor of future beta

will have to incorporate a weighted average of the historical beta, and the industry

norm

Events to which a firm might have heavy exposure are expected to become more

important for the market portfolio in the future, although the firms exposure to such

events is not expected to change

Currentbeta = a + b(pastbeta) +

K

X

k=1

19/48

ck firmchark +

J

X

dj inddumj + e

j=1

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Lets take a real-life example of Markowitz optimization with 10

Use data from 1999:01 to 2006:12 to

estimate variances and covariances of the stock returns by two

methods: (a) Sample variances and covariances (b) Using the single

index model

estimate expected returns on the stocks by two methods: (a)

Historical averages (b) CAPM estimates

Try to form the tangency (a.k.a. MVE) portfolio using both

estimates of expected return and both variance/covariance matrices

See which method works better for portfolio composition and future

performance

20/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Exp. return

Var-covar

Stock

Reliance Energy

Bajaj Auto

Coromandel Fert.

Essar Steel

Hindustan Unilever

ICICI Bank

Infosys

SBI

Tata Chemicals

Thermax

Sample

Single index

Weight(%)

Weight(%)

0.5

-4.5

30.7

29.6

52.2

43.0

-6.8

-0.2

-65.3

-61.1

41.5

33.2

31.7

32.7

5.6

10.4

-25.1

-8.6

35.0

25.5

Sample

Single index

Weight(%)

Weight(%)

9.0

9.8

-0.3

8.4

8.0

7.1

4.0

5.0

19.3

17.0

4.4

5.8

22.5

12.1

14.0

14.6

16.9

11.8

2.1

8.4

Using historical average returns results in a portfolio with large positions (long

and short)

Using CAPM returns results in much better behaved portfolios

21/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Exp. return

Var-covar

Average (%)

Standard deviation (%)

Sharpe ratio

Sample

Single index

4.34

3.80

12.02

10.57

0.361

0.360

Sample

Single index

3.43

3.98

7.31

7.25

0.469

0.549

Portfolios formed on the basis of the CAPM and the single index

22/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Empirical evidence

Perhaps the most popular use of the CAPM is to calculate cost of

While using the CAPM, what should one plug in as the E (rm ) rf ?

Answer: No one really knows!

Depends on where you are

Look at data

Country

U.S.A.

U.K.

Japan

Germany

France

Sweden

India

India

23/48

Period

1926-2004

1947-1999

1970-1999

1978-1997

1973-1998

1919-2003

1981-1991

1991-2005

Equities (%)

8.0

5.7

4.7

9.8

9.0

11.1

23.23

22.96

Risk-free (%)

0.7

1.1

1.4

3.2

2.7

5.6

12.02

9.51

Premium (%)

7.2

4.6

3.3

6.6

6.3

5.5

11.21

13.45

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Big question

The US equity premium is between 7-8 %. Is this justified?

Did people know in say, 1925 or 1947 that stocks would earn 7%

more than bonds on average; and were somehow rationally unwilling

to hold more stocks?

Mehra and Prescott (1985): The 7% difference between stocks and

T-bills is too large to be explained by standard economic models:

This is the equity premium puzzle

Essentially, says that people are much more risk averse according to

economic models, compared to what they actually seem to be...

24/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Predictive ratios

Run a regression of past equity premia against dividend yield ratios.

The idea is that higher dividend yield today makes stocks more

attractive and predicts a higher future equity premium

Now plug in to your estimated regression the current dividend yield

to predict an equity premium next period

Unfortunately, this method does not work very well in terms of

predictability

Philosophical predictions

Try to reason what premium would be appropriate for investors to be

lured from bonds to stocks, after extra risk should be accompanied

by extra return.

People usually come up with an equity premium of 1-3%

25/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Consensus surveys

A recent survey (2007) of finance professors says the most common

Other surveys are inconclusive. Consider a WSJ survey on Feb 28,

2005:

26/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Conclusion

EPP is a result of survivorship bias

Search for more sophisticated (and complicated) utility functions

Look to investor participation in stock market as an explanation

Behavioral idea that maybe people are excessively risk averse, but

mistakenly so

27/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Besides resulting in extreme portfolios, traditional Markowitz

subjective estimates of expected return and associated confidence

levels

Black and Litterman (1992)

Illustrate these problems in a global asset allocation framework

Build a Bayesian model that combines equilibrium expected

Bayesian statistics is based on Bayes rule which is:

P(GoodSAPMgrade | HighFOFAgrade) =

P(HighFOFAgrade|Goodstudent)P(Goodstudent)

P(HighFOFAgrade)

28/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

n method: Black and Litterman(1992)

Market weights

in expected return inputs

Equilibrium/implied

expected returns

few assets

w portfolio managers to

e confidence in their subjective

expected return

Subjective views on

expected returns

Degree of confidence

in subjective views

erman (1992)

mework

expected returns with subjective

.k.a views

| High midterm score) =

29/48

Pr(High midterm score)

Lecture 6: Practical Matters - Asset allocation, the CAPM and investing

Ramana Sonti

Market risk premium

Black-Litterman Approach

Time diversification

are in some sense neutral. In reality, of course, they are not

neutral at all, but rather are a very special set of weights

that go short assets that have done poorly and go long assets

that have done well in the particular historical period.

Half or half

Equa

l MGlobal

eans

Recognizing the problem of using past returns, the investor

asset

allocation

The

BL example

might hope that assuming equal means for returns across all

7 countries

asset allocation

Global

3 asset

classes per country: Stocks, Bonds and Currencies

7 countries

Exhibit

20 risky assets: 7x3=21; USD

cash3is an idle asset

Data: January 1975

through

August 1991

Optimal

Portfolios

Based on

Searching for an

Historical

Average

Approach

efficient portfolio

with

10.7% volatility (Global

(percent of portfolio value)

CAPM

equilibrium

portfolio)

Searching for an efficient portfolio with 10.7% volatility (Global CAPM equilibrium portfolio)

Results

using

meansasasexpected

expected

returns

usinghistorical

historical means

returns

Results

Unconstrained

Germany

Currency exposure

Bonds

Equities

78.7

30.4

4.4

France

Japan

U.K.

U.S.

15.5

40.4

15.5

28.6

1.4

13.3

54.5

44.0

Japan

U.K.

U.S.

18.0

88.8

0.0

23.7

0.0

0.0

0.0

0.0

46.5

40.7

4.4

Canada Australia

65.0

95.7

44.2

5.2

52.5

9.0

Germany

Currency exposure

Bonds

Equities

160.0

7.6

0.0

France

115.2

0.0

0.0

Canada Australia

77.8

0.0

0.0

13.8

0.0

0.0

is the

asset

allocation?

Where

Where

is the

asset

allocation?

30/488

2007 -6:Indian

Business

PracticalSchool

Mattersof

- Asset

allocation, the CAPM and investing

14 Sonti

Ramana

Fixed

IncomeMarket risk premium

Research

Black-Litterman Approach

Time diversification

Half or half

Exhibit

Exhibit 66

Black and

LittermanEquilibrium

example

2 Premiums

Risk

The BL example

...nnucontinued

Fixed

((ppeerrce

aali

cenntt aannu

lizzeedd exce

excess

ss rreettuurrnn))

Income

Research

Equilibrium

expected

excess

returns

(using

Blacks

global CAPM)

expected

excess

(using

Blacks

global

Equilibrium

expected

excess returns

returns

(using

Blacks

global CAPM)

CAPM)

Equilibrium

Germany

Germany

Currencies

Currencies

Bonds

Bonds

Equities

Equities

France

France

Japan

Japan

U.K.

Exhibit

Exhibit 77U.K.

U.S.

U.S.

1.01

1.10

1.40

0.91

1.01

1.10

1.40

0.91

Equilibrium

Optimal

Portfolio

2.29

2.23

2.88

3.28

1.87

2.29

2.23

2.88

3.28

1.87

6.27

8.48

8.72

6.27

8.48

8.72

7.32

((ppeerrce

ppoorrttfo

vvaalluue)

cenntt of

of

foli

lio10.27

o10.27

e) 7.32

Canada

Canada

0.60

0.60

2.54

2.54

7.28

7.28

Australia

Australia

0.63

0.63

1.74

1.74

6.45

6.45

Results

using

equilibrium

expected

returns

using

equilibrium

returns

Results

using

equilibrium expected

expected

returns

Results

Germany

Germany

Currency

Currency exposure

exposure

Bonds

Bonds

Equities

Equities

France

France Japan

Japan

1.1

1.1

2.9

2.9

Exhibit

Exhibit

2.6

2.6

0.9

0.9

1.9

1.9

shows

shows

2.4

2.4

U.K.

U.K.

5.9

2.0

5.9

2.0

1.8

6.0

1.8

the

equilibrium

the6.0

equilibrium

23.7

8.3

23.7

8.3

U.S.

U.S.

Canada

Canada Australia

Australia

0.6

0.6

0.3

0.3

16.3

1.4

0.3

16.3

1.4 for

0.3as66

risk

premiums

risk

premiums

for all

all

as29.7

1.6

1.1

29.7

1.6

1.1

sets,

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given this

this value

value of

of the

the universal

universal hedging

hedging constant.

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This

is

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benchmark

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How

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the

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rium

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as

our

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means

when

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How is

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How

he

basic

that

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problem

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optimal

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the

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Exhibit

shows the

the

optimal

portfolio.

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is simply

simply

the

use

quantitative

asset

allocation

models

is

how

to

use

quantitative

asset

allocation

models

is

how

to

Mid-1991

was

a

time

of

recession:

(not-so-confident)

views

are

that...

Mid-1991

a time

of recession:

(not-so-confident)

are

that...

Mid-1991

waswas

a time

of

recession:

(not-so-confident)

views

are

market

capitalization

portfolio

80%

currency

risk

market

capitalization

portfolio with

withviews

80% of

of the

the

currency

risk

that...

31/48

translate

translate their

their views

views into

into aa complete

complete set

set of

of expected

expected

hedged.

Other

portfolios

on

the

frontier

with

different

levels

hedged.returns

Other

portfolios

onthat

the can

frontier

with

different

levels

...stocks

equilibrium

expected

returns

2.5%

...stocks will

will underperform

underperform

equilibrium

expected

returns

by

2.5%

excess

on

be

used

as

for

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returns

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assets

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As

will

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the problem

problem

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expected

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will

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expected

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by here,

0.8%

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willwill

underperform

equilibrium

expected

returns

by model

2.5%

ing

lending

plus

or

of

portfolio.

ing or

or

lending

plus more

more

or less

less

of this

this

portfolio.

that

optimal

portfolio

weights

from

aa mean-variance

that

optimal

portfolio

weights

from

mean-variance

model

Simply

the

expected

return

vector

to

reflect

this

Simply adjust

adjust

the

expected

return

vector

to

reflect

this

...bonds

will outperform

equilibrium

returns

by 0.8%

are

sensitive

minor

in

excess

are incredibly

incredibly

sensitive to

toexpected

minor changes

changes

in expected

expected

excess

By

the

equilibrium

is

but

particularly

By itself,

itself,The

theadvantage

equilibrium

is interesting

interesting aa

but

not equilibrium

particularly

of

global

returns.

The

advantage

of incorporating

incorporating

global

equilibrium

Why not simplyreturns.

adjust

the

expected

return

vector

tonot

reflect

this?

useful.

The

real

value

of

the

equilibrium

is

to

provide

aa

useful.

The

real

value

of

the

equilibrium

is

to

provide

will

become

apparent

will

become

apparent when

when we

we show

show how

how to

to combine

combine it

it with

with

INVA

School

of

15

INVA -- Term

Term 44 -- 2007

2007 -- Indian

Indian

School

of Business

Business

neutral

framework

to

which

the

investor

can

add

his

own

neutral

framework

to

which

the

investor

can

add

his

own 15

an

an investors

investors views

views to

to generate

generate well-behaved

well-behaved portfolios,

portfolios, withwithperspective

in

terms

of

views,

optimization

objectives,

and

perspective

in

terms

of

views,

optimization

objectives,

and

out

out requiring

requiring the

the investor

investor to

to express

express aa complete

complete set

set of

of exexLecture 6: Practical

Matters - Asset

allocation,

CAPM

and investing

Ramana Sonti

constraints.

These

are

the

issues

to

constraints.

These

arethe

the

issues

to which

which we

we now

now turn.

turn.

Income

Market risk premium

Research

Black-Litterman Approach

Time diversification

Half or half

Exhibit 8

Portfolios

Based on a Moderate View

InvestorInvestor

views:Optimal

Naive

adjustment

views:

(perNaive

cent of portfoliadjustment

o value)

Results

usingusing

adjusted

expected

returns

adjusted

expected

returns

Results

Unconstrained

Currency exposure

Bonds

Equities

Germany

France

1.3

13.6

3.7

8.3

6.4

6.3

Japan

U.K.

U.S.

3.3

15.0

27.2

6.4

3.3

14.5

112.9

30.6

Japan

U.K.

U.S.

5.0

0.0

28.3

3.0

0.0

13.6

35.7

0.0

Canada Australia

8.5

42.4

24.8

1.9

0.7

6.0

Germany

Currency exposure

Bonds

Equities

2.3

0.0

2.6

France

4.3

0.0

5.3

Canada Australia

9.2

0.0

13.1

0.6

0.0

1.5

Compare

Compare

to earlier asset allocation with equilibrium expected returns. We see

We see that:

that:

bonds. This lack of apparent connection between the views

Allocation

decreases

and

US

(expected)

AllocationtotoUS

USstocks

stocks

decreases

andthat

that

USbonds

bonds

increases

(expected)

the investor

attempts

tototo

express

andincreases

the optimal

portfolio

Allocation to German

Canadian

bonds

sharply

(unforeseen)

theand

model

generates

is decreases

a pervasive

problem

with standard

mean-variance

arises because,

as we returns

saw in

Problem: Optimal allocation

a highlyoptimization.

non-linear It

function

of expected

trying

to generate

a portfolio

representing

no views,

in the

Optimal

allocation

a highly

non-linear

function

of expected

returns

Big problem:

(involving

variances

and correlations

optimization

there is a complex interaction between expected

(involving variances

and correlations

32/48

measuring risk.

INVA - Term 4 Lecture

- 20076: -Practical

IndianMatters

School

of Business

- Asset

allocation, the CAPM and investing

Ramana Sonti 16

Black-Litterman Approach

Time diversification

Half or half

BL start with single factor model: ri = i + i f + i

In plain English, the return on asset i will equal its equilibrium

expected return plus a factor surprise plus an asset-specific surprise

The world is not in equilibrium, i.e., E (f ) 6= 0, and E (i ) 6= 0

In the BL framework, there is uncertainty regarding E (ri ) which

Assume that uncertainty in expected returns is normally distributed

Uncertainty in returns ... summarized by

Uncertainty in expected returns ... summarized by

assets

e.g., the expected return on stocks will be 2% more than that on

bonds in the next quarter, and I believe in this view with 90%

confidence

Mathematically all the investors views are written as

0

P E (r ) = Q + ; N (0, )

33/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Example of views

Imagine 3 views:

IBM will have an expected return of 1% next month (65%

confidence)

GE will outperform GM by 0.4% next month (75% confidence)

MSFT return will be 0.2% more than that of IBM next month (90%

confidence)

These views can be succinctly written as:

0

P E (r ) = Q + ; N (0, ), where:

1

P = 0

1

E (r ) =

0

1

0

E (rIBM )

0

0

1

E (rGM ) E (rGE )

1%)

Q = 0.4%

0.2%

34/48

0

1

0

1/0.65

0

0

0

1/0.75

0

E (rMSFT )

0

1/0.90

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Using Bayesian statistics, B-L come up with the following formula

h

i1 h

i

0

0

1

1

E (r ) = ( ) + P 1 P

( ) + P 1 Q

Intuitively, a weighted average of equilibrium expected return and

More confidence in subjective forecast more weight given

Sensible models: e.g. CAPM, APT

Implied equilibrium return from market data thru reverse optimization

35/48

Ramana Sonti

directly.

directly.

Market risk premium

Black-Litterman Approach

Time diversification

Half or half

In

InExhibit

Exhibit99we

weshow

showthe

thecomplete

completeset

setofofexpected

expectedexcess

excess

returns

returns when

whenwe

weput

put100%

100%confidence

confidenceininaaview

viewthat

thatthe

the

differential

of

expected

excess

returns

of

U.S.

equities

Fixed

differential

of expected excess returns of U.S. equitiesover

over

Fixed

bonds

is

2.0

percentage

points,

below

the

equilibrium

differIncome

bonds

is 2.0 percentage points, below the equilibrium differIncome

ential

ofof5.5

Research

ential

5.5percentage

percentagepoints.

points.Exhibit

Exhibit10

10shows

showsthe

theoptimal

optimal

Research

portfolio

portfolioassociated

associatedwith

withthis

thisview.

view.

Back

Back to

to the

the BL

BL example

example

Exhibit

9views

Using their formula, BL

can incorporate

Exhibitinexplicable

9

This

Thisisisinincontrast

contrasttotothe

the inexplicableresults

resultswe

wesaw

sawearlier.

earlier.

We

see

here

a

balanced

portfolio

ininwhich

the

Expected

Excess

Returns

They

try

a

simple

view

that

says

US

stocks

will

outperform

UShave

BL

can

views

WeExpected

see

hereincorporate

a balanced

portfolio

which

theweights

weights

have

Using

Excess

Returns

Usingtheir

theirformula,

formula,

BL

can

incorporate

views

tilted

away

from

market

capitalizations

toward

U.S.

bonds

Combining

Investor

With

Equilibrium

tilted

away

from Views

market

capitalizations

toward

U.S.

bonds

bonds

(with

100%

confidence).

Note

that

this

isweless

than

the

Investor

Views

With

Equilibrium

They by

try Combining

a2%

simple

view

that

says

US

stocks

will

outperform

US

bonds

by

2%

(100%

away

from

U.S.

equities.

Given

our

view,

now

obtain

They try a simple and

view

that says

US

outperform

US bonds

by 2%

(100%

and away

U.S.

our view,

we now

obtain

(from

a(annu

aalistocks

zzeeequities.

ddppewill

rece

nn

tGiven

)t)

nnu

liconsider

rce

confidence

view).

Note

that

this

is

less

than

the

equilibrium

difference

of

5.5%

equilibrium

difference

of

5.5%

a

portfolio

that

we

reasonable.

confidence view). Note

that this

lessconsider

than the

equilibrium difference of 5.5%

a portfolio

thatiswe

reasonable.

Revised

expected

returns

Revisedset

set of expected

returns

Revised set of expected returns Exhibit 10

Exhibit 10

Germany

France

Japan

U.K.

U.S.

Canada Australia

Germany

France

Japan

U.K.

U.S.

Canada Australia

Optimal

Portfolio

Optimal

Currencies

1.32

1.28

1.73 Portfolio

1.22

0.44

0.47

Currencies

1.32

1.28

1.73

1.22

0.44

0.47

Investor

Views

Equilibrium

Bonds Combining

2.69

2.39

3.29

3.40

2.39

2.70

1.35

Investor

ViewsWith

With

Equilibrium

Bonds Combining

2.69

2.39

3.29

3.40

2.39

2.70

1.35

Equities

5.28

6.42

7.71

7.83

4.39

4.58

3.86

(6.42

p(peerrcecennt tofof7.71

ppoortrfo

Equities

5.28

4.58

3.86

tfolilioov7.83

vaalulue)e) 4.39

Revised portolio

allocation

weights

Revised

Revised

portolio

allocation

weights

set

of portfolio

allocations

Currency exposure

Currency exposure

Bonds

Bonds

Equities

Equities

22

22

Germany

France

JapanAboveU.K.

U.S. only

Canada

Australiato

totoadjust

accordingly.

we

the

Germany

JapanAboveU.K.

U.S. only

Canada

Australiato

adjustFrance

accordingly.

weadjusted

adjusted

thereturns

returns

U.S.

and

U.S.

other

1.4 bonds1.1

7.4equities,

2.5holding fixed all0.8

0.3

U.S.

and U.S.7.4equities,2.5holding fixed all0.8

otherexpectexpect1.4 bonds1.1

0.3

3.6

2.4

7.5

2.3

67.0

1.7

0.3

ed

excess

Another

difference

isisthat

3.6

2.4

7.5

2.3

67.0

1.7 we

0.3

ed

excessreturns.

returns.

Another

difference

thathere

here

wespecify

specify

3.3

2.9

29.5

10.3

3.3

2.0

1.4

aa differential

letting

3.3

2.9 ofofmeans,

29.5

10.3 the

3.3

2.0 determine

1.4

differential

means,

letting

theequilibrium

equilibrium

determine

the

theactual

actuallevels

levelsofofmeans;

means;above

abovewe

wehad

hadtotospecify

specifythe

thelevels

levels

Well-behaved portfolio;

changes are in line with views, with no strange sidedirectly.

Well-behaved portfolio;

changes are in line with views, with no strange sideWell-behaved

portfolio;directly.

changes

are in line with views, with no

effects

effects

9 we show the complete set of expected excess

strange side effects InInExhibit

Exhibit 9 we show the complete set of expected excess

returns when we put 100% confidence in a view that the

differential of expected excess returns of U.S. equities over

differential

of expected excess returns of U.S. equities over

INVA - Term 4 - 2007 - Indian School

of

20

is Business

2.0 percentage points, below the equilibrium differINVA - Term 4 - 2007 - Indianbonds

School

20

bonds of

is Business

2.0 percentage points, below the equilibrium differ36/48

ential -of

5.5allocation,

percentage

points.

Exhibit 10 shows the optimal

Lecture 6: Practical Matters

the CAPM

and investing

Ramana Sonti

ential Asset

of 5.5

percentage

points.

Exhibit 10 shows the optimal

Black-Litterman Approach

Time diversification

Half or half

True or false?

Time diversification

Over time, good returns and bad will cancel out, hence, stocks are

Does this idea have economic merit?

fallacy

37/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

True or false?

Defining returns

Suppose the prices of a risky asset are P0 and P1 on consecutive

days. Then we can define the following returns over one period

P1

The gross return is (1 + R1 ) = P

0

The continuously compounded return is

What about over two periods?

Over two periods, the gross return is

P2

P0

= (1 + R1 )(1 + R2 )

1

The two period continuously compounded return is

In general, over T periods, we have

The annualized rate of return satisfies

(1 + r0,T )T = [(1 + R1 )(1 + R2 ) (1 + RT )]

The continuously compounded return is

z0,T = log (PT /P0 ) = z1 + z2 + + zT

38/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

True or false?

Suppose every period, the continuously compounded (iid) return of

Now, if we look at the logarithm of annualized return, we have

1

T

[ + + + ] =

2

Var [log(1 + r0,T )] = T12 2 + 2 + + 2 = T

Standard deviation of annualized return =

T

Expected return stays constant with horizon, while risk (standard

deviation) decreases with time. This is why there is so much popular

advice saying stocks are less risky in the long run

E [log(1 + r0,T )] =

E [z0,T ] = [ + + + ] = T

Var [z0,T ] = 2 + 2 + + 2 = T 2

Expected return and risk (standard deviation), both increase with

time

What matters to investors is total return, i.e., their terminal wealth

39/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

True or false?

Assume that the continuously compounded (iid) stock market return

15%

Standard deviation of annualized return decreases with time

Standard deviation of total return increases with time

Horizon (years)

1

5

10

20

10

50

100

200

Sdev(total)(%)

15.00

33.54

47.43

67.08

Sdev(annualized)(%)

15.00

6.71

4.74

3.35

40/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Resolution

Assume the alternative investment is in risk-free bonds with a

Now, start with $1000, and compare terminal wealth after T years,

Terminal wealth with risky stocks: WT = 1000e z0,T

Terminal wealth with risk-free bonds: BT = 1000e 0.03T

Years

1

5

10

20

Bonds ($)

1030.45

1161.83

1349.86

1822.12

Lower ($)

Upper ($)

823.66

1482.90

854.36

3181.66

1072.82

6887.51

1984.15

27517.11

32.04

14.84

7.00

1.84

By year 20, the lower end of the 95% confidence interval of the risky

The probability that stocks underperform bonds decreases with the

horizon

41/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Resolution

However...

Consider the expected value of terminal wealth with investment in

Years

1

5

10

20

300.35

146.44

77.82

26.92

69.97

85.36

92.22

97.31

The growing improbability of such underperformance is accompanied

Investors care not just about the probability of losses, but also about

Risky asset choice should not depend upon horizon as long as

asset returns are random

future wealth depends only upon investment income

there are no taxes or transaction costs

42/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

An idea closely related to time diversification: Practitioners

greater proportion of bonds (and less stocks) as she ages

Time diversification cannot be the reason

We have shown that stocks are not less risky in the long run

Besides, if an investor can rebalance her portfolio regularly, the long

interval between rebalancings

A plausible reason for shifting to bonds as one ages is

income decreases (even if you are very good at what you do). How

should the investor re-optimize her portfolio in response?

If your labor income is risk-free, or at least not positively correlated

exposure to stocks as you age, to make up for loss in labor income

If your labor income is highly correlated with stock returns (mutual

fund managers): you should increase your exposure to stocks as you

age, again to make up for loss in labor income

43/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

The puzzle

Half stocks all the time or all stocks half the time?

Which alternative is better?

1 Invest half your wealth in stocks and half in risk-free bonds all the

time

2 Invest all your wealth in stocks half the time and risk-free bonds for

the other half

To analyze this, lets make the following assumptions:

We expect stocks to have a higher average return than risk-free

bonds

Stock returns are random; hence we cannot anticipate whether

There are no taxes or transaction costs to between stocks and bonds

risk-free bonds yield a constant periodic rate of 5%

44/48

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

The puzzle

Year

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

45/48

Stock

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

20%

-5%

Results:

Bond

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

5%

Returns

Balanced

Switching

12.5%

20.0%

0.0%

-5.0%

12.5%

20.0%

0.0%

-5.0%

12.5%

20.0%

0.0%

-5.0%

12.5%

20.0%

0.0%

-5.0%

12.5%

20.0%

0.0%

-5.0%

12.5%

5.0%

0.0%

5.0%

12.5%

5.0%

0.0%

5.0%

12.5%

5.0%

0.0%

5.0%

12.5%

5.0%

0.0%

5.0%

12.5%

5.0%

0.0%

5.0%

6.25%

6.25%

Wealth

Balanced

Switching

1.125

1.200

1.125

1.140

1.266

1.368

1.266

1.300

1.424

1.560

1.424

1.482

1.602

1.778

1.602

1.689

1.802

2.027

1.802

1.925

2.027

2.022

2.027

2.123

2.281

2.229

2.281

2.340

2.566

2.457

2.566

2.580

2.887

2.709

2.887

2.845

3.247

2.987

3.247

3.136

3.247

3.136

Exposure

Balanced

Switching

0.500

1.000

0.563

1.200

0.563

1.140

0.633

1.368

0.633

1.300

0.712

1.560

0.712

1.482

0.801

1.778

0.801

1.689

0.901

2.027

0.901

1.925

1.014

0.000

1.014

0.000

1.140

0.000

1.140

0.000

1.283

0.000

1.283

0.000

1.443

0.000

1.443

0.000

1.624

0.000

0.9551

0.8234

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

The puzzle

1988-2007

Year

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

46/48

Stock

17.6%

28.4%

-6.1%

33.6%

9.1%

11.6%

-0.8%

35.7%

21.2%

30.3%

22.3%

25.3%

-11.0%

-11.3%

-20.8%

33.1%

13.0%

7.3%

16.2%

7.3%

Bond

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

Balanced

11.3%

16.7%

-0.5%

19.3%

7.0%

8.3%

2.1%

20.3%

13.1%

17.7%

13.6%

15.1%

-3.0%

-3.1%

-7.9%

19.1%

9.0%

6.2%

10.6%

6.1%

Returns

Switch 1

17.6%

28.4%

-6.1%

33.6%

9.1%

11.6%

-0.8%

35.7%

21.2%

30.3%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

Switch 2

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

5.0%

22.3%

25.3%

-11.0%

-11.3%

-20.8%

33.1%

13.0%

7.3%

16.2%

7.3%

Balanced

1.113

1.299

1.292

1.541

1.650

1.787

1.824

2.195

2.483

2.921

3.320

3.822

3.706

3.590

3.306

3.936

4.291

4.555

5.039

5.348

Wealth

Switch 1

1.176

1.510

1.418

1.895

2.067

2.306

2.289

3.105

3.762

4.903

5.149

5.406

5.676

5.960

6.258

6.571

6.900

7.244

7.607

7.987

Switch 2

1.050

1.103

1.158

1.216

1.276

1.340

1.407

1.477

1.551

1.629

1.992

2.495

2.219

1.969

1.559

2.076

2.345

2.517

2.926

3.139

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Evaluation

Of course, the above results are specific to this 20 year period

How do we make general inferences?

One idea is bootstrapping

Step 1: Generate a sample of 20 yearly returns by picking from the

Step 2: Calculate expected returns, standard deviations, and ending

Repeat Step 1 and Step 2 a large number of times, e.g. 10,000

Calculate average values of expected return, standard deviation and

Results with 100,000 trials

Expected return (%)

Standard deviation (%)

47/48

Balanced

5.66

9.06

7.97

Switch 1

5.58

9.05

11.97

Switch 2

5.58

9.06

11.97

Ramana Sonti

Black-Litterman Approach

Time diversification

Half or half

Evaluation

The only way a switching strategy can be justified is if you believe

you can time the market to generate an expected return more than

the balanced strategy. How much more?

The Sharpe ratio is a good way to compare the balanced and

switching strategies, since it represents a reward-to-risk ratio

Sharpe ratio =

E (r )rf

Question: If you believe you are a market timer, what extra return

have the same Sharpe ratio?

In other words, what is the in 0.09060.05

=

0.0797

We can solve to give = 2.04%.

0.09060.05+

?

0.1197

This means your timing skill will have to result in a 2% extra annual

48/48

Ramana Sonti

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