4 - 0

Second Investment Course November 2005

Topic Four:

Portfolio Optimization: Analytical Techniques
4 - 1
Overview of the Portfolio Optimization Process
The preceding analysis demonstrates that it is possible for investors
to reduce their risk exposure simply by holding in their portfolios a
sufficiently large number of assets (or asset classes). This is the
notion of nave diversification, but as we have seen there is a limit to
how much risk this process can remove.

Efficient diversification is the process of selecting portfolio holdings
so as to: (i) minimize portfolio risk while (ii) achieving expected
return objectives and, possibly, satisfying other constraints (e.g., no
short sales allowed). Thus, efficient diversification is ultimately a
constrained optimization problem. We will return to this topic in the
next session.

Notice that simply minimizing portfolio risk without a specific return
objective in mind (i.e., an unconstrained optimization problem) is
seldom interesting to an investor. After all, in an efficient market,
any riskless portfolio should just earn the risk-free rate, which the
investor could obtain more cost-effectively with a T-bill purchase.
4 - 2
The Portfolio Optimization Process
As established by Nobel laureate Harry Markowitz in the 1950s, the
efficient diversification approach to establishing an optimal set of portfolio
investment weights (i.e., {w
i
}) can be seen as the solution to the following
non-linear, constrained optimization problem:

Select {w
i
} so as to minimize:


subject to: (i) E(R
p
) = R*
(ii) E w
i
= 1

The first constraint is the investors return goal (i.e., R*). The second
constraint simply states that the total investment across all 'n' asset
classes must equal 100%. (Notice that this constraint allows any of
the w
i
to be negative; that is, short selling is permissible.)


Other constraints that are often added to this problem include: (i) All w
i
> 0
(i.e., no short selling), or (ii) All w
i
< P, where P is a fixed percentage
] w 2w ... w [2w ] w ... [w
n , 1 n n 1 n n 1 - n 2 , 1 2 1 2 1
2
n
2
n
2
1
2
1
2
p
+ + + + + = o o o o o o o
4 - 3
Solving the Portfolio Optimization Problem
In general, there are two approaches to solving for the
optimal set of investment weights (i.e., {w
i
}) depending
on the inputs the user chooses to specify:

1. Underlying Risk and Return Parameters: Asset class expected
returns, standard deviations, correlations)
a. Analytical (i.e., closed-form) solution: True solution but
sometimes difficult to implement and relatively inflexible at
handling multiple portfolio constraints
b. Optimal search: Flexible design and easiest to implement, but
does not always achieve true solution

2. Observed Portfolio Returns: Underlying asset class risk and
return parameters estimated implicitly
4 - 4
The Analytical Solution to Efficient Portfolio Optimization
For any particular collection of assets, the efficient frontier refers to the set of portfolios that offers
the lowest level of risk for a pre-specified level of expected return. Given information about the
expected returns, standard deviations, and correlations amongst the securities, we have seen that
efficient portfolio weights can be determined analytically by solving the following problem:

Select {w
i
} so as to minimize:



subject to: (i) E(R
p
) = R*

(ii) Ew
i
= 1.

To make the solution somewhat more transparent, we can first rewrite the problem in matrix
notation. Assuming there are "n" securities available, define:

V = (n x n) covariance matrix (i.e., the diagonal elements are the n variances and
the off-diagonal elements are the correlation coefficients amongst the
securities);

w = (n x 1) vector of portfolio weights;

R = (n x 1) vector of expected security returns;

i = (n x 1) "unit" vector (i.e., a vector of ones).


With this notation, the efficient frontier problem can be recast as:

Min [(0.5) w' V w]
w
subject to

R* = w' R
and
1 = w' i
] w 2w ... w [2w ] w ... [w
n , 1 n n 1 n n 1 - n 2 , 1 2 1 2 1
2
n
2
n
2
1
2
1
2
p
+ + + + + = o o o o o o o
4 - 5
The Analytical Solution to Efficient Portfolio Optimization (cont.)
Note here that the variance of the portfolio (i.e., w' V w) has been divided by two; this is merely an
algebraic convenience and does not change the values of the optimal weights.

One approach to solving this constrained optimization problem is the Lagrange-multiplier method.
That is, to convert the constrained problem into an unconstrained one, select the vector of portfolio
weights so as to:

Min L = Min [ (0.5) w
'
Vw -
1
(R
*
- w
'
R) -
2
(1 - w
'
i ) ]


where
1
and
2
are the Lagrangean multipliers. Notice that this method incorporates the
constraints directly into the orginal function by creating two new variables to be solved.
Consequently, the solution can proceed by differentiating L with respect to w,
1
and
2
. The first
order conditions of the minimum are:


o L
o w
= Vw -
1
R -
2
i = 0
(1)


o L
o
1
=R
*
- w
'
R = 0 = R
*
- R
'
w
(2)


o L
o
2
= 1 - w
'
i = 0 = 1 - i
'
w
(3)


Solving (1) for w yields:


w =
1
V
-1
R +
2
V
-1
i = V
-1
[Ri]
(4)
4 - 6
The Analytical Solution to Efficient Portfolio Optimization (cont.)
For a particular value of R*, solve for
1
* and
2
* by combining the constraint equations in (3a)
and (3b) with an expanded form of (4):


R
*
= R
'
w =
1
*
R
'
V
-1
R +
2
*
R
'
V
-1
i
(5a)
and


1 = i
'
w =
1
*
i
'
V
-1
R +
2
*
i
'
V
-1
i
(5b)

Also, define the following efficient set constants:


A = R
'
V
-1
i = i
'
V
-1
R
(6a)


B = R
'
V
-1
R
(6b)


C = i
'
V
-1
i
(6c)

Substituting (6) into (5) yields:


BA
AC

1

2
= M =
R
-
1
(7)

or:


= M
-1
R
-
1
(8)


Substituting (8) into (4) leaves:


w
*
= V
-1
[ R i ] M
-1
R
*
1
(9)
where w* is the vector of weights for the minimum variance portfolio having an expected return of
R* and a variance of o
2
= w*'Vw*.
4 - 7
Example of Mean-Variance Optimization: Analytical Solution
(Three Asset Classes, Short Sales Allowed)
4 - 8
Example of Mean-Variance Optimization: Analytical Solution (cont.) (Three
Asset Classes, Short Sales Allowed)
4 - 9
Example of Mean-Variance Optimization: Optimal Search Procedure
(Three Asset Classes, Short Sales Allowed)
4 - 10
Example of Mean-Variance Optimization: Optimal Search Procedure
(Three Asset Classes, No Short Sales)
4 - 11
Measuring the Cost of Constraint: Incremental Portfolio Risk
Main Idea: Any constraint on the optimization process imposes a cost to the
investor in terms of incremental portfolio volatility, but only if that constraint is
binding (i.e., keeps you from investing in an otherwise optimal manner).
4 - 12
Mean-Variance Efficient Frontier With and Without Short-Selling
4 - 13
Optimal Search Efficient Frontier Example: Five Asset Classes
4 - 14
Example of Mean-Variance Optimization: Optimal Search Procedure
(Five Asset Classes, No Short Sales)
4 - 15
Mean-Variance Optimization with Black-Litterman Inputs
One of the criticisms that is sometimes made about the mean-
variance optimization process that we have just seen is that the
inputs (e.g., asset class expected returns, standard deviations, and
correlations) must be estimated, which can effect the quality of the
resulting strategic allocations.

Typically, these inputs are estimated from historical return data.
However, it has been observed that inputs estimated with historical
datathe expected returns, in particularlead to extreme portfolio
allocations that do not appear to be realistic.

Black-Litterman expected returns are often preferred in practice for
the use in mean-variance optimizations because the equilibrium-
consistent forecasts lead to smoother, more realistic allocations.
4 - 16
BL Mean-Variance Optimization Example
Recall the implied expected returns and other inputs from the earlier example:
4 - 17
BL Mean-Variance Optimization Example (cont.)
These inputs can then be used in a standard mean-variance optimizer:
4 - 18
BL Mean-Variance Optimization Example (cont.)
This leads to the following optimal allocations (i.e., efficient frontier):
4 - 19
BL Mean-Variance Optimization Example (cont.)
4 - 20
BL Mean-Variance Optimization Example (cont.)
Another advantage of the BL Optimization model is that it provides a
way for the user to incorporate his own views about asset class
expected returns into the estimation of the efficient frontier.

Said differently, if you do not agree with the implied returns, the BL
model allows you to make tactical adjustments to the inputs and still
achieve well-diversified portfolios that reflect your view.

Two components of a tactical view:
- Asset Class Performance
- Absolute (e.g., Asset Class #1 will have a return of X%)
- Relative (e.g., Asset Class #1 will outperform Asset Class #2 by Y%)
- User Confidence Level
- 0% to 100%, indicating certainty of return view

(See the article A Step-by-Step Guide to the Black-Litterman Model
by T. Idzorek of Zephyr Associates for more details on the
computational process involved with incorporating user-specified
tactical views)
4 - 21
BL Mean-Variance Optimization Example (cont.)
Suppose we adjust the inputs in the process to include two tactical views:
- US Equity will outperform Global Equity by 50 basis points (70% confidence)
- Emerging Market Equity will outperform US Equity by 150 basis points (50% confidence)
4 - 22
BL Mean-Variance Optimization Example (cont.)
The new optimal allocations reflect these tactical views (i.e., more Emerging Market
Equity and less Global Equity:
4 - 23
BL Mean-Variance Optimization Example (cont.)
This leads to the following new efficient frontier:
4 - 24
Optimal Portfolio Formation With Historical Returns: Examples
Suppose we have monthly return data for the last three
years on the following six asset classes:
- Chilean Stocks (IPSA Index)
- Chilean Bonds (LVAG & LVAC Indexes)
- Chilean Cash (LVAM Index)
- U.S. Stocks (S&P 500 Index)
- U.S. Bonds (SBBIG Index)
- Multi-Strategy Hedge Funds (CSFB/Tremont Index)

Assume also that the non-CLP denominated asset
classes can be perfectly and costlessly hedged in full if
the investor so desires
4 - 25
Optimal Portfolio Formation With Historical Returns: Examples (cont.)
Consider the formation of optimal strategic asset allocations under a
wide variety of conditions:
- With and without hedging non-CLP exposure
- With and Without Investment in Hedge Funds
- With and Without 30% Constraint on non-CLP Assets
- With different definitions of the optimization problem:
- Mean-Variance Optimization
- Mean-Lower Partial Moment (i.e., downside risk) Optimization
- Alpha-Tracking Error Optimization

Each of these optimization examples will:
- Use the set of historical returns directly rather than the underlying set of
asset class risk and return parameters
- Be based on historical return data from the period October 2002
September 2005
- Restrict against short selling (except those short sales embedded in the
hedge fund asset class)
4 - 26
1. Mean-Variance Optimization: Non-CLP Assets 100% Unhedged
4 - 27
Unconstrained Efficient Frontier: 100% Unhedged
E(R) op Relative op W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 1.13% 1.000 7.95% 6.18% 85.87% 0.00% 0.00% 0.00%
6.00% 1.65% 1.000 11.80% 9.15% 79.05% 0.00% 0.00% 0.00%
7.00% 2.18% 1.000 15.65% 12.12% 72.23% 0.00% 0.00% 0.00%
8.00% 2.71% 1.000 19.49% 15.09% 65.42% 0.00% 0.00% 0.00%
9.00% 3.24% 1.000 23.34% 18.06% 58.60% 0.00% 0.00% 0.00%
10.00% 3.77% 1.000 27.19% 21.03% 51.78% 0.00% 0.00% 0.00%
11.00% 4.30% 1.000 31.03% 24.00% 44.96% 0.00% 0.00% 0.00%
12.00% 4.83% 1.000 34.88% 26.97% 38.15% 0.00% 0.00% 0.00%
13.00% 5.36% 1.000 38.73% 29.94% 31.33% 0.00% 0.00% 0.00%
14.00% 5.90% 1.000 42.57% 32.92% 24.51% 0.00% 0.00% 0.00%

4 - 28
One Consequence of the Unhedged M-V Efficient Frontier
Notice that because of the strengthening CLP/USD
exchange rate over the October 2002 September 2005
period, the optimal allocation for any expected return
goal did not include any exposure to non-CLP asset
classes

This unhedged foreign investment efficient frontier is
equivalent to the efficient frontier that would have
resulted from a domestic investment only constraint.

The issue of foreign currency hedging will be considered
in a separate topic
4 - 29
Mean-Variance Optimization: Non-CLP Assets 100% Hedged
4 - 30
Unconstrained M-V Efficient Frontier: 100% Hedged
E(R) op Relative op W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 0.71% 1.000 2.20% 9.45% 68.45% 0.59% 0.00% 19.31%
6.00% 1.02% 1.000 3.36% 13.82% 53.57% 0.74% 0.00% 28.51%
7.00% 1.34% 1.000 4.51% 18.19% 38.68% 0.89% 0.00% 37.72%
8.00% 1.67% 1.000 5.67% 22.56% 23.80% 1.04% 0.00% 46.93%
9.00% 2.00% 1.000 6.83% 26.93% 8.92% 1.19% 0.00% 56.13%
10.00% 2.33% 1.000 8.58% 26.81% 0.00% 0.68% 0.00% 63.93%
11.00% 2.72% 1.000 11.18% 20.28% 0.00% 0.00% 0.00% 68.54%
12.00% 3.16% 1.000 13.75% 13.98% 0.00% 0.00% 0.00% 72.28%
13.00% 3.63% 1.000 16.32% 7.67% 0.00% 0.00% 0.00% 76.01%
14.00% 4.11% 1.000 18.88% 1.37% 0.00% 0.00% 0.00% 79.75%

4 - 31
Comparison of Unhedged (i.e. Domestic Only) and
Hedged (i.e., Unconstrained Foreign) Efficient Frontiers
Expected Return
Unhedged M-V op Hedged M-V op Relative op
5.00% 1.13% 0.71% 1.598
6.00% 1.65% 1.02% 1.620
7.00% 2.18% 1.34% 1.624
8.00% 2.71% 1.67% 1.624
9.00% 3.24% 2.00% 1.622
10.00% 3.77% 2.33% 1.617
11.00% 4.30% 2.72% 1.581
12.00% 4.83% 3.16% 1.531
13.00% 5.36% 3.63% 1.480
14.00% 5.90% 4.11% 1.433

4 - 32
A Related Question About Foreign Diversification
What allocation to foreign assets in a domestic investment portfolio
leads to a reduction in the overall level of risk?

Van Harlow of Fidelity Investments performed the following analysis:
- Consider a benchmark portfolio containing a 100% allocation to U.S.
equities
- Diversify the benchmark portfolio by adding a foreign equity allocation in
successive 5% increments
- Calculate standard deviations for benchmark and diversified portfolios
using monthly return data over rolling three-year holding periods during
1970-2005
- For each foreign allocation proportion, calculate the percentage of
rolling three-year holding periods that resulted in a risk level for the
diversified portfolio that was higher than the domestic benchmark
4 - 33
Portfolio Risk Reduction and Diversifying Into Foreign Assets
United States, 1970-2005
0%
5%
10%
15%
20%
25%
30%
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65%
Foreign Stock Allocation
F
r
e
q
u
e
n
c
y

o
f

H
i
g
h
e
r

R
i
s
k

(
v
s

D
o
m
e
s
t
i
c

O
n
l
y
)
R
o
l
l
i
n
g

3

Y
e
a
r

P
e
r
i
o
d
s

1
9
7
0
-
2
0
0
5
4 - 34
Foreign Diversification Potential (cont.)
Ennis Knupp Associates (EKA) have provided an alternative way of quantifying the
diversification benefits of adding international stocks to a U.S. stock portfolio:
EKA concludes that international diversification adds an important element
of risk control within an investment program; the optimal allocation from a
statistical standpoint is approximately 30%-40% of total equities, although
they generally favor a slightly lower allocation due to cost considerations.
I mpact of Diversification on Volatility
1971 - 2001
15.0
15.5
16.0
16.5
17.0
17.5
18.0
18.5
19.0
0 10 20 30 40 50 60 70 80 90 100
Percentage in Foreign Stocks
V
o
l
a
t
i
l
i
t
y
4 - 35
Foreign Diversification Potential: One Caveat
During recent periods, it appears as though the correlations between U.S.
and non-U.S. markets are increasing, reducing the diversification benefits of
non-U.S. markets.

While this is true, the fact that these markets are less than perfectly
correlated means that there is still a diversification benefit afforded to
investors who allocate a portion of their assets overseas.

Rolling 3-Year Correlations
U.S. and Non-U.S. Stocks
1971-2001
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1
9
7
4

1
9
7
5

1
9
7
7

1
9
7
8

1
9
7
9

1
9
8
0

1
9
8
2

1
9
8
3

1
9
8
4

1
9
8
5

1
9
8
7

1
9
8
8

1
9
8
9

1
9
9
0

1
9
9
2

1
9
9
3

1
9
9
4

1
9
9
5

1
9
9
7

1
9
9
8

1
9
9
9

2
0
0
0

2
0
0
2

4 - 36
More on Mean-Variance Optimization:
The Cost of Adding Additional Constraints
Start with the following base case:
- Six asset classes: Three Chilean, Three Foreign (Including
Hedge Funds)
- No Short Sales
- 100% Hedged Foreign Investments
- No Constraint on Total Foreign Investment
- No Constraint on Hedge Fund Investment

Consider the addition of two more constraints:
- 30% Limit on Foreign Asset Classes
- No Hedge Funds
4 - 37
Additional Constraints: 30% Foreign Investment
E(R) op Relative op W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 0.71% 1.000 2.20% 9.45% 68.45% 0.59% 0.00% 19.31%
6.00% 1.02% 1.000 3.36% 13.82% 53.57% 0.74% 0.00% 28.51%
7.00% 1.40% 1.040 7.00% 16.77% 46.22% 0.63% 0.00% 29.37%
8.00% 1.85% 1.109 10.87% 19.60% 39.53% 0.50% 0.00% 29.50%
9.00% 2.34% 1.171 14.73% 22.43% 32.84% 0.37% 0.00% 29.63%
10.00% 2.84% 1.218 18.59% 25.25% 26.15% 0.24% 0.00% 29.76%
11.00% 3.35% 1.233 22.45% 27.97% 19.58% 0.10% 0.00% 29.90%
12.00% 3.87% 1.226 26.31% 30.93% 12.76% 0.00% 0.00% 30.00%
13.00% 4.39% 1.212 30.16% 33.90% 5.94% 0.00% 0.00% 30.00%
14.00% 4.92% 1.195 33.99% 36.01% 0.00% 0.00% 0.00% 30.00%

4 - 38
Additional Constraints: 30% Foreign Investment & No Hedge Funds
E(R) op Relative op W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 1.03% 1.449 5.82% 11.38% 72.44% 4.63% 5.73% 0.00%
6.00% 1.51% 1.477 8.75% 16.68% 60.13% 6.66% 7.78% 0.00%
7.00% 1.99% 1.485 11.68% 21.98% 47.82% 8.69% 9.83% 0.00%
8.00% 2.48% 1.488 14.62% 27.28% 35.50% 10.72% 11.88% 0.00%
9.00% 2.97% 1.488 17.55% 32.57% 23.19% 12.76% 13.93% 0.00%
10.00% 3.46% 1.485 20.57% 37.75% 11.69% 14.64% 15.36% 0.00%
11.00% 3.96% 1.455 23.98% 42.31% 3.71% 15.85% 14.15% 0.00%
12.00% 4.46% 1.412 27.45% 42.55% 0.00% 16.67% 13.33% 0.00%
13.00% 4.98% 1.373 30.97% 39.03% 0.00% 17.13% 12.87% 0.00%
14.00% 5.51% 1.339 34.57% 36.16% 0.00% 17.52% 11.74% 0.00%

4 - 39
2. Mean-Downside Risk Optimization Scenario
Start with Same Base Case as Before:
- Six Asset Classes: Three Domestic, Three Foreign
- Fully Hedged Foreign Investments; No Short Sales
- No Constraint on Foreign Investments
- No Constraint on Hedge Funds

Downside Risk Conditions:
- Threshold Level = 2.93% (i.e., annualized return from Chilean
cash market)
- Power Factor for Downside Deviations = 2.0
4 - 40
Mean-Downside Risk Optimization: Non-CLP Assets 100% Hedged
4 - 41
Unconstrained M-LPM Efficient Frontier: 100% Hedged
E(R) LPMp Rel. LPMp W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 0.19% 1.000 3.36% 12.91% 67.61% 0.65% 0.00% 15.47%
6.00% 0.26% 1.000 5.13% 16.98% 54.49% 0.61% 0.00% 22.79%
7.00% 0.33% 1.000 6.79% 20.98% 41.13% 0.57% 0.00% 30.53%
8.00% 0.41% 1.000 8.44% 24.98% 27.78% 0.52% 0.00% 38.27%
9.00% 0.48% 1.000 10.10% 28.99% 14.42% 0.48% 0.00% 46.01%
10.00% 0.56% 1.000 11.75% 32.99% 1.06% 0.44% 0.00% 53.75%
11.00% 0.65% 1.000 14.07% 26.91% 0.00% 0.00% 0.00% 59.01%
12.00% 0.79% 1.000 16.40% 20.05% 0.00% 0.00% 0.00% 63.55%
13.00% 0.94% 1.000 18.92% 13.64% 0.00% 0.00% 0.00% 67.44%
14.00% 1.11% 1.000 21.67% 7.76% 0.00% 0.00% 0.00% 70.57%

4 - 42
Additional Constraints: 30% Foreign Investment
E(R) LPMp Rel. LPMp W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 0.19% 1.000 3.36% 12.91% 67.61% 0.65% 0.00% 15.47%
6.00% 0.26% 1.000 5.13% 16.98% 54.49% 0.61% 0.00% 22.79%
7.00% 0.33% 1.002 7.12% 20.75% 42.13% 0.42% 0.00% 29.58%
8.00% 0.45% 1.098 11.04% 24.30% 34.66% 0.00% 0.00% 30.00%
9.00% 0.59% 1.233 14.90% 27.81% 27.29% 0.00% 0.00% 30.00%
10.00% 0.76% 1.361 18.79% 32.63% 18.58% 0.00% 0.00% 30.00%
11.00% 0.93% 1.432 22.68% 37.57% 9.75% 0.00% 0.00% 30.00%
12.00% 1.12% 1.422 26.46% 43.47% 0.07% 0.89% 0.00% 29.11%
13.00% 1.32% 1.401 30.29% 39.71% 0.00% 0.00% 0.00% 30.00%
14.00% 1.53% 1.384 33.99% 36.01% 0.00% 0.00% 0.00% 30.00%

4 - 43
Additional Constraints: 30% Foreign Investment & No Hedge Funds
E(R) LPMp Rel. LPMp W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


5.00% 0.33% 1.720 5.72% 12.96% 75.04% 5.44% 0.84% 0.00%
6.00% 0.47% 1.818 8.40% 18.62% 62.72% 8.16% 2.11% 0.00%
7.00% 0.62% 1.867 11.07% 24.24% 50.41% 10.88% 3.40% 0.00%
8.00% 0.77% 1.894 13.71% 29.74% 38.10% 13.66% 4.79% 0.00%
9.00% 0.92% 1.911 16.37% 35.30% 25.76% 16.41% 6.15% 0.00%
10.00% 1.07% 1.922 19.02% 40.86% 13.43% 19.17% 7.52% 0.00%
11.00% 1.22% 1.868 21.78% 46.41% 1.81% 21.75% 8.25% 0.00%
12.00% 1.38% 1.754 24.87% 46.27% 0.00% 23.66% 5.20% 0.00%
13.00% 1.56% 1.661 28.11% 45.57% 0.00% 25.30% 1.02% 0.00%
14.00% 1.76% 1.589 31.03% 41.76% 0.00% 27.22% 0.00% 0.00%

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3. Alpha-Tracking Error Optimization Scenario
Start with Same Base Case as Before:
- Six Asset Classes: Three Domestic, Three Foreign
- Fully Hedged Foreign Investments; No Short Sales
- No Constraint on Foreign Investments or Hedge Funds

Optimization Process Defined Relative to Benchmark Portfolio:
- Minimize Tracking Error Necessary to Achieve a Required Level of
Excess Return (i.e., Alpha) Relative to Benchmark Return
- Benchmark Composition: Chilean Stock: 35%; Chilean Bonds: 30%,
Chilean Cash: 5%; U.S. Stock: 15%; U.S. Bonds: 15%; Hedge Funds:
0%

Notice that Benchmark Portfolio Could Be Defined as Average Peer
Group Allocation
4 - 45
Alpha-Tracking Error Optimization: Non-CLP Assets 100% Hedged
4 - 46
Unconstrained o-TE Efficient Frontier: 100% Hedged
o TE Relative TE W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


0.20% 0.07% 1.000 35.23% 30.87% 2.16% 15.01% 14.83% 1.90%
0.40% 0.13% 1.000 35.51% 31.35% 0.00% 14.94% 14.46% 3.74%
0.60% 0.22% 1.000 35.96% 30.57% 0.00% 14.60% 13.46% 5.41%
0.80% 0.31% 1.000 36.41% 29.79% 0.00% 14.26% 12.45% 7.08%
1.00% 0.40% 1.000 36.85% 29.02% 0.00% 13.93% 11.45% 8.75%
1.20% 0.49% 1.000 37.30% 28.24% 0.00% 13.59% 10.44% 10.42%
1.40% 0.59% 1.000 37.75% 27.47% 0.00% 13.25% 9.44% 12.09%
1.60% 0.68% 1.000 38.19% 26.69% 0.00% 12.92% 8.43% 13.76%
1.80% 0.78% 1.000 38.64% 25.92% 0.00% 12.58% 7.43% 15.43%
2.00% 0.87% 1.000 39.09% 25.14% 0.00% 12.25% 6.42% 17.10%

4 - 47
Additional Constraints: 30% Foreign Investment
o TE Relative TE W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


0.20% 0.09% 1.336 35.52% 30.68% 3.80% 14.86% 13.89% 1.25%
0.40% 0.18% 1.325 36.04% 31.37% 2.60% 14.72% 12.78% 2.50%
0.60% 0.27% 1.225 36.56% 32.05% 1.39% 14.58% 11.67% 3.75%
0.80% 0.35% 1.151 37.08% 32.76% 0.16% 14.45% 10.56% 5.00%
1.00% 0.44% 1.108 37.58% 32.42% 0.00% 14.15% 9.40% 6.45%
1.20% 0.54% 1.083 38.09% 31.91% 0.00% 13.83% 8.23% 7.94%
1.40% 0.63% 1.068 38.59% 31.41% 0.00% 13.52% 7.06% 9.42%
1.60% 0.72% 1.058 39.10% 30.90% 0.00% 13.20% 5.89% 10.91%
1.80% 0.82% 1.051 39.60% 30.40% 0.00% 12.88% 4.72% 12.40%
2.00% 0.91% 1.045 40.11% 29.89% 0.00% 12.56% 3.55% 13.89%

4 - 48
Additional Constraints: 30% Foreign Investment & No Hedge Funds
o TE Relative TE W
cs
W
cb
W
cc
W
uss
W
usb
W
hf


0.20% 0.10% 1.558 35.68% 30.92% 3.40% 15.24% 14.76% 0.00%
0.40% 0.21% 1.546 36.36% 31.83% 1.81% 15.49% 14.51% 0.00%
0.60% 0.31% 1.430 37.05% 32.77% 0.19% 15.73% 14.27% 0.00%
0.80% 0.42% 1.353 37.75% 32.25% 0.00% 15.84% 14.16% 0.00%
1.00% 0.53% 1.314 38.45% 31.55% 0.00% 15.94% 14.06% 0.00%
1.20% 0.64% 1.292 39.16% 30.84% 0.00% 16.03% 13.97% 0.00%
1.40% 0.75% 1.278 39.86% 30.14% 0.00% 16.12% 13.88% 0.00%
1.60% 0.87% 1.268 40.60% 29.70% 0.00% 16.19% 13.51% 0.00%
1.80% 0.98% 1.261 41.34% 29.29% 0.00% 16.25% 13.13% 0.00%
2.00% 1.10% 1.255 42.07% 28.88% 0.00% 16.31% 12.74% 0.00%

4 - 49
The Portfolio Optimization Process: Some Summary Comments
The introduction of the portfolio optimization process was an important step
in the development of what is now considered to be modern finance theory.
These techniques have been widely used in practice for more than fifty
years.

Portfolio optimization is an effective tool for establishing the strategic asset
allocation policy for a investment portfolio. It is most likely to be usefully
employed at the asset class level rather than at the individual security level.

There are two critical implementation decisions that the investor must make:
- The nature of the risk-return problem:
- Mean-Variance, Mean-Downside Risk, Excess Return-Tracking Error
- Estimates of the required inputs:
- Expected returns, asset class risk, correlations

Portfolio optimization routines can be adapted to include a variety of
restrictions on the investment process (e.g., no short sales, limits on foreign
investing).
- The cost of such investment constraints can be viewed in terms of the incremental
volatility that the investor is required to bear to obtain the same expected
outcome