Asset Management

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Asset Management

© All Rights Reserved

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Martijn Boons - Nova SBE

TODAY

optimally across broad asset classes?

AMI - Strategic Asset Allocation

Intuition from answer to How much to invest in

risky versus riskless asset? easily generalizes

Risky: aggregate stock market portfolio, e.g., S&P500

Riskless: short-term Treasury bill

Horizon

Buy and hold versus rebalancing

When returns are not versus are predictable

Investors should control the risk (= variance) of their portfolio not

by re-allocating among risky assets, but through the split between

risky and risk-free

Held by the aggregate market, and in CAPM equilibrium

optimal for all investors

If not exactly optimal, at least well-diversified and attractive

assets, aggregate stock market index usually used as proxy

Uncertain market return equals capital gain + dividend:

=

(Nominally) Risk-free one-period return is known at time

and equals = ,

,

asset to maximize mean-variance utility over portfolio

return

Assumptions

Wealth is 1$, to abstract from wealth effects

Ascertains investor has constant relative risk

aversion (CRRA): dollar investment in risky asset

increases in wealth, but the share of wealth

invested in risky asset remains constant

No practical constraints: positivity or no short-sales

(x 0), no leverage (0 x 1)

SOLUTION

=

!"

#$

Example: = 8%, = 2%, = 20%, and %=3

1 6%

=

= 0.50

3 (20%)

Traditional portfolio advice: put 50% of wealth in

stocks

Note, Sharpe ratio of optimal portfolio is independent of %:

( )

.=

=

portfolio

/01

=8%

2%+0.5*

6%=5%

%=3

=2%

Slope=0.3

% = 1.5

return versus standard

deviation of optimal

portfolios

2. Indifference curves

determine which portfolio

choice is optimal for

each % (with utility

increasing in northwest

direction)

0.5*20%=

10%

= 20%

6

PROBLEM

Horizon of one period is unreasonable for most investors

Pension funds (horizon of liabilities 20 years)

Saving for a house, college, new campus etc.

2.

over this horizon

What is a period? Year (individuals), quarter (institutions),

, second (high-frequency traders)?

Why change?

1.

Time-varying investment opportunities (e.g.,

predictable returns and volatilities as the investor

passes through economic recessions / expansions),

2.

when approaching the horizon,

3.

or when risk aversion varies over time.

weight depends on horizon or time 3, or both

1.

with horizon at time 4 > + 1

Wealth varies from to + 1 due to portfolio return, which

is a function of the portfolio choice

Suppose T=5

trading strategy. Dynamic because weights can change

over time.

choosing a dynamic trading strategy: max (;(7< ))

{9 }

implemented immediately. The strategy optimally

responds to changes in asset returns, utility etc.

transaction costs

Lower investment in risky asset as 4 approaches (Bequest

motive)

Invest less in risky asset in high volatility recessions or

more when prices are low after crash. State dependency

from

2.

Time-varying risk aversion, i.e., may vary with wealth

Abstract from (2) today!

1.

The solution to this problem is easily found working backwards

Final wealth is the product of current wealth and uncertain oneperiod returns: 7> = 1 + , (1 + ,> )

maximize expected utility at t+5(=T):

max (;(7> )) = max (;(1 + ,> (A )))

9@

9@

utility:

1 A ,A

A

=

%

A

Conditional moments, as state of economy at t+4 unknown

Indirect utility: the maximum utility obtained at t+4,

)

10

B and A to maximize expected utility at t+5 (=T):

.

max (;(1 + ,A (B ))A )

9C

would do at + 3.

The A -term captures the advantage of being a long-term

investor. The utility derived from this A -term depends on

uncertain wealth and investment opportunities at + 4

each point in time..

max (;(7> ))

9C, 9@

11

GRAPHICAL REPRESENTATION

from buy and hold, which solves

one five-period problem!

12

LESSONS

Dynamic portfolio choice over long horizons is

first and foremost about solving one-period

portfolio choice problems!

This view destroys two widely held

misconceptions:

2.

from short-term investors

Buy-and-hold is optimal

1.

13

DIFFERENT FROM SHORT-TERM INVESTING

Dynamic programming shows that long-run investors do

everything that short-run investors do!

advantage of a long horizon.

The horizon effect enters through the indirect utility (VFG ) in

each one-period problem

For instance, suppose at t you know that stock market returns

will be high from t+1 to t+2. How might this affect the optimal

portfolio choice xF ?

Some will invest more risky, because future return can

compensate if returns are low from t to t+1

Some will invest less risky, to ensure that they have

sufficient money to invest when it is most attractive at t+1

Exact solution depends, among other things, on

Covt(, , , ) with mean-variance utility, and smoothing

preferences with other utility functions

14

BUY AND HOLD!

hold portfolios do, but also much more!

and hold; long-horizon investing is a continual process of

buying and selling.

the next ten years is 50%.

You need to rebalance each period!

If not, over a sufficiently long period of time, you will have

100% in risky assets. That is not what you wanted, right?

optimal choice is to do nothing

15

PREDICTABLE!

rate is fixed

one-period strategies

max (;(1 + ,A (B )))A

9C

!"

#$

16

Partial explanations include: inertia, natural tendency

to invest more in assets that do well than in assets

doing poorly, transaction costs (rebalancing bands)

For the two asset case (stock market and risk-free asset),

rebalancing is countercyclical:

Buy (sell) stocks after low (high) returns

Portfolio rebalancing ensures wealth remains to be

allocated optimally (in line with risk preferences) over

time, and is also advantageous if returns are

mean-reverting / predictable: prices drop when

expected future returns increase (more on

predictability later)

Example: Great depression

17

GREAT DEPRESSION

With rebalancing: sell some stocks before they are hit hard in 1930,

and buy some stocks before they rebound in 1932

Reduces variance

and increases returns

Similar evidence obtains in recent financial crisis!

18

AND HARVEY, 2006)

without reducing portfolio arithmetic return

you do not rebalance (weight in risky asset 100%)

diversification does increase portfolio geometric

return

This diversification return exists for a long-term investor

and is collected by rebalancing (also known as rebalancing

return or variance reduction)

Which two consecutive returns do you prefer: (90%,-50%) or

(10%,-10%)?

Excel example

19

RETURNS ARE PREDICTABLE (I)

If returns are predictable (not i.i.d.): additional benefits

from long-term horizon

Long-term weight (t) =

1. Long-run myopic weight +

2. (Short-run weight (t) Long-run myopic weight) +

3. Opportunistic weight (t)

Strategic asset allocation is the sum of these three

components!

1. Long-run fixed weight determined by long-run

average return and volatility

1 I

%

This is the constant rebalancing weight in the i.i.d. case!

20

RETURNS ARE PREDICTABLE (II)

2.

! ",

#$

I "

!

,

#$

short-and long-term investors can benefit.

3. Captures how long-term investor can take

advantage of time-varying, predictable returns in

ways short-run investors cannot.

The knowledge that market Sharpe ratio is going

to be high in the future: only the long-term

investor can benefit.

short- and long-run investors to changing means

and volatilities

21

WEIGHT

1.

Investor-specific: risk tolerance (like in one-period

portfolio) and horizon

2.

Asset-specific: how do returns vary over time?

Interaction between horizon and time-variation is

crucial:

An asset with low returns (high volatility) today, but

high returns (low volatility) in the (long-run) future is

not attractive for short-term investors, but long-term

investors might want to invest in them.

We can obtain more insight into the opportunistic weight

(or intertemporal hedge demand, as it was coined in

Merton (1973)), thinking about optimal buy-and-hold

portfolios as in Campbell and Viceira (CV, 1999, 2002,

2005)

22

THE CV-APPROACH

CV set out to find the optimal portfolio choice for buy-andhold investors with investment horizon K

(among other things) determined by the conditional

expectation and conditional variance of the risky assets

returns over the investors horizon K

(L)

(L)

( ( ), ( )), where ( ) is

the average expected per period return over horizon K

L

( ( ) defined analogously)

a regression of stock and t-bill returns on a set of predictors

(e.g., the dividend yield)

23

To get the necessary intuition, let us think about a

case where , is time-varying, but the market risk

M

premium

= , is constant

K-period horizon are of the following approximate

form:

L

M L

M L

/OP

(

,

1 ( )

1

, )

(L)

+ ( 1)

M L

% ( M L )

%

(

)

M L

L

/OP ( , , ) is

where

the average per period

covariance of risky assets return with risk-free return

over horizon K

1.

Myopic demand of a K-period investor (as before)

24

market returns are high whenever expected future returns

L

on both market and t-bills are high (, )

(relative to myopic demand), because it pays off exactly when

he does not need the money, i.e., when the future is bright

Risk loving investor (%<1) will over-weight (relative to myopic

demand), because he will be able to invest more in exactly

those states where expected future returns are high

portfolio. Short-run investors do not hedge

M L

L

intertemporally: /OP ( , , )=0 for K=1!

M L

L

/OP ( , , )

2.

25

PRACTICE

future stock returns

Example: the global minimum variance portfolio

hedging demands is debated heavily

CV estimate is large: risk-averse, long-run investor

over-weights stocks dramatically. Why?

Mean-reversion captured by the fact that dividend

yield predicts stock returns with a positive sign insample

When future expected stock returns increase,

current prices decrease and dividend yield

L

M L

increases (/OP ( , , )<<0)

26

RUN

27

IN STOCK RETURNS

Evidence in CV consistent with in-sample stock return

predictability by a range of variables:

Cash-flow based (dividend yield, earnings yield); Business

cycle indicators (term spread); Technical (momentum)

predictability out-of-sample, i.e., for an investor that is making

his investment decisions in real-time

Goyal and Welch (2008): coefficients unstable in sub-samples;

in-sample R2 small; out-of-sample R2 tiny

the tactical and opportunistic portfolio weights be small in practice.

Opportunistic hedging demands become much smaller once investors

have to learn about return predictability or when they take into

account estimation error.

28

Few investors are without liabilities.

First, meet the liabilities and then invest wealth, in excess of the

present value of liabilities, as before

Long-run weight (t) = Liability hedge (t) + Short-run weight

(t) + Opportunistic weight (t)

liabilities

Invests in assets with large covariance with liabilities

Intuition: if stock market return is high when liabilities

increase in value, it is attractive as a hedge. The more risk

averse the investor (%), the more weight he will place on

liability hedging.

Q

! ",

#$

( 1)

V (" )

29

PORTFOLIOS

Cash flow matching: Match a portfolio of fixed, future outflows

with bonds of appropriate maturities

2.

liabilities with a portfolio of Treasury bonds

3.

just duration

For most pension funds

horizon exceeds longest available maturity of liquidly

traded Treasury bonds

liabilities denominated in real, not nominal, terms, whereas

real, long-maturity bonds have only been traded in recent

years, but not in every country

Additional risks that need to be matched: liquidity risk,

longevity risk, economic growth, and credit risk.

1.

30

2.

3.

1.

buckets

Protective portfolio, which covers personal risk.

The portfolio is designed to minimize downside risk

and is a form of safety first.

Market portfolio, which is a balance of risk and

return to attain market-level performance from a

broadly diversified portfolio and is exposed to

market risk.

Aspirational portfolio, which is designed to take

measured risk to achieve significant return

enhancement. Aspirational risk is a property of an

investors utility function and is a desire to grow

wealth opportunistically to reach the next desired

wealth target.

31

CONCLUSIONS

Rebalancing is the foundation of any long-term

investment strategy!

Under i.i.d. returns the optimal policy is to

rebalance to constant weights for both short- and

long-term investors.

When returns are predictable, the optimal shortrun portfolio changes over time, and the long-run

investor has additional opportunistic strategies

Liabilities need to be adequately matched before

the investment portfolio is constructed.

32

LITERATURE

Books

Ang, Asset Management, Ch. 2-4

Campbell and Viceira, Strategic Asset Allocation, Ch. 2-3

Articles

Erb and Harvey, 2006, The Tactical and Strategic Value of

Commodity Futures, Financial Analysts Journal.

Merton, 1973, An Intertemporal Capital Asset Pricing Model,

Econometrica

Campbell and Viceira, 2005, The term structure of the risk-return

trade-off, NBER Working Paper

Campbell and Viceira, 2005, The term structure of the risk-return

trade-off, Financial Analysts Journal

Goyal and Welch, 2008, A Comprehensive Look at The Empirical

Performance of Equity Premium Prediction, Review of Financial

Studies

33

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