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- Chapter One

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Prof. Sandra Paterlini

Chair of Financial Econometrics & Asset Management

EBS Universitt fr Wirtschaft und Recht

Style Analysis

Sharpes Style Analysis

Sharpes Style Analysis

Sharpe's style analysis equation

where

sensitivity(factor loadings) of j-th fund w.r.t. the factor index Fi (i=1

ij

,,k with k=number of indexes)

Fit return of the i-th market index at time t

e jt unexplained component of the return of the j-th fund (selection)

Sharpes Style Analysis

Sharpe's style analysis equation

style

where

sensitivity(factor loadings) of j-th fund w.r.t. the factor index Fi (i=1

ij

,,k with k=number of indexes)

Fit return of the i-th market index at time t

e jt unexplained component of the return of the j-th fund (selection)

Sharpes Style Analysis

The "style

! The style component of a fund is estimated using a

properly chosen linear combination of market indexes

! Every market index is properly weighted in the

combination in order to replicate the fund return

! Such combination of indexes can be interpreted as a

portfolio equivalent to the fund portfolio w.r.t to the risk-

return profile (mimicking portfolio)

Sharpes Style Analysis

Sharpes model

selection

where

sensitivity(factor loadings) of j-th fund w.r.t. the factor index Fi (i=1

ij

,,k with k=number of indexes)

Fit return of the i-th market index at time t

e jt unexplained component of the return of the j-th fund (selection)

Sharpes Style Analysis

The "selection"

! The "selection of a fund is a residual component, that

cannot be estimated using the market indexes

! The "selection" component can be due to

- Non-inclusion of relevant financial indexes in the

model (model misspecification),

- Presence of active management,

" Realized through asset class rotation in a shorter time frame than

the one considered (market timing)

" And/or asset selection within each asset class (selectivity)

Sharpes Style Analysis

Sharpes model

style selection

where

sensitivity(factor loadings) of j-th fund w.r.t. the factor index Fi (i=1

ij

,,k with k=number of indexes)

Fit return of the i-th market index at time t

e jt unexplained component of the return of the j-th fund (selection)

Sharpes Style Analysis

Sharpes model

style selection

! Objective:

Estimate (1,...,k) such that the residual variance is

minimal, i.e. min (Var(ej))

where

Sharpes Style Analysis

Model Inputs

- Time series of the fund return under consideration

" Rj = time series of j-th fund return in the period t=1,...,T

! EXAMPLE

Monthly Returns

Period

Sharpes Style Analysis

Model Inputs

- Time series of the returns of the k factors

" F1,...,Fk = time series of the k factors in the period t=1,...,T

! EXAMPLE

Monthly Returns

Period

Sharpes Style Analysis

Model Outputs

- Factor loadings

" (1,...,k) = sensitivity (factor loadings) w.r.t. the factors Fi (i=1,,k)

Sharpes Model

Beta Estimates

Sharpes Style Analysis

Model Outpus

- Factor loadings

" (1,...,k) = sensitivities (factor loadings) w.r.t. to Fi (i=1,,k)

MSCI:

ITALY (1)

NORTH AMERICA (2)

JAPAN (3)

EMU + UK (4)

ITALY 1 - 3Y (E) (5)

WRLD. SOV. (6)

WRLD. SOV. EX. EMU (7)

Sharpes Style Analysis

Sharpes model

! The Beta coefficients can be interpreted as weights of the

financial activities of a portfolio equivalent to the portfolio

of the fund under consideration (strong style analysis)

! In such case, the sum of the beta has to be equal to 1 and

each beta must have value larger or equal to zero

i=1,...,k i 0 and i = 1

Sharpes Style Analysis

Model Outputs

- Factor loadings

" (1,...,k) = sensitivities (factor loadings) w.r.t. factors Fi (i=1,,k)

Sharpes Model

Beta Estimates

Sharpes Style Analysis

Model Outputs

- Factor loadings

" (1,...,k) = sensitivities (factor loadings) w.r.t. factors Fi (i=1,,k)

RF . Az. America ,t = 1 FMSCI N . America ,t + ... + k FMSCI EMU ,t + et

MSCI:

ITALY (1)

NORTH AMERICA (2)

JAPAN (3)

EMU + UK (4)

ITALY 1 - 3Y (E) (5)

WRLD. SOV. (6)

WRLD. SOV. EX. EMU (7)

Sharpes Style Analysis

Sharpes Model

! Factorial models are usually evaluated w.r.t. their

capability of explaining the returns of the fund under

consideration (e.g. RUSA Equity )

! A metric commonly used is the proportion of the

variance explained by the combination of the chosen

indexes => the so-called R2

! R2 quantifies the style component, while (1-R2) relates

to selection component

Sharpes Style Analysis

The R2 Index

2

Var (e j )

R = 1

Var ( R j )

where

Var(Rj) =Variance of the j-th fund

Var(ej) = Variance of the residual

Sharpes Style Analysis

A small R2 could be due to

! Some relevant asset classes have not been included in the

analysis

! The fund manager has a selection capability different from

the benchmark

! Data or Statistical Errors (e.g. errors in the input- NaN)

Sharpes Style Analysis

Style vs Selection

MONTHLY RETURNS

Selection

1%

Style

99%

Factors

Sharpes Style Analysis

Style vs Selection

Fund Returns vs Style Benchmark Return

Monthly Returns

Period

Sharpes Style Analysis

Style vs Selection

Fund Returns vs Style Benchmark Return

Monthly Returns

Period

Sharpes Style Analysis

Sum(Weights)

Style

Selection

Sharpes Style Analysis

Selection

18%

% of Total

Style

82%

Factors Weights

Sharpes Style Analysis

Fund Returns vs Style Benchmark Return

Returns

Period

Sharpes Style Analysis

Returns (Base 100)

Period

Effective Asset Mix

Effective Asset Mix

Effective Asset Mix

! The portfolio return of an investor can be decomposed as

N. funds

Rp,t = R j,tW j,t

! where j=1

Rj,t=j-th fund return at time t

Wj,t=j.th fund asset weight at time t

Effective Asset Mix

Effective Asset Mix.

! From Sharpes model, the return of the j-th fund is

R jt = [ 1 j F1t + 2 j F2t + ... + kj Fkt ] + e jt

" N. funds % " N. funds % " N. funds %

Rp,t = $ W j,t j,1 ' F1,t +... + $ W j,t k,1 ' Fk,t + $ W j,t e j '

$# j=1 '& $# j=1 '& $# j=1 '&

! Then,

R p ,t = p ,1 F1,t + ... + p ,k Fk ,t + e p ,t

Effective Asset Mix

Example

! An investor has allocated 20% of his capital to fund A and

the remaining 80% to fund B

Effective Asset Mix

Example

! Using Sharpes approach, we estimate the betas of both funds

as reported below

factors

! The exposure to factor 1 depends then both on the amount

invested in fund A and in fund B

Effective Asset Mix

Example Portfolio XYZ

Effective Asset Mix

Example

! If we look at the transpose matrix, we can determine the

weights (relative to the total investment) w.r.t. the two

factors.

30%x20%=6%

Effective Asset Mix

Why shall we invest in different funds ?

! Assuming the residuals are uncorrelated, the

diversification among funds will strongly reduce the

variance of the residual component, increasing the

proportion of variance explained by the asset allocation.

(E.S. O' Neal 1997, L.F. Fant & E.S. O'Neal, 1999)

Effective Asset Mix

How can we determine the Style?

! The effective mix of factors is the investor total portfolio

style

! If the portfolio is multimanaged, the style identification

is crucial to understand the portfolio risk and return

Strategic Asset Allocation

The Multimanager Approach

Multimanager Approach

Why shall we invest in more than one fund?

! Style diversification

! Manager diversification

managers and not in a signle one, lead to diminish the

standard deviation of the final wealth. The multimanager

or multi-brand approach should be preferred to the mono-

brand or single manager approach

(E.S. O' Neal 1997, L.F. Fant & E.S. O'Neal, 1999, G.Cinquemani & G.Siciliano 2001)

Multimanager Approach

How shall we choose in how many and which

funds to invest?

Ibbotson Associates, Lucas (1999)

! Optimizing Manager Structure and Budgeting

Manager Risk

Barclays Global Investor, Waring et al. (2000)

! Choosing managers and funds

Ibbotson Associates, Baierl e Chen (2000)

Strategic Asset Allocation

"Hitting the target!"

Ibbotson Associates, Lucas (1999)

"Hitting the target!"

The Idea

! Lets assume we know the investment targets

Investment Targets

achieve the investment targets

"Hitting the target!"

The "Naive Approach

! Lets choose 5 funds of categories that are coherent with

the investment targets and invest the corresponding

amount in each fund. Then:

Investment Targets

R p ,t = 0,05 RF .cashA,t + 0,25 RF.int ermedA,t + 0,25 RF . growthA ,t + 0,20 RF .smallA,t + 0,25 RF .int ernA,t

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 43

"Hitting the target!"

"Hitting the target!"

Attention...

! The investment style of the funds could be different from

what they declare and then the naive approach could

not lead to achieve the investment targets

! The Sharpes style analys can help us to evaluate the

presence of possible mismatch between the desired and

the achieved targets

Effective Asset Mix

Effective Asset Mix

! The portfolio return of an investor can be decomposed as

N. funds

Rp,t = R j,tW j,t

! where j=1

Rj,t=j-th fund return at time t

Wj,t=j.th fund asset weight at time t

Effective Asset Mix

Effective Asset Mix

! From Sharpes model, the return of the j-th fund is

R jt = [ 1 j F1t + 2 j F2t + ... + kj Fkt ] + e jt

" N. funds % " N. funds % " N. funds %

Rp,t = $ W j,t j,1 ' F1,t +... + $ W j,t k,1 ' Fk,t + $ W j,t e j '

$# j=1 '& $# j=1 '& $# j=1 '&

! Then,

R p ,t = p ,1 F1,t + ... + p ,k Fk ,t + e p ,t

"Hitting the target!"

Attention...

!Doing the Sharpes style analysis for 5 funds

RcashA,t=0,8Fcash,t+0,2Fintermediate,t+ecashA,t

RintermA,t=0,4Fcash,t+0,52Fintermediate,t+0,08Flong-term,t+eintermA,t

....

Betas of Sharpes Style Model

"Hitting the target!"

Attention...

! Then, the multi-manager portfolio can be decomposed in

the corresponding factors,

RcashA,t=0,8Fcash,t+0,2Fintermediate,t+ecashA,t

.....

and

R p = 0,05 RcashA + 0,25 Rint ermA + 0,25 RgrowthA + 0,20 RsmallA + 0,25 Rint ernA

R p = 0,05(0,8Fcash + 0,2 Fint ermediateB + ecashA ) + ..... + 0,20(....) + 0,25(....)

R p = 0,29 Fcash + 0,16 Fint ermediateB + 0,05 Flong + ....

..... + 0,02 Fint ernationalB + 0,22 Fl arg ecap + 0,15 Fsmall + 0,11Fint ernationalS + e p

"Hitting the target!"

Attention...

! Considering the Style analysis and the shares to be invested

in each fund, we get the decomposition in the factors of the

multimanager portfolio

Rp,t=0,29RcashA,t+0,16RintermediateA,t+...+0,11RinternA,t+ept

"Hitting the target!"

Attention...

! Then, we can determine the difference from the investment

target

(Allocation)

- =

"Hitting the target!"

"Hitting the target!"

"Hitting the target!"

An alternative strategy...

! How much shall we invest in the 5 funds to achieve our

investment target?

! The nave approach does not seem to offer an adequate

suggestion

! The "naive" approach does not allow to reach our

investment target

"Hitting the target!"

An alternative strategy...

! How much shall we invest in the 5 funds to achieve our

investment target?

! Using an optimization approach, we can determine the

optimal amount to be invested in each fund

! The objective is to determine how much to invest in each

fund to be able to achieve the investment target

"Hitting the target!"

In practice...

Small Target

Intermediate International Multimanager Actual Target Desired

Model Factors Cash Fund A Growth Fund A Compan Difference

Bond Fund A

y Fund A

Fund A Portfolio Weights (A) Target(B)

(A-B)

Cash

Intermediate

Bonds

w (N.funds

Large Cap Stocks x1) =

t (N.factors t (N.factors t (N.factors

Small Caps B' (N.factors x N. Funds)

International

x1) x1) x1)

Stocks

Long-term Bonds

International

Bonds

"Hitting the target!"

In practice...

Small Target

Multimanager

Intermediate Compan International Actual Desired

Model Factors Cash Fund A Growth Fund A y Fund Portfolio Difference

Bond Fund A Fund A

Weights Target (A) Target(B)

A (A-B)

Intermediate

Bonds 20% 52% 8% WFintermA 25% 25% 0.00%

Large Cap Stocks 60% 10% 20% WFgrowthA = 25% 25% 0.00%

International

Stocks 4% 40% WFIntern 25% 25% 0.00%

International

Bonds 4% 5% 0% 2% 0% 2.00%

"Hitting the target!"

In practice...

Small Target

Intermediate International Multimanager Actual Target Desired

Model Factors Cash Fund A Growth Fund A Company Difference

Bond Fund A

Fund A

Fund A Portfolio Weights (A) Target(B)

(A-B)

Large Cap Stocks 60% 10% 20% WFgrowthA = 25% 25% 0.00%

International

Stocks 4% 40% WFInternA 25% 25% 0.00%

"Hitting the target!"

Using the Solver in Excel...

"Hitting the target!"

Lets determine the ...

Multimanager Target

Actual Target Desired

Portfolio Difference

Weights (A) Target(B)

(A-B)

Cash Fund A -52.9% 5% 5% 0.00%

Intermediate

Bond Fund A

59.0% 25% 25% 0.00%

Growth Fund A 16.6% = 25% 25% 0.00%

Small Company

Fund A

28.7% 20% 20% 0.00%

International

Fund A

60.8% 25% 25% 0.00%

112.2% 5% 0% 5.00%

2% 0% 2.00%

100%

Sum Difference (absolute value)

Actual vs Desired Actual Target- 7.0000%

Desired Target

"Hitting the target!"

Target

Actual Target Desired

Difference

(A) Target(B)

(A-B)

5%

25%

- 5%

25%

= 0.00%

0.00%

5% 0% 5.00%

2% 0% 2.00%

100%

Actual vs Desired Actual Target- Desired 7.0000%

Target

"Hitting the target!"

....but attention!! It is not a realistic solution

Multimanager

Portfolio Weights

Intermediate Bond Fund A 59.0%

112.2%

Sum Weights1

"Hitting the target!"

Using the solver in Excel....

Lets set the constraints that the asset weights are 0 and their sum is 1

Small Target

Multimanager

Intermediate Compan International Actual Desired

Model Factors Cash Fund A Growth Fund A y Fund Portfolio Difference

Bond Fund A Fund A

Weights Target (A) Target(B)

A (A-B)

Intermediate

Bonds 20% 52% 8% WFintermA 25% 25% 0.00%

Large Cap Stocks 60% 10% 20% WFgrowthA = 25% 25% 0.00%

= 20% 20% 0.00%

International

Stocks 4% 40% WFIntern 25% 25% 0.00%

International

Bonds 4% 5% 0% 2% 0% 2.00%

"Hitting the target!"

Lets compute the weights...

Target

Multimanager Actual Target Desired

Portfolio Weights Difference

(A) Target(B)

(A-B)

Intermediate

Bond Fund A

0.0% 5% 25% -20.00%

Small Company

Fund A

29.5% 20% 20% 0.00%

International

Fund A

61.6% 25% 25% 0.00%

100.0% 0% 0% 0.00%

2% 0% 2.00%

100%

Sum Difference (absolute value)

Actual vs Desired Actual Target- -5.0000%

Desired Target

"Hitting the target!"

....the investment strategy is implementable...

Multimanager

Portfolio

Weights

Intermediate

Bond Fund A

0.0%

Small Company

Fund A

29.5%

International

Fund A

61.6%

"Hitting the target!"

but we do not reach completely the target

Target

Actual Desired

Difference

Target (A) Target(B)

(A-B)

22% 5% 17.00%

5% 25% -20.00%

0% 0% 0.00%

2% 0% 2.00%

100%

Sum Difference (absolute value)

Actual vs Desired Actual Target- -5.0000%

Desired Target

"Hitting the target!"

Summarizing....

! The optimization problem does not always have an

optimal realistic solutio. Hence, a suboptimal solution

has to be considered

different objective functions and constraints

In MATLAB

QP and Sharpe's style analysis

r jt = [ 1 j f1t + 2 j f 2t + ... + nj f nt ] + e jt

style selection

where - other financial assets

rjt = return at time t of centroid time series j - active management

fit = return of the i-th market index in period t

ejt = unexplained component (selection)

Finally, we determine the ij with quadratic optimization

QP and Sharpe's style analysis

! determine 1, 2, ..., n such that the variance of the selection

(error) et is minimized, i.e.,

T T n

min et2 = min (rt i f it ) 2

i i

t =1 t =1 i =1

quadratic objective function

subject to i i 0 i = 1 linear constraints

! Note: this is a special subclass of a quadratic programming

problem called constrained linear least square problem

2

min C x d

x

QP and Sharpe's style analysis

MatLab implementation

function [b ,RSS, e, rsq, var_e] = style_sharpe (y, X, type)

% INPUT

% y = (vector num_observations x 1 ): time series of the funds

% X = (matrix num_observations x num_indexes): matrix of the indexes in Sharpe's model

% type (scalar 1x1): specifies which Sharpe model will be used

% type = 1 Weak style analysis; type = 2 Semi-strong style analysis; type = 3 Strong style analysis

% OUTPUT

% b = vector of weights for the Sharpe model

% RSS = scalar: regression sum of squares

% e = vector (num_observations x 1): vector of the errors

% rsq = scalar: R-square statistic

% var_e = vector (num_observations x 1): vector of the variance of the errors

[T, k] = size(X);

QP and Sharpe's style analysis

% continued from previous slide

if type==1

% Weak style analysis. Unconstrained weights

[b, bint, e] = regress (y, X);

RSS = sum(e.^2);

elseif type==2

% Semi-strong style analysis. Each weight >= 0

[b, RSS, e] = lsqnonneg (X, y); % Linear least squares with non-negative constraints

elseif type==3

% Strong style analysis. Each weight >= 0. Sum of the weights = 1

% Constraints input

R = -eye(k); d = zeros(k,1); i = ones(1,k);

[b, bint, e] = regress (y, X); % Use regression coefficient to initialise

[b, RSS, e] = lsqlin (X, y, R, d, i, 1, [], [], b, options); % Constrained linear least squares

end

yhat = X*b;

ESS = norm(yhat-mean(y))^2; % Explained sum of squares

TSS = norm(y-mean(y))^2; % Total sum of squares

var_e = var(yhat-y); % Variance of the error

rsq = ESS/TSS; % R-square statistic

Statistics

Out-of-Sample Statistics

Challenge

Perform Rolling Window Style Analysis and

Interpret

References

and Performance Measurement.

http://www.stanford.edu/~wfsharpe/art/sa/sa.htm

Lucas, L. (1996) The Role of Returns-Based

Style Analysis: Understanding, Implementing,

and Interpreting the Technique

Lucas, L. (1999) Hitting the Target: How to

Implement an Optimal Portfolio Using Mutual

Funds

Copyright

modified, distributed or displayed without Prof.

Paterlini's express written permission.

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