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Sharpes Style Analysis:

The Multimanager Approach


Prof. Sandra Paterlini
Chair of Financial Econometrics & Asset Management
EBS Universitt fr Wirtschaft und Recht
Style Analysis
Sharpes Style Analysis

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 3


Sharpes Style Analysis
Sharpe's style analysis equation

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

where

R jt return of the j-th fund at time t


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 4


Sharpes Style Analysis
Sharpe's style analysis equation

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


style
where

R jt return of the j-th fund at time t


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 5


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 6


Sharpes Style Analysis
Sharpes model

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


selection
where

R jt return of the j-th fund at time t


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 7


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 8


Sharpes Style Analysis
Sharpes model

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


style selection
where

R jt return of the j-th fund at time t


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 9


Sharpes Style Analysis
Sharpes model

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


style selection
! Objective:
Estimate (1,...,k) such that the residual variance is
minimal, i.e. min (Var(ej))
where

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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 10


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 11


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 12


Sharpes Style Analysis
Model Outputs
- Factor loadings
" (1,...,k) = sensitivity (factor loadings) w.r.t. the factors Fi (i=1,,k)

! Example (Unconstrained Regression Weak Style Analysis)

Sharpes Model
Beta Estimates

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Sharpes Style Analysis
Model Outpus
- Factor loadings
" (1,...,k) = sensitivities (factor loadings) w.r.t. to Fi (i=1,,k)

! Example (Unconstrained Regression)

MSCI:
ITALY (1)
NORTH AMERICA (2)
JAPAN (3)
EMU + UK (4)
ITALY 1 - 3Y (E) (5)
WRLD. SOV. (6)
WRLD. SOV. EX. EMU (7)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 14


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

! To estimate the beta we need to use quadratic programming

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 15


Sharpes Style Analysis
Model Outputs
- Factor loadings
" (1,...,k) = sensitivities (factor loadings) w.r.t. factors Fi (i=1,,k)

! Example (Constrained Regression)-Table

Sharpes Model
Beta Estimates

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Sharpes Style Analysis
Model Outputs
- Factor loadings
" (1,...,k) = sensitivities (factor loadings) w.r.t. factors Fi (i=1,,k)

! Example (Unconstrained Regression)-


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 17


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 18


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 19


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 20


Sharpes Style Analysis
Style vs Selection

MONTHLY RETURNS
Selection
1%

Style
99%

Factors

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 21


Sharpes Style Analysis
Style vs Selection
Fund Returns vs Style Benchmark Return
Monthly Returns

Period

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Sharpes Style Analysis
Style vs Selection
Fund Returns vs Style Benchmark Return
Monthly Returns

Period

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 23


Sharpes Style Analysis

Style vs Selection - Another Example

Sharpes Model Beta Estimates

Sum(Weights)

Style
Selection

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Sharpes Style Analysis

Stile vs Selezione - Un altro esempio

Selection
18%
% of Total

Style
82%

Factors Weights

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 25


Sharpes Style Analysis

Style vs Selection Another Example


Fund Returns vs Style Benchmark Return
Returns

Period

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Sharpes Style Analysis

Style vs Selection Another Example

Fund Returns vs Style Benchmark Return (Base 100)


Returns (Base 100)

Period

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Effective Asset Mix

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 28


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

Rp,t=investors portfolio return at time t


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 29


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

! and plugging-in we get


" 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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 30


Effective Asset Mix
Example
! An investor has allocated 20% of his capital to fund A and
the remaining 80% to fund B

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 31


Effective Asset Mix
Example
! Using Sharpes approach, we estimate the betas of both funds
as reported below

! Both funds have a positive exposure with respect to both


factors
! The exposure to factor 1 depends then both on the amount
invested in fund A and in fund B

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 32


Effective Asset Mix
Example Portfolio XYZ

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 33


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%

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 34


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 35


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 36


Strategic Asset Allocation

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 37


The Multimanager Approach

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 38


Multimanager Approach
Why shall we invest in more than one fund?
! Style diversification
! Manager diversification

! Different studies show how to invest in funds of different


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 39


Multimanager Approach
How shall we choose in how many and which
funds to invest?

! "Hitting the target!"


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)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 40


Strategic Asset Allocation
"Hitting the target!"
Ibbotson Associates, Lucas (1999)

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 41


"Hitting the target!"
The Idea
! Lets assume we know the investment targets

Investment Targets

! We want to determine in which funds we should invest to


achieve the investment targets

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 42


"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!"

Investment Targets Naive Approach

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 44


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 45


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

Rp,t=investors portfolio return at time t


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 46


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

! and plugging-in we get


" 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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 47


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 48


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 49


"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

Betas of Sharpes Style Model

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 50


"Hitting the target!"
Attention...
! Then, we can determine the difference from the investment
target

Actual Desired Actual Desired


(Allocation)
- =

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 51


"Hitting the target!"

Naive Approach Investment Targets

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 52


"Hitting the target!"

Investment Targets Effective Investment

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 53


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 54


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 55


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 56


"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)

Cash 80% 40% 20% 20% 24% WFcashA 5% 5% 0.00%


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

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

Small Caps 8% 65% WFsmallA 20% 20% 0.00%


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

Long-term Bonds 8% 4% 0% 0% 100.0% 5% 0% 5.00%


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 57


"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)

Cash 80% 40% 20% 20% 24% WFcashA 5% 5% 0.00%

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

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

Small Caps 8% 65% WFsmallA 20% 20% 0.00%


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

Long-term Bonds 8% 4% 0% 0% 100.0% 5% 0% 5.00%

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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 58


"Hitting the target!"
Using the Solver in Excel...

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 59


"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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 60


"Hitting the target!"

Target
Actual Target Desired
Difference
(A) Target(B)
(A-B)

5%

25%
- 5%

25%
= 0.00%

0.00%

25% 25% 0.00%

20% 20% 0.00%

25% 25% 0.00%

5% 0% 5.00%

2% 0% 2.00%
100%

Sum Difference (absolute value)


Actual vs Desired Actual Target- Desired 7.0000%
Target

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 61


"Hitting the target!"
....but attention!! It is not a realistic solution

Multimanager
Portfolio Weights

Cash Fund A -52.9% Single Weight < 0


Intermediate Bond Fund A 59.0%

Growth Fund A 16.6%

Small Company Fund A 28.7%

International Fund A 60.8%

112.2%
Sum Weights1

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 62


"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)

Cash 80% 40% 20% 20% 24% WFcashA 5% 5% 0.00%


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

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

Small Caps 8% 65% WFsmallA


= 20% 20% 0.00%
International
Stocks 4% 40% WFIntern 25% 25% 0.00%

Long-term Bonds 8% 4% 0% 0% 100.0% 5% 0% 5.00%


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 63


"Hitting the target!"
Lets compute the weights...
Target
Multimanager Actual Target Desired
Portfolio Weights Difference
(A) Target(B)
(A-B)

Cash Fund A 0.0% 22% 5% 17.00%

Intermediate
Bond Fund A
0.0% 5% 25% -20.00%

Growth Fund A 8.9% = 21% 25% -4.00%

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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 64


"Hitting the target!"
....the investment strategy is implementable...

Multimanager
Portfolio
Weights

Cash Fund A 0.0% Single Weight 0


Intermediate
Bond Fund A
0.0%

Growth Fund A 8.9%

Small Company
Fund A
29.5%

International
Fund A
61.6%

100.0% Sum Weights=1

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 65


"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%

21% 25% -4.00%

20% 20% 0.00%

25% 25% 0.00%

0% 0% 0.00%

2% 0% 2.00%

100%
Sum Difference (absolute value)
Actual vs Desired Actual Target- -5.0000%
Desired Target

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 66


"Hitting the target!"
Summarizing....
! The optimization problem does not always have an
optimal realistic solutio. Hence, a suboptimal solution
has to be considered

! It is possible to consider such approach and then use


different objective functions and constraints

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 67


In MATLAB

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 68


QP and Sharpe's style analysis

Sharpe's style analysis equation


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

ij = sensitivity of j-th fund w.r.t. to market index fi


fit = return of the i-th market index in period t
ejt = unexplained component (selection)

Strong sharpes style analysis: i,j ij 0 ij = 1


Finally, we determine the ij with quadratic optimization

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 69


QP and Sharpe's style analysis

Why do we need quadratic programming?


! 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

semi-strong analysis strong analysis


! Note: this is a special subclass of a quadratic programming
problem called constrained linear least square problem
2
min C x d
x

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 70


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

options = optimset ('LargeScale', 'off', 'Display', 'off');


[T, k] = size(X);

% continued on next slide

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 71


QP and Sharpe's style analysis

MatLab implementation (cont.)


% 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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 72


Statistics

Out-of-Sample Statistics

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 73


Challenge

Implement the Excel Spreadsheet in MATLAB


Perform Rolling Window Style Analysis and
Interpret

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 74


References

Sharpe, W., Asset Allocation: Management Style


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

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 75


Copyright

The material cannot be copied, reproduced,


modified, distributed or displayed without Prof.
Paterlini's express written permission.

Prof. Sandra Paterlini, Chair of Financial Econometrics & Asset Management 76