BFE 420 Portfolio Engineering Lecture 5

Ms P. Mawire

Harare Institute of Technology

pmawire@hit.ac.zw

March 13, 2019

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Overview

1 Asset Allocation in Practice

MVO-Finding efficient frontier

2 Experience-based Approaches

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WAKE UP

If eleven plus two equals one, what does nine plus

five equal?

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Mean variance optimization (MVO)

The fundamental goal of portfolio theory is to optimally allocate your

investments between different assets.
Mean variance optimization (MVO) is a quantitative tool which will
allow you to make this allocation by considering the trade-off between
risk and return.
The goal will be to maximize your expected return subject to a
selected level of risk. MVO was developed in the pioneering work of
Markowitz.

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Mean variance optimization (MVO) assumptions

To apply this framework some assumptions about reality are required.

Investors need to be risk averse and wealth maximizing these

assumptions reflect the real world.

Another assumption is that either returns are normally distributed (or

can be transformed to that distribution), or investors are interested
only in mean and variance (or semi-variance); this is only an
approximation of reality

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Markowitz Portfolio Optimization

Inputs:
The expected return for each asset

The standard deviation of each asset (a measure of risk)

The correlation matrix between these assets

Output:
The efficient frontier, i.e. the set of portfolios with expected return
greater than any other with the same or lesser risk, and lesser risk
than any other with the same or greater return.
The efficient frontier is conventionally plotted on a graph with the
standard deviation (risk) on the horizontal axis, and the expected
return on the vertical axis.
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Markowitz Portfolio Optimization-Steps

The Markowitz portfolio selection problem can be divided into three

parts.

First, we need to calculate the efficient frontier. Secondly, we need to

choose the optimal risky portfolio given one’s capital allocation line
(find the point at the tangent of a CAL and the efficient frontier).

Finally, using the optimal complete portfolio allocate funds between

the risky portfolio and the risk-free asset.

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Finding efficient frontier
First, we need to calculate expected return, standard deviation, and
covariance matrix.

The expected return and standard deviation can been calculated by

applying the Excel STDEV and AVERAGE functions to the historic
monthly percentage returns data.

Once expected returns, variances, and covariances of asset classes are

estimated, we can calculate the expected returns and variances of
portfolios reflecting different asset weights.

For a given expected portfolio return, we can search for the weights
associated with the portfolio offering the lowest overall variance; we
call this the minimum variance portfolio (MVP), which we can use to
plot the efficient frontier.
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Finding efficient frontier

M–V frontier, which is the set of portfolios with the lowest risk for a
given level of return.
Mathematically the efficient frontier is the intersection of the set of
portfolios with minimum variance and the set of portfolios with
maximum return.
From this set the efficient frontier, the portfolio with the highest
return for a given level of risk, is identified.
Deriving the efficient frontier may be quite difficult conceptually, but
computing and graphing it with any number of assets and any set of
constraints is quite straightforward.
We can use EXCEL, R and MATLAB to generate the efficient frontier.
Once the investor identifies the efficient frontier, the goal is to
identify the portfolio with the risk that best fits with their preferences.

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M–V frontier curve

Figure: Efficient frontier of risky assets and individual assets

All portfolios below the efficient frontier, even those on the

mean-variance frontier but below the global minimum variance
portfolio, are sub-optimal.
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Short selling

Various constraints may preclude a particular investor from choosing

portfolios on the efficient frontier, however, short sale restrictions are
only one possible constraint.

Short sale is a usual regulated type of market transaction.

It involves selling assets that are borrowed in expectation of a fall in

the assets’ price.

When and if the price declines, the investor buys an equivalent

number of assets at the new lower price and returns to the lender the
assets that was borrowed

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Optimal portfolio
Finding the optimal portfolio (that is the portfolio with the highest
utility) for an investor means finding the best combination of the
risk-free asset and the market portfolio.

One of the factors to consider when selecting the optimal portfolio for
a particular investor is degree of risk aversion, investor’s willingness to
trade off risk against expected return.

This level of aversion to risk can be characterized by defining the

investor’s indifference curve, consisting of the family of risk/return
pairs defining the trade-off between the expected return and the risk.

It establishes the increment in return that a particular investor will

require in order to make an increment in risk worthwhile.

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Criticisms of mean/variance analysis

Asset only approach technique

All models are wrong. Some models are dangerous.

There are many drawbacks to mean variance analysis.

Much of this class is devoted to overcoming these drawbacks.

Investors care about more than just mean and variance.

The µ and Σ are hard to estimate.

They are not a complete description of market returns.

Returns are not linear functions of the investment weights.

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Unconstrained Minimum Variance Frontier(MVF)

The Unconstrained Minimum Variance Frontier (MVF) places no

constraints on asset class weights

In practise the Sign-Constrained MVF is used as it requires asset class

weights to be non-negative.

The optimal portfolio may also include risk-free asset (cash

equivalents) for investor’s liquidity needs.

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Black Litterman Model

BL seeks to overcome problems that institutional investors have

encountered in applying modern portfolio theory in practice.

Black and Litterman identified two sources of information about the

expected returns and they combined these two sources of information
in one expected return formula.

The first source of information is obtained quantitatively, these are

the expected returns that follow from the CAPM and thus should
hold if the market is in an equilibrium.

Second source of information are the views held by the investment

manager. The investment manager has access to different information
and could therefore have different opinions about the expected return
of the asset, than those that would hold in an equilibrium.

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Mathematics of the Black-Litterman model
Mathematically, the main challenge is to combine the two separate sources
of information into one vector of expected returns.
Steps
Define equilibrium market weights andcovariance matrix for all asset
classes
Back-solve equilibrium expected returns
Express views and confidence for each view
Calculate the view-adjusted market equilibrium returns
Run mean–variance optimization

Strengths
Unlike in MVO, in BL investor assumes market-cap weights are
optimal and uses these and the Cov Matrix to solve for E(R).
BL models helps overcome the unintuitive, highly concentrated and
input sensitivity associated with MVO. It mitigates the problem of
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Black Litterman Model

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Monte Carlo Simulation

Computer-based statistical technique used in many areas of

investments

Can be used to model SAA under random scenarios for investment

returns, inflation and other relevant variables.

Simulates real-world SAA in an investments laboratory.

Useful where there are cash-flows in and out of the portfolios unlike
other analytical models which are not path dependent

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Experience-based Approaches

In practice, most investment managers/advisors rely on tradition,

experience and rules-of-thump when making SAA decisions instead of
the quantitative approaches.

Many investment advisers, however—particularly those serving

individual clients—rely on tradition, experience, and rules of thumb in
making SAA recommendations.

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Common experience-based approaches

60/40 stock/bond allocation as ideal or starting point

Allocation to bonds increase with increasing risk aversion

Investors with longer time horizon increase their allocation to stocks

Allocation to equities = 100 minus age of investor (rule of thump for

individual investors)

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Summary of SAA approaches

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 The End

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