Modern portfolio theory

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Portfolio analysis redirects here. For theorems about the meanvariance efficient frontier, see Mutual fund separation theorem. For non-mean-variance portfolio analysis, see Marginal conditional stochastic dominance. Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize[1] for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, as prices in the stock market tend to move independently from prices in the bond market, a collection of both types of assets can therefore have lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated. More technically, MPT models an asset's return as a normally distributed function (or more generally as an elliptically distributed random variable), defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not perfectly positivelycorrelated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets areefficient. MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, many theoretical and practical criticisms have been leveled against it. These include the fact that financial returns do not

follow aGaussian distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there is growing evidence that investors are not rational and markets are not efficient.[2][3]
Contents
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• • •

1 Concept 2 History 3 Mathematical model

○ ○ ○ ○ ○ •

3.1 Risk and expected return 3.2 Diversification 3.3 The efficient frontier with no risk-free asset 3.4 The two mutual fund theorem 3.5 The risk-free asset and the capital allocation line

4 Asset pricing using MPT

○ ○ •

4.1 Systematic risk and specific risk 4.2 Capital asset pricing model

5 Criticism

○ ○ ○

5.1 Assumptions 5.2 MPT does not really model the market 5.3 The MPT does not take its own effect on asset prices into account

• •

6 Extensions 7 Other Applications

7.1 Applications to project portfolios and other "nonfinancial" assets

○ • • • •

7.2 Application to other disciplines

8 Comparison with arbitrage pricing theory 9 See also 10 References 11 Further reading

12 External links

[

edit]Concept

The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)[4] MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.

[

edit]History
Markowitz classifies it simply as "Portfolio Theory," because "There's

Harry Markowitz introduced MPT in a 1952 article[5] and a 1959 book.
[6]

nothing modern about it." See also this[4] survey of the history.

[

edit]Mathematical model

In some sense the mathematical derivation below is MPT, although the basic concepts behind the model have also been very influential.[4] This section develops the "classic" MPT model. There have been many extensions since.

[edit]Risk

and expected return

MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact tradeoff will be the same for all investors, but different investors will evaluate

however. for all asset pairs (i.. the share of asset i in the portfolio). Note that the theory uses standard deviation of return as a proxy for risk.  Portfolio return variance: where ρij is the correlation coefficient between the returns on assets i and j. Ri is the return on asset i and wi is the weighting of component asset i (that is. Under the model:  Portfolio return is the proportion-weighted combination of the constituent assets' returns.e. j). where ρij = 1 for i=j. see criticism. if for that level of risk an alternative portfolio exists which has better expected returns. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile – i. There are problems with this. In general:  Expected return: where Rp is the return on the portfolio.  Portfolio return volatility (standard deviation): For a two asset portfolio: .  Portfolio volatility is a function of the correlations ρij of the component assets. which is valid if asset returns are jointly normally distributed or otherwise elliptically distributed. Alternatively the expression can be written as: .the trade-off differently based on individual risk aversion characteristics.

[edit]The efficient frontier with no risk-free asset . If all the asset pairs have correlations of 0—they are perfectly uncorrelated—the portfolio's return variance is the sum over all assets of the square of the fraction held in the asset times the asset's return variance (and the portfolio standard deviation is the square root of this sum). )). investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk. Portfolio return:  Portfolio variance: For a three asset portfolio:  Portfolio return:  Portfolio variance: [edit]Diversification An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated (correlation coefficient In other words.

Combinations along this upper edge represent portfolios (including no holdings of the risk-free asset) for which there is lowest risk for a given level of expected return. is a "risk tolerance" factor. for a given "risk tolerance" . which means investors can short a security. The left boundary of this region is a hyperbola. As shown in this graph. With a risk-free asset. can be plotted in risk-expected return space. and  R is a vector of expected returns. where 0 results in the portfolio with minimal risk and results in the portfolio infinitely far out on the frontier with both expected return and risk unbounded. without including any holdings of the risk-free asset. In matrix form. i i    (The weights can be negative. Σ is the covariance matrix for the returns on the assets in the portfolio. . The hyperbola is sometimes referred to as the 'Markowitz Bullet'. the efficient frontier is found by minimizing the following expression: wTΣw − q * RTw where  w is a vector of portfolio weights and ∑ w = 1. Equivalently.). a portfolio lying on the efficient frontier represents the combination offering the best possible expected return for given risk level. and the collection of all such possible portfolios defines a region in this space. and is the efficient frontier if no risk-free asset is available.[7]and the upper edge of this region is the efficient frontier in the absence of a risk-free asset (sometimes called "the Markowitz bullet"). the straight line is the efficient frontier. every possible combination of the risky assets.Efficient Frontier. Matrices are preferred for calculations of the efficient frontier.

The above optimization finds the point on the frontier at which the inverse of the slope of the frontier would be q if portfolio return variance instead of standard deviation were plotted horizontally. MATLAB. Many software packages.  wTΣw is the variance of portfolio return. provide optimizatio n routines suitable for the above problem. This problem is easily solved using a Lagrange multiplier. This version of the problem requires that we minimize wTΣw subject to RTw = μ for parameter μ. The frontier in its entirety is parametric on q. [edit]The two mutual fund theorem . RTw is the expected return on the portfolio. Mathematica and R. An alternative approach to specifying the efficient frontier is to do so parametrically on expected portfolio return RTw. including Microsoft Excel.

In practice. both mutual funds will be held in positive quantities. when it is combined with any other asset. the tangency with the hyperbola represents a portfolio with no risk-free holdings and 100% of assets held in the portfolio occurring at the tangency point. F is the riskfree asset. the latter two given portfolios are the "mutual funds" in the theorem's name. since its variance is zero). an investor can achieve any desired efficient portfolio even if all that is accessible is a pair of efficient mutual funds. then one of the mutual funds must be sold short (held in negative quantity) while the size of the investment in the other mutual fund must be greater than the amount available for investment (the excess being funded by the borrowing from the other fund). By the diagram. and its formula can be shown to be In this formula P is the sub-portfolio of risky assets at the tangency with the Markowitz bullet.One key result of the above analysis is the two mutual fund theorem.[7] This theorem states that any portfolio on the efficient frontier can be generated by holding a combination of any two given portfolios on the frontier. If the desired portfolio is outside the range spanned by the two mutual funds. the half-line shown in the figure is the new efficient frontier. It is tangent to the hyperbola at the pure risky portfolio with the highest Sharpe ratio. and points on the half-line beyond the tangency point are leveraged portfolios involving negative holdings of the risk-free asset (the latter has been sold short—in other words. Its horizontal intercept represents a portfolio with 100% of holdings in the risk-free asset. it is also uncorrelated with any other asset (by definition. because they pay a fixed rate of interest and have exceptionally low default risk. and C is a combination of portfolios P and F. The risk-free asset has zero variance in returns (hence is risk-free). This efficient half-line is called the capital allocation line (CAL). points between those points are portfolios containing positive amounts of both the risky tangency portfolio and the risk-free asset. When a risk-free asset is introduced. So in the absence of a risk-free asset. the introduction of the risk-free asset as a possible component of the portfolio has improved the range of risk-expected return combinations available. the investor has borrowed at the risk-free rate) and an amount invested in the tangency portfolio equal to more than 100% of the investor's initial capital. because everywhere except at the tangency portfolio the half-line gives a higher expected return than the hyperbola does at every possible . As a result. If the location of the desired portfolio on the frontier is between the locations of the two mutual funds. or portfolio of assets. the change in return is linearly related to the change in risk as the proportions in the combination vary. [edit]The risk-free asset and the capital allocation line Main article: Capital allocation line The risk-free asset is the (hypothetical) asset which pays a risk-free rate. short-term government securities (such as US treasury bills) are used as a risk-free asset.

[ edit]Asset pricing using MPT The above analysis describes optimal behavior of an individual investor. and therefore their expected returns. [7] where the mutual fund referred to is the tangency portfolio. The fact that all points on the linear efficient locus can be achieved by a combination of holdings of the risk-free asset and the tangency portfolio is known as the one mutual fund theorem. Specific . [edit]Sy stemat ic risk and specifi c risk Specific risk is the risk associate d with individual assets within a portfolio these risks can be reduced through diversifica tion (specific risks "cancel out"). Since everyone holds the risky assets in identical proportions to each other—namely in the proportions given by the tangency portfolio—in market equilibrium the risky assets' prices.risk level. Thus relative supplies will equal relative demands. Asset pricing theory builds on this analysis in the following way. MPT derives the required expected return for a correctly priced asset in this context. will adjust so that the ratios in the tangency portfolio are the same as the ratios in which the risky assets are supplied to the market.

systemati c risk cannot be diversified away (within one market). unique.except for selling short as noted below. unsystem atic.a . Syst ematic risk (a. .k. or idiosyncra tic risk.risk is also called diversifiab le. Within the market portfolio. portfolio risk or market risk) refers to the risk common to all securities .

Since a security will be purchase d only if it improves the riskexpected return characteri stics of the market portfolio. the relevant measure of the risk of a . Systemati c risk is therefore equated with the risk (standard deviation) of the market portfolio.asset specific risk will be diversified away to the extent possible.

In this context. and its correlatio n with the market portfolio. are historicall y observed and are therefore given. (There are several approach es to asset pricing that attempt to price assets by . and not its risk in isolation. the volatility of the asset.security is the risk it adds to the market portfolio.

) Systemati c risks within one market can be managed through a strategy of using both long and short positions within one portfolio.modelling the stochastic properties of the moments of assets' returns these are broadly referred to as condition al asset pricing models. [edit]C apital asset pricin . creating a "market neutral" portfolio.

The CAP M is a model which derives the theoretica .g model Main article: C apital Asset Pricing Model The asset return depends on the amount paid for the asset today. The price paid must ensure that the market portfolio's risk / return characteri stics improve when the asset is added to it.

discount rate) for an asset in a market.e. B e t a .. i s . The CAPM is usually expresse d:  β .l required expected return (i. given the risk-free rate available to investors and the risk of the market as a whole.

t h e m e a s u r e o f a s s e t s e n s i t i v i t y t o a .

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h e r i s k f r e e r a t e . This equ atio n can be stati stic ally esti mat ed u sing the follo win g re gres sion equ .

atio n: w h e r e α i i s c a ll e d t h e a s s e t' s a l p h a . β i i s t h e .

a s s e t' s b e t a c o e ff ic i e n t a n d S C L is t h e S e c u ri t y C h .

a r a c t e ri s ti c L i n e . O n c e a n a s s e t' s e x p e c t e d r e t .

E ( R i ) . is c a lc u l a t e d u si n g C A P M .u r n . t h e f u t u r e c .

a s h fl o w s o f t h e a s s e t c a n b e d is c o u n t e d t o t h e ir p .

r e s e n t v a l u e u si n g t h is r a t e t o e s t a b li s h t h e c o rr .

A ri s ki e r s t o c k w ill h a v e a h i .e c t p ri c e f o r t h e a s s e t.

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e a s it s v a l u e c a lc u l a t e d u si n g t h e C A P M d e ri v e d d .

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t h e n t h e a s s e t is o v e r v a l u e d . it is .t h e v a l u a ti o n .

is added . a. (1) The increment al impact on risk and expected return when an additional risky asset.u n d e r v a l u e d f o r a t o o l o w p ri c e .

to the market portfolio. Market portfolio's risk = Hence. th improvement in its risk-to-expected return ratio achiev . These results are used to derive the assetappropriat e discount rate. i. additional risk = Market portfolio's expected return = Hence additional expected return = (2) If an asset.e. follows from the formulae for a twoasset portfolio. a. m. correctly priced. risk added to portfolio = but since the weight of the asset will be relatively low.

: i. β -.by adding it to the market portfolio. Rf.the covariance between the asset's return and the market's return divided by the variance of the market return— i.e.e.e. this is rational if Thus: i. the sensitivity of the asset price to movement in the market portfolio's value. m will at least match gains of spending that money on an increased stake in the market portfol The assumption is that the investor w purchase the asse with funds borrow at the risk-free rate. [ edit]Criticis Despite its theore critics of MPT que an ideal investing because its mode markets does not world in many wa [edit]Assump . : is the “beta”.

it is f observed tha and other ma normally distr swings (3 to 6 deviations fro occur in the m frequently tha distribution as predict. Others ar the neglect of taxe fees. Corr on systemic r between the u and change w relationships Examples inc declaring war . In fact. suc ofNormal distribut returns. Som the equations. a compromises MP  Asset return (jointly) norm distributed r .The framework of many assumption and markets.[8] Whi also be justifi any return dis isjointly ellipti joint elliptical symmetrical w returns empir  Correlations are fixed and forever. None of thes are entirely true.

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.[11]  There are no transaction c financial prod both to taxes costs (such a and taking the will alter the c optimum port assumptions with more com of the model. ca prices to be in inefficient. . Th studied in the of behavioral uses psychol assumptions alternatives to as the overco asset pricing Daniel. In markets conta asymmetry. in those who are informed than  Investors ha conception o returns.e.hypothesis. beliefs of inv the true distr returns. David Avanidhar Su (2001). i. A dif is that investo are biased.

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Very o expected values f of new circumstan exist when the his generated. but says n those losses migh measurements us are probabilistic in structural.statements about expected value of in the above equa in the definitions of variance and co practice investors predictions based measurements of and volatility for th equations. This is as compared to m approaches to ris Options theory an important concep the probabilistic ri nuclear power [pla economists would The components relationships are m simulations. If val of back pressure in flow to vessel Z . More fundamenta stuck with estimat parameters from p because MPT atte risk in terms of the losses.

ISBN 978-0 Essentially. For this rea structural models markets are unlike forthcoming beca essentially be stru the entire world. Hu Management'. there is no of it. p. the m MPT view the ma collection of dice. 2009. but this markets are actua upon a much bigg complicatedchaot world. past market data hypotheses about weighted. which sh sophisticated mar Mathematical risk are also useful on that they reflect in concerns—there i . If nuclear en management this able to compute t a particular plant occurred in the sa —Douglas W.But in the Black-S there is no attemp structure to price outcomes are sim And. unlike the PR a particular system crisis. N is growing awaren concept of system markets.

It only maximize risk-adj without regard to consequences. In its complete relian asset prices make all the standard m failures such as th from information asymmetry. varia symmetric measu abnormally high r risky as abnormal Some would argu investors are only losses.minimizing a varia cares about in pra the mathematical of variance to qua might be justified assumption of elli distributed returns distributed returns return distribution measures (like co measures) might investors' true pre In particular. exter and public goods. MPT does not acc personal. . environ or social dimensio decisions. our intuitive fundamentally asy nature. A view. and do no dispersion or tight average returns.

contributing to what is called Modern Portfolio Theory. you are left with hot air.279 [edit]The MP its own effec prices into a Diversification elim risk. they rewarded two theoreticians. More may have strateg that shape its inve and an individual have personal go information other returns is relevan Financial econom Nicholas Taleb ha modern portfolio t assumes a Gauss After the stock market crash (in 1987). Harry Markowitz and William Sharpe. [12]:p. who built beautifully Platonic models on a Gaussian base. when would be of little f result is that the w . if you remove their Gaussian assumptions and treat prices as scalable. increased deman assets that. The Nobel Committee could have tested the Sharpe and Markowitz models – they work like quack remedies sold on the Internet – but nobody in Stockholm seems to have thought about it.corporate fraud an accounting. but at the cos the systematic ris the portfolio mana without analyzing solely for the bene portfolio’s non-sys (the CAPMassum available assets). Simply.

the risk of the Empirical evidenc hike that stocks ty they are included the S&P 500. [ edit]Other [edit]Applica portfolios an financial" as Some experts app projects and othe financial instrume applied outside of portfolios. asymm This helps with so but not others. Post-modern port MPT by adopting distributed. especially assumptions. The assets in practical purp . 1. Black-Litterman m extension of unco optimization which and absolute `view returns.more expensive a probability of a po (i.e. some d different types of considered.[citation [ edit]Extens Since MPT's intro attempts have be model.

the recovery/salv project). 2. that cannot b optimization m the discrete n account. The assets of liquid.while portfolio For example.e. the optimal po is. They si to run the optimiz set of mathematic constraints that w to financial portfol Furthermore. position for a allow us to sim spent on a pr or nothing or.. som elements of Mode applicable to virtu portfolio. 44%. they ca assessed at a opportunities may be limite windows of tim already been abandoned w costs (i. say. Neither of these n possibility of using portfolios. The con risk tolerance of a documenting how acceptable for a g .

mo has been used to in social psycholo attributes compris constitute a well-d psychological out the individual suc esteem should be the self-concept is . MPT us as a measure of r assets like major well-defined "histo case. the MPT inv be expressed in m "chance of an RO capital" or "chanc half of the investm in terms of uncert and possible loss transferable to va investment.[13] [edit]Applica disciplines In the 1970s. con Portfolio Theory fo field of regional sc seminal works.applied to a variet problems. M needed] modeled the economy using po methods to exam variability in the la followed by a long relationship betwe and volatility.[14] More recently.

the APT. h reveal the identity the number and n likely to change o economies. [ edit]See al Treynor ratio   Investment th .prediction has bee involving human s Recently. modern been applied to m and correlation be information retriev aim is to maximiz of a ranked list of same time minimi uncertainty of the [ edit]Comp arbitrage pr The SML and CA with the arbitrage which holds that t financial asset ca a linear function o economic factors. changes in each f a factor specific b The APT is less re assumptions: it al (as opposed to st returns. and assu will hold a unique particular array of the identical "mar CAPM.

(reprinte 1970. doi:10. 6. H Selection". ^ Koponen.         [ Jensen's alph Sortino ratio Bias ratio (fin Black-Litterm Roll's critique Value investin Two-moment Fundamental Marginal cond dominance edit]Refere 1. Th 77–91. 75974. ISBN 97 . ^ Markowitz. H Selection: Effi Investments. ^ Harry M. ^ Andrei Shlei Introduction to Clarendon Lec 3. ^ Markowitz. Ma Nobel Prizes 1 [Nobel Founda 2. ^ a b c Edwin J "Modern portfo Journal of Ban 1743-1759 5. N Sons. Ti in action: mea imposing valu Volume 50 Iss 4.

R Profile Books. ^ 'Overconfide Equilibrium As David Hirshlei Subrahmanya (June. Si Economy Size Frontier: Evide Regional Scie 122. ^ Chandra. Intangibles in Measure Anyt Wiley & Sons. ^ Chamberlain of the distribut utility functions Theory 29. Nass Swan: The Im Random Hous 13. ^ Owen. 18 10. ^ Mandelbrot. doi:10. an the class of el applications to choice".. ^ a b c Merton. 14. ^ a b Hubbard. The (Mis)Beha View of Risk.Basil Blackwe 108-5) 7. Journ 11. ^ Taleb.11 . 9. 12. J. 2001). Financial and of the efficient September 19 8.

Willia asset prices: equilibrium un risk". The Rev Studies 25 (2 86.230 96205.2 977928.15. Goetzmann. doi:10. Prof.doi:10.10 [ edit]Furthe  Lintner.23 24119. Sh  An Introductio Theory.  Sharpe. [ edit]Extern  Macro-Invest William F. doi:10. ^ Chandra. Journal 442. James preference as risk". Si (2007). John of Risk Asset Risky Investm and Capital B Economics an Press) 47 (1) 39. Y Management .  Tobin. Jour Personality 41 373. doi:10. "Cross Applying finan the organizatio concept".

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