Portfolio advice for a multifactor world

Nicola Borri

LUISS

This version: October 30, 2018

The new view of the world

I There are strategies with high average returns without large

betas.
I Multifactor models have replaced the simple CAPM.
I Stock and bond returns are predictable at long horizons.
I There seems to be a premium for holding macroeconomic risk
(e.g., business cycle risk) independent of the tendency of
moving with the aggregate market.
I What should an investor do?
Traditional portfolio advice: two-fund theorem (I/IV)

I Starting point is that the CAPM is correct and returns are not
predictable over time.
I Investors should split their wealth between risk-free bonds and
a broad market index (e.g., a passive fund who buys the
market).
I More risk-tolerant investors will have a larger share of the
risky asset.
I Less risk-tolerant investors will have a larger share of the
risk-free asset.
I All investors hold just a combination of these two assets: this
is the two-fund theorem (Markowitz, 1952).
Traditional portfolio advice: two-fund theorem (II/IV)

Average
Return E(R) Investors want Mean-variance frontier

Optimal portfolios Risky asset frontier

Market portfolio

Original assets

Rf

Volatility σ(R)

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Traditional portfolio advice: two-fund theorem (III/IV)

Everyone holds the same market portfolio, the only decision is how
much of it to hold.
Traditional portfolio advice: two-fund theorem (IV/IV)

I We can reconcile a bit of active management and

customization of the investment if we assume that investors
have different information, or beliefs (Black and Litterman,
1991).
I Empirical evidence: often does not pay.
I The average investor must hold the market.
What about the investment horizon?

I According to the traditional view, returns are i.i.d.: in this

case the horizon does not matter (i.e., the mean and the
variance of continuously compounded returns grow at the
same rate with the horizon).
I Stock are not safer in the long-run.
I Classic elegant proofs of this result: Merton (1969) and
Samuelson (1969).
New portfolio theory (I/VI)

I What happens to the simple two-fund theorem if we account

for the fact we live in a multifactor world?
New D(0#%&
portfolio theory
E ).":) .": (II/VI)
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New portfolio theory (III/VI)

I We have represented a multi-factor frontier when there is only

one additional risk-factor with respect to the standard
mean-variance framework.
I Investors may differ in their desire or ability to take on
recession-related risk, as well as in their tolerance for overall
risk.
I Investors will hold portfolios with different weights in three
multifactor efficient portfolios.
I This is a three-fund theorem
I risk-free rate
I market portfolio
I additional portfolio on the multi-factor efficient frontier
New portfolio theory (IV/VI)

The average investor must hold the market portfolio, so the market
return is no longer on the mean-variance frontier (of the 2-factor
world).
New portfolio theory (V/VI)

I Suppose you are mean-variance investor living in a

multi-factor world.
I You should no longer hold the market portfolio.
I You can still achieve a mean-variance efficient portfolio, but
now your tangency portfolio takes stronger positions than the
market portfolio in factors such as value or recession-sensitive
stocks that the average investor fears.
I Note that the mean-variance frontier still exists: it is the
projection of the cone from figure 2 on the mean-variance
plane
New portfolio theory (VI/VI)

I If returns are predictable, the portfolio advice also changes

with respect to:
1. horizon effects
2. market-timing strategies
3. multiple factors through hedging demands.
Horizon effects

I Suppose high return today implies a high return tomorrow

(i.e., positive serial correlation).
I In this case, the variance of returns will increase with horizon
faster than does the mean return: stocks are worse in the
long-run.
I Suppose instead that high return today implies a low return
tomorrow (i.e., mean-reversion in returns).
I In this case, the variance of long-horizon returns is lower than
the variance of one-period returns times the horizon: stocks
are more attractive in the long-run.
I Which is true? Evidence points to some degree of
mean-reversion.
How big are the horizon effects? (I/II)

I Barberis (2000) studies the optimal portfolios for different

horizons.
I He considers a set up in which an investor allocates his
portfolios between stock and bonds, and then holds it without
rebalancing for the indicated horizon.
I The objective of the investor is supposed to be to maximize
the expected utility of wealth at the indicated horizon.
I Barberis (2000) estimates significant mean-reversion: the
implied standard deviation of 10-year return is 23.7%, against
45.2% for monthly returns.
How big are the horizon effects? (II/II)

A=10
90

80

% allocation to stocks
70

60

50

40

30

20
0 1 2 3 4 5 6 7 8 9 10
horizon

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Uncertainty about predictability

I The baseline estimates from Barberis (2000) ignore the fact

that we do not know how predictable returns really are.
I In particular, Barberis uses a simple model to quantify the
effects of predictability and assumes investors know the
process perfectly.
I Barberis (2000) and Kandel and Stambaugh (1996) study the
case in which investors treat uncertainty about the
forecastability of returns as part of the risk that they face.
Market timing using R 2 (I/III)

I Gallant, Hansen and Tauchen (1990) calculate the benefits of

market timing based on the R 2 of return-predicting
regressions.
I First, they note that if the risk-free rate is constant and
known, the square of the maximum unconditional Sharpe ratio
(SR) is the average of the squared conditional SRs.
I Since we take an average of squared (i.e., non negative!) SRs,
time-variation in expected returns, or return volatility, is good
for an investor who cares about the unconditional SR.
Market timing using R 2 (II/III)

I By moving into stocks in times of high SR and moving out of

the market in times of low SR, the investor does better then
by buy-and-holding.
I Furthermore, the best unconditional SR is directly related to
the R 2 in the return forecasting regression.
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Market timing: Euler equation approach (I/II)
I Brandt (1999) takes as given the standard consumption Euler
equation:
−γ
E [ct +1 Zt +1 ] = 0,
where Z is an excess returns and ct , a constant, can be eliminated.
I For a given value of the parameter γ, we can estimate the optimal
portfolio choice.
I For example, for a one-period problem, we know that terminal
wealth must equal consumption so that:
 −γ 
f m
E αR + (1 − α)Rt +1 Zt +1 = 0,

where ct +1 ≡ Wt +1 = Wt (αR f + (1 − α)Rtm+1 ) and α is the share

invested in the risk-less asset.
I Brandt extends this approach to a multi-period setting, and
problems in which the allocation depends on the forecasting variable
(i.e, the dividend-price ratio).
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Market timing: Euler equation approach (II/II)
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Economic Perspectives
Market timing: Campbell and Viceira, 1999 (I/III)

I Campbell and Viceira (1999) calculate a solution to the

optimal timing question.
I Investors maximize lifetime utility from consumption (and not
portfolio returns).
I They model time-variation in expected excess returns via an
equation with the dividend-price ratio.
I Investors live off invested wealth, and have no labor income or
labor income risk.
I They show that the investors should take strong advantage of
market-timing possibilities.
Market timing: Campbell and Viceira,1999 (II/III)

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Market timing: Campbell and Viceira, 1999 (III/III)
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Federal Reserve Bank of Chicago

Market timing: Doubts (I/IV)

I The unconditional SR of Gallant et al. (1990) must be

interpreted as the SR one can achieve over very long periods,
when the investor evaluates his portfolio based on five years
returns.
I But we would rather know, given the current d /p, what is the
best SR that we can possibly achieve for the next five years by
following market timing strategies.
Market timing: Doubts (II/IV)

I The d/p ratio has crossed its mean four times in the period
1950-2000: you need to be very patient to profit from trading
this rule.
I In the 1950-2000 period we have only four data points!
I Dividend/price ratio has been selected in sample and does not
work as well out-of-sample.
I The dividend-return regressions are spurious.
I What about parameter uncertainty? Barberis (2000) show
that uncertainty regarding the parameters of the regressions of
returns on d/p almost eliminates the usefulness of market
timing.
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timing: Doubts (III/IV)
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A=10, T=523 A=20, T=523

% allocation to stocks

% allocation to stocks
100 100
80 80
60 60
40 40
20 20
0 0
2.06% 3.75% 5.43% 2.06% 3.75% 5.43%

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Market timing: Doubts (IV/IV)

I Market timing requires patience and willingness to stick with a

portfolio that departs from passive strategies.
I Market timing implies loading up on different risks: for
example, buying at the bottom of the market when everyone
else is in panic.
Hedging demands (I/II)

I Market-timing addresses whether you should change your

allocation to stocks over time as a function of some signal.
I Hedging demands address whether your overall allocation to
stocks, or specific portfolios, should be higher or lower as a
result of return predictability, in order to protect you against
reinvestment risk.
I Good example is long-term bond: changes in the value of the
long-term bond hedge the reinvestment risk of short-term
bonds.
I In general, size and sign of hedging demand depend on risk
aversion and horizon.
Hedging demands (II/II)

I The predictability evidence suggests that period of high

returns are followed by period of low returns.
I Therefore, stocks are a good hedge against their own
reinvestment risk and act as a long-term asset.
I This consideration raises the attractiveness of stocks for a
typical investor.
Choosing a risk-free rate

I What is the appropriate risk-free asset to mix with stocks for

a typical consumer, whose objective is lifetime consumption?
I Real level annuity (or interest-only strip).
I What if only nominal bonds are available? (real rate vs.
nominal rate variability).
Notes of caution

I The portfolio tips seen so far asks: How should an investor

who does not care about extra risks (i.e., additional factors,
predictability,etc.) profit from them?.
I But never forget that: the average investor must hold the
market portfolio.. Therefore, multiple factors and return
predictability cannot have any portfolio implication for the
average investor.
Notes of caution

I For every investor that follows a value strategy, or times the

market, there must be an investor who follow exactly the
opposite advice
I Why is such investor following a growth strategy, or selling a
stock at the bottom and buying at the top?
I Risk-based answer: because he is unusually exposed to or
adverse to the risks the value or market-timing strategies.
I Bottomline: The stock market acts as a big insurance market.
Notes of caution

I Will these effects last?

- Risk-based explanation: yes, they are likely to persist.
- Behavioral finance explanation: no, they are less likely to
persist (with some caveat).
- Narrowly held risks (eg., catastrophe-insurance enhanced
bonds): yes, but size decline a bit over time.
Notes of caution

I The arguments that a factor will persist are all inconsistent

with aggressive portfolio advice.
I If the risk is completely irrational, then by the time you and I
know about it, it’s too late.
I If the average return comes from a behavioral aversion to risk,
then it is as inconsistent with widespread portfolio advice as if
were real (i.e., the average investor must have the behavioral
aversion to risk!).
I If the average return comes from a narrowly held risk, one
should ask what are the institutional barriers that keep
investors from sharing the risk more widely.
Conclusion

I Practical application of portfolio theory:

1. What is your overall risk tolerance?
2. What is your horizon?
3. What are your risks?
4. What are not your risks?
5. Apply the logic of the multifactor efficient frontier.
6. Do not forget, the average investor holds the market.
7. Of course, avoid taxes and transaction costs.
References

I John Cochrane. ”Portfolio advice for a multifactor world”,

NBER WP 7170, June 1999.
Appendix
Conditional variance (I/II)

I Recall the formula for the unconditional variance:

VAR (Y ) = E (Y 2 ) − [E (Y )]2 .

I Similarly, the formula for the conditional variance (e.g., conditional

on the information available at t) is:

VARt (Y ) = Et (Y 2 ) − [Et (Y )]2 .

I Even though the sub-index t may look innocuous, it has important

implications. For example, the conditional variance is a random
variable and we can meaningfully take its unconditional expectation:

E (VARt (Y )) = E (Et (Y 2 )) − E ([Et (Y )]2 ) (1)

Conditional variance (II/II)
I By the law of iterated expectations (LIE):

E (Et (Y 2 )) = E (Y 2 ).

I Consider now the formula for the variance of the conditional

expected value:

VAR (Et (Y )) = E ([Et (Y )]2 ) − [E (Et (Y ))]2

= E ([Et (Y )]2 ) − [E (Y )]2 (2)

while in the last equality we have used again the LIE.

I Combining (1) and (2), we have that:

VAR (Et (Y )) + E (VARt (Y )) = E (Y 2 ) − [E (Y )]2 = VAR (Y ).

I Therefore, the unconditional variance depends on the expected

value of the conditional variance, and the variance of the conditional
means.