DTU406 PORTFOLIO MANAGEMENT

Dr. Nguyen Thi Hoang Anh

Lecture 2:
Application: Portfolio Optimisation
Contents
 Introduction
 The portfolio expected returns
 The variance-covariance matrix
 The portfolio variance
 The covariance between two portfolios
 Portfolio optimisation
 The minimum variance frontier
 The efficient set without a risk free asset
 The efficient set with a risk free asset
 Estimation of the optimal portfolio when there is a risk free asset
 Short selling constraints
 Alternative formulations of the mean-variance portfolio optimisation analysis
 Practical issues in mean-variance analysis

2
Introduction

 In this lecture, we reconsider the problem of portfolio optimisation

 Suppose that a fund manager faces a set of possible investment opportunities; which combination of these
is optimal?

 When there are a large number of stocks to choose from, the portfolio optimisation problem is made
much easier by the use of Excel’s matrix functions

 We therefore start by reviewing the principles of portfolio optimisation in a matrix setting

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 Portfolios

 Suppose there are N assets; a portfolio P is defined as a combination of these N assets with portfolio
weights w given by
 w1 
w 
w 2
  
 
 wN 
 Note that since these are portfolio weights, we must have
N

w
i 1
i 1

 Portfolio weights represent the proportion invested in each asset; for mutual funds, these weights must
typically be greater than or equal to zero, but for hedge funds, they can also be negative

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The portfolio expected returns 1

 In matrix notation, the expected returns of the N assets are given by

 E  r1  
 
E  r 
E  R   2 
  
 
 E  r 
N 

 The expected return of the portfolio is given by

N
E  rP    wi E  ri 
i 1

 E  r1  
 
E  r 
  w1 w2  wN   2 
  
 
 E  rN 
 wT E  R 

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 The portfolio expected returns 2

 For example, suppose we have collected five years of monthly data for IBM, GE, DIS and KO and have
computed simple returns

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The portfolio expected returns 3
 Consider two portfolios P1 = (0.2, 0.3, 0.1, 0.4) and P2 = (0.1, -0.3, 0.8, 0.4).

 We can estimate the expected returns of the four stocks by their sample mean returns; the sample mean
return of the individual stocks and the portfolios, P1 and P2, are given as follows

 Note that it is very difficult to accurately

estimate expected returns; here we have
used the sample mean returns, but this
will generally be a very noisy estimate
and is used purely for illustration; in
practice, we would often use a more
sophisticated approach based on an asset
pricing model such as the CAPM

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 The variance-covariance matrix

 As we have seen, the variance-covariance matrix of N assets is the N x N matrix is estimated as

 r11  r1  r1T  r1   r11  r1  rN 1  rN 
1  
Vˆ        
T 1    
 rN 1  rN  rNT  rN   r1T  r1  rNT  rN 
1
 R  R R  R
T

T 1
 For our four stocks, we have the
following calculation

 Note that because the mean

returns are in a column vector, it
must be first transposed before
subtracting it from the return array

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The portfolio variance
 The variance of the portfolio return is given by
n n
   wi w j ij
2
p
i 1 j 1

 We can write the portfolio variance using matrix algebra as

  12   1N   w1 
 
 p2   w1  wN         
 N 1   N2   wN 
 
 wT Vw

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The covariance between two portfolios

 In due course, we will need the covariance between two portfolios, P1 and P2; this is given by

 12  w1T Vw 2

 For our four stocks, we have the following

calculations in Excel for the variances of the
two portfolios and the covariance between
them

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Portfolio optimisation 1
 We now turn to the question of which portfolio of these four stocks is optimal for an investor

 We consider two cases; firstly where there is no risk free asset, and secondly where there is a risk free
asset such as the three month Treasury bill

 When there is no risk free asset, we cannot establish a unique optimal risky portfolio since this will
depend on an investor’s risk-return preferences (or on a fund manager’s risk tolerance); however, we can
establish the set of efficient portfolios, i.e. those that have the highest expected return for a given level of
risk

 When there is a risk free asset, we can identify a unique risky optimal portfolio; different investors satisfy
their risk-return preferences by investing different proportions of their wealth in this portfolio

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Portfolio optimisation 2

 Note also that for some investors (most private investors, mutual funds, pension companies and insurance
companies) short selling is not allowed and so the weights of the optimal portfolio must be non-negative

 For other investors (primarily hedge funds) short selling is allowed and so the optimal portfolio weights
can be negative

 There may also be other constraints (such as a constraint on the maximum investment in a particular asset
class) that must be satisfied

 In the following, we will consider portfolio optimisation in the following cases:

No risk free asset and no short selling constraints (i.e. the efficient set with short selling allowed)
Risk free asset and no short selling constraints (i.e. the optimal portfolio with short selling allowed)
Risk free asset and short selling constraints (i.e. the optimal portfolio with short selling not allowed)

 We will not consider the case of no risk free asset when there are short selling constraints as it is
computationally quite difficult

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The minimum variance frontier and the efficient set

 The efficient frontier is the segment of the

minimum variance frontier that lies above
the global minimum variance portfolio

 For an individual investor, the optimal

portfolio is the portfolio that lies at the
tangency of the efficient set and the
investor’s indifference curve

 A mutual fund manager, in contrast, would

typically derive the efficient set and establish
the optimal portfolio for a target level of risk

 A hedge fund manager might instead use a target expected return

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The minimum variance frontier 1
 In order to derive the efficient set, we first derive the minimum variance frontier, or envelope

 There are a number of ways that this can be achieved; however, perhaps the most intuitive approach is to
use Excel’s Solver function to find the weights that minimise the portfolio standard deviation for a given
expected return (i.e. a typical hedge fund strategy)

 Suppose, for instance,

we have the following
expected return vector
and variance
covariance-matrix
(both estimated using
the sample of return
data) for our four
stocks

 The initial weights of

portfolios P1 and P2
are chosen arbitrarily,
and we have added
cells that are the sums of the portfolio weights

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The minimum variance frontier 2
 We can find the minimum variance frontier by finding the weights of P1 that minimise the portfolio
variance for a range of expected returns, and plot the portfolio standard deviation for each of these
expected returns

 On the face of it, it would seem that we would have to do this for all possible values of expected returns

 However, a result due to Black (1972) says that any combination of two minimum variance portfolios is
itself a minimum variance portfolio

 This leads to a neat way of deriving the minimum variance frontier: we derive two minimum variance
portfolios and simply trace out the expected return and standard deviation of all possible combinations of
these two portfolios

 For the first portfolio, we can find the portfolio weights that minimise the portfolio variance for an
expected return of 0.30%

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The minimum variance frontier 3

 Given the mean-variance optimisation framework, the investor solves the following constrained
optimisation problem:
min  P21  w1' Vw1
w

subject to
E ( RP1 )  w1' R1  µ
n

and w 1
i 1
i

 We invoke solver by going to Tools/Solver (in

Excel 1997-2003) or Data/Solver (in Excel 2007-
2010) which generates the following dialogue box

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The minimum variance frontier 4

 Here we have told solver to minimise the target cell (the variance of P1) by changing the weights of P1

 But we have to add two constraints: the first is that the portfolio weights sum to unity, and the second is
that the portfolio return is 0.3%

 To add these constraints, click on ADD, which generates the following dialogue box, completed for the
first constraint

 With both constraints added, the Solver dialogue box

looks like this

 For the second constraint, we have

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The minimum variance frontier 5

 Clicking Solve and then OK gives us the minimum variance portfolio with and expected return equal to
0.30%

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 The minimum variance frontier 6

 We can also find the portfolio P2 that has the minimum variance for an expected return of 0.60%, which
yields

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The minimum variance frontier 7

 We can now combine P1 and P2 into a ‘super-portfolio’, and by varying the weights on P1 and P2, trace
out the expected return and standard deviation of the minimum variance frontier

 First, set up the super-portfolio and its expected return, variance and standard deviation

 Note that the initial weight in P1 in the super-portfolio is arbitrarily set to zero

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The minimum variance frontier 8

 Now we can construct data tables for the expected return and standard deviation, by varying the weights
on P1 and P2

 Plotting the values of the standard deviation and the expected

return using the XY scatter graph yields the minimum
variance frontier

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The efficient set 1

 We have so far assumed that there is no risk free asset

 When an individual investor is faced with just these four risky assets, we cannot say which portfolio
he/she will invest in, since that would depend on the investor’s risk preferences

 However, we can say that his/her chosen portfolio would lie on the efficient frontier, which is defined as
the upper segment of the minimum variance frontier

 In particular, the optimal portfolio would be the portfolio that lies at the tangency of the efficient set and
the investor’s indifference curve

 As noted above, a fund manager would instead choose the optimal portfolio associated with either a target
level of risk or a target expected return

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The efficient set with a risk free asset 1

 When there is a risk free asset, the efficient

frontier is the straight line that connects the risk
free asset with the tangency portfolio, P

 Investors satisfy their risk preferences by holding

different amounts of the risky tangency portfolio
and the risk free asset

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The efficient set with a risk free asset 2

 To find the portfolio P, we solve the following maximisation problem

E  RP   rf N
max  
P
subject to w
i 1
i 1

where E  RP   wT E (R ) and  P2  w T Vw

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Estimation of the optimal portfolio when there is a risk free asset 1

 To estimate the optimal portfolio when there is a risk free asset, we use solver to find the portfolio P
 We first set up the spreadsheet to include the risk free rate (in this case 0.1%) and the definition of Theta

 We then invoke solver to maximise Theta,

subject to the constraint that the portfolio
weights sum to unity

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Short selling constraints

 When investors are not able to short sell, the feasible set of portfolios is reduced and the efficient set will
be inferior to that when short selling is allowed

 To incorporate short selling constraints into the estimation

of the efficient frontier when there is a risk free asset, we
simply add the constraint that all of the weights of P must
be greater than or equal to zero in solver, when we
maximise theta

 This yields the following solution

 To impose short selling constraints when there is no

risk free asset, we must use solver to minimise the
standard deviation, subject to the short selling
constraint, for every expected return

 This is straightforward but tedious, but can be

automated using VBA.

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Alternative formulations of the mean-variance portfolio optimisation analysis
 In the above section, we examine the investor who wants to minimise risk for a target expected return.
Another perspective is to look at the decision that the investor has to make to maximise expected return
when he cannot take more risk

 The investor now pre-determines a given level of risk  2 and maximises his expected return of the
portfolio. He solves the maximum expected return problem:
 
max E R p  w T E ( R )
w
subject to
n

w T Vw   2 and  w 1.
i 1
i

 The mean-variance analysis can be formulated in an alternative way. Incorporating expected return and
risk in a utility function in which the investor would prefer a high expected return with low variance
portfolio, and the maximum expected utility formulation is given by

 
max E U   E  R p    p2  wT E (R )  wT Vw
w 2 2
n

subject to  w  1 . Here,  measures the investor's level of risk aversion

i 1
i

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Practical issues in mean-variance analysis 1

 Markowitz optimisation treats expected returns, variances and covariances as deterministic. However, in
practice, these moments of returns are unobservable and must be estimated.

 We now discuss practical issues that arise in the application of mean–variance analysis in choosing
portfolios. The two areas of focus are:
o estimating inputs for mean–variance optimization, and
o the instability of the minimum-variance frontier, which results from the optimisation process’s
sensitivity to the inputs.

 Relative to the first area, we must ask two principal questions concerning the prediction of expected
returns, variances, and correlations.
o First, which methods are feasible?
o Second, which are most accurate?

 Relative to sensitivity of the optimisation process, we need to ask:

o What is the source of the problem, and
o What corrective measures are available to address it.

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Practical issues in mean-variance analysis 2

 Now, we compare the feasibility and accuracy of several methods for computing the inputs for mean–
variance optimization. These methods may use one of the following:

o historical means, variances, and correlations;

o historical betas estimated using the market model;
o or adjusted betas.

 Historical estimates involve calculating means, variances, and correlations directly from historical data.
The two limitations of the historical approach involve the quantity of estimates needed and the quality of
historical estimates of inputs.

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Practical issues in mean-variance analysis 3

 Market Model Estimates: Historical Beta (Unadjusted): A simpler way to compute the variances and
covariances of asset returns involves the insight that asset returns may be related to each other through
their correlation with a limited set of variables or factors. The simplest such model is the market model,
which describes a regression relationship between the returns on an asset and the returns on the market
portfolio. For asset i, the return to the asset can be modelled as
Ri   i   i RM   i

 E  Ri    i   i E  RM  ,  i2  i2 M2   2i and  ij   i  j M2

 Market Model Estimates: Adjusted Beta: Researchers have shown that adjusted beta is often a better
forecast of future beta than is historical beta. As a consequence, practitioners often use adjusted beta.

 i ,t 1   0  1i ,t   i ,t 1

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Practical issues in mean-variance analysis 4

 The chief problem with mean–variance optimization is that small changes in input assumptions can lead
to large changes in the minimum-variance (and efficient) frontier. This problem is called instability in
the minimum-variance frontier. It arises because, in practice, uncertainty exists about the expected
returns, variances, and covariances used in tracing out the minimum-variance frontier.

T=60 T=120
22 22

20 20
The figure illustrates the estimation error problem in
18 18
using the sample estimates of expected returns and the
covariance matrix to construct the mean-variance
Expected Return (%)

Expected Return (%)

16 16
efficient frontiers. The blue solid curve is the true
14 14
efficient frontier, while the red dashed curves are the
12 12
250 simulated actual frontiers. The frontiers are
10 10
constructed using real and simulated data of 10 US
8 8
industry portfolios for two sample sizes of 60 and 120
6 6 monthly observations. Expected returns and
4
10 15 20 25 30
4
10 15 20 25 30
volatilities are annualised.
Risk (%) Risk (%)

The True and Actual Mean-Variance Efficient Frontiers.

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Practical issues in mean-variance analysis 5

 Despite the simple and intuitive appeal of Markowitz’s mean-variance optimisation, its application is
often problematic.

 Extensive research has been done to provide resolutions to the well-documented practical problems
associated with the mean-variance framework.

 Improved estimates of expected returns and the covariance matrix have been suggested, ranging from
factor models to shrinkage estimators.

Further readings

BRANDT, M. W. 2009. Portfolio choice problems. In: AIT-SAHALIA, Y. & HANSEN, L. P. (eds.) Handbook of
Financial Econometrics. North Holland.

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Practice exercise

You are an analyst in a US fund management company that specialises in global equity investment. The company is
considering launching a new fund, the ‘G7 Equity Fund’, which will invest in a broad selection of large stocks in the equity
markets of the G7 countries (US, UK, Japan, Germany, France, Canada and Italy). Your manager has asked you to establish
the efficient frontier for these markets, assuming that there is a risk free asset. As a proxy for the investment in each market,
you decide to use monthly simple returns calculated using an aggregate equity return index for each market.
1. The data
You can use the return index data in “Practice Exercise data 2.xlsx” file. Ignore exchange rate fluctuations (you could
assume that the currency risk is perfectly hedged). Use the return index data to compute monthly simple returns.
2. Estimating the inputs to the optimisation
Use the return data to compute the VCV for the seven markets.
A significant problem with applying portfolio optimisation in practice is that sample estimates of expected returns are very
noisy, and hence not reliable. Using an alternative approach, Harvey (2000) estimates the following monthly expected
returns for the G7 countries:
US 1.58% UK 1.22%
Japan 0.43% Germany 1.42%
France 1.49% Italy 1.02%
Canada 1.04%
3. Computing the efficient set
The ‘G7 Equity Fund’ will have constraints. The first is that short sales are not allowed, and the second is that no
investment in a single market should be bigger than 25 percent. Estimate the efficient set of the seven equity markets under
the above constraints, assuming that there is a risk free asset. Obtain the US risk free rate from Yahoo! Finance for a three
month holding period.

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