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Tactical Asset Allocation

A factor regression model TAA Team 01/20/2011

2000 Optimal asset allocation : vector Global minimum-variance portfolio Strategic bet Tactical bet .TAA Framework  Reference Book: Advanced Theory and Methodology of Tactical Asset Allocation – Wai Lee. January 19.

 Given by  γ is the constant relative risk aversion (CRRA) coefficient  σ is the risk. portfolio variance.1  Expected Utility of Wealth is expressed from a total risk and total return perspective.Derivation of Formula .  ω is the vector of portfolio weights ( ω’1 = 1 ) .

25)  we obtain .2  Forming the standard LaGrangian as  λ is a LaGrangian multiplier  Substitute (2.Derivation of Formula .23) into (2.

3  Substitute (2.23) we get the well- known Mutual Fund Separation Theorem.Derivation of Formula .  ωg is the global minimum variance portfolio .26) into (2.

Derivation of Formula . .4  Assume R-bar is the equilibrium returns and E[R] ≠ R-bar.

Optimal Portfolio  Optimal Asset Allocation: .

Tactical bet: If expected return is different from equilibrium returns. . shift asset to higher expected return.TAA Framework Global minimum-variance portfolio Strategic bet: If equilibrium returns are different. the investor should shift asset from lower return to higher return.

For Simple Implementation  We need:  Covariance matrix of returns  Expected return  Constant relative risk aversion (CRRA) coefficient (γ : 1-10 ) .

Steepness . PPP.Expected Return  Bond: 10 year US Bond Index  Equity: S&P 500  Basic Model Factors  Bond model factor  Credit Spread  Market Volatility  Momentum  Real Interest Rate  Term Structure  Yield Spread of Corp  Equity model factor  Famma French Factor :  Size (small – big)  Growth (growth – value)  Momentum  Real Interest Rate  Yield Spread of Corp  Other possible factors: GDP. Sentiment. PE Ratio.

turn over  Step 4:  Adjust for γ: constant relative risk aversion coefficient 1-10 . long short. preprocess data  Step 3:  Risk management: add constraints.Modeling Tuning  Step 1:  Factor-based regression to estimate expected return  Step 2:  Fine-tuning factors: filter input data.

Expected Return Result  Cumulative expected return vs. real return .

0033955 0.134634493 0.336941763 .031688035 -0.Expected Return Result  Statistics AvgReturn StdReturn Equity Bond IR SkewReturn 0.23750056 0.00412713 0.01049768 0.00497951 0.547816062 KurtosisReturn 0.13693123 0.

Optimal Portfolio W/O Constraint  Cumulative Portfolio Return vs. Benchmark .

Optimal Portfolio W/ Constraints  Added Long-only and turnover(40%) constraints .

DataStream) Trading System (Charles River) Data Warehous e (SQL Server) Investment Model (SAS.net) Portfolio Accntng System (Advent APX) Client Service Rpt. Performance. Attribution . MarketQA. Barra. . CompuStat.System Workflow Automated Data Feed (Bloomberg.

SQL. etc  SAS Statistic Packages  Procedure: REG. MEAN. Excel Database.SAS Model Walk Through  Data Input  Flat File / Excel File / Database / SAS dataset  Data Output  Flat File. PHREG. LOGISTIC  IML Matrix  ETS  Code Demo . DATA.

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