Fundamentals Drive Alpha

Presentation to the NYU Economics Honors Society Discussion Series
April 12, 2006

This talk is based on a paper, ―Fundamentals Drive Alpha‖ co-authored by: Andrew Alford, PhD Bob Jones, CFA Terence Lim, PhD, CFA, CPA Bob Litterman, PhD The paper is available at: http://activealpha.gs.com/structured_equity.html

This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell, or the solicitation of offers to buy, any security. Opinions expressed herein are current as of the date appearing in this material.

What motivated the Black-Litterman model?

Optimizers are very powerful, sometimes very sensitive tools Investors had, historically, found optimizers didn’t add much value to portfolio construction or asset allocation because the results were badly behaved

In 1989 I posed a question to Fischer Black:
―Our asset allocation optimizer is extremely sensitive to its inputs. What can we do?‖

Black responded: ―I’ve just written a paper using a Global CAPM framework to analyze currency hedging. Perhaps we should embed the optimization in the context of such an equilibrium‖ I pondered Black’s suggestion and thought: ―I wonder what that means?‖

Fundamentals Drive Alpha

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Views specified by the investor pull expected returns away from the equilibrium values along curved paths defined by the covariance structure of the underlying asset returns Not only does the equilibrium make economic sense.‖ They describe how to combine Prior Information with a Sample. but when those expected returns are used to drive the optimizer. ―Equilibrium‖ with an investor’s ―Views‖ The Global CAPM Equilibrium becomes the center of gravity for expected returns.The Black-Litterman model The answer begins almost 30 years earlier with Theil and Goldberger (1961) ―On Pure and Mixed Statistical Estimation in Econometrics. the optimizer stops misbehaving Fundamentals Drive Alpha 2 . This well known formula is called ―mixed estimation‖ Black and Litterman (1992) ―Global Portfolio Optimization‖ use the same formula to combine a prior.

in 626 pages. we provide more details) Fundamentals Drive Alpha 3 .An advertisement for our book (where.

This diagram shows where Black-Litterman fits into our Quantitative Equity process Quantitative Analysis of Fundamental Factors View Portfolios Current Portfolio Risk Allocation Risk Model BlackLitterman Optimal Tilt Portfolio Transaction cost estimates Reverse Optimization Implied stock alphas Optimization Optimal Trades Client objectives Constraints Fundamentals Drive Alpha 4 .

We call its inverse the ―confidence‖ in the view. has a particular expected return q The investor provides a set of such views (defined by a kxn matrix P containing the weights of the portfolios). (We can also use the off-diagonal elements of W to specify views for which the degrees of confidence should be related) Fundamentals Drive Alpha 5 . a k-vector Q of expected returns for the portfolios. W ) Where m is the vector of expected returns for individual assets Each row of P reflects a view: that the portfolio with the given weights has the given expected return W specifies. p. and the Covariance Structure for these ―View Portfolios‖ We write: P m = Q + e e ~ N( 0. along the diagonal.View portfolios Views are represented as mathematical statements: A particular portfolio. the degree of uncertainty about the view.

Black-Litterman combines the Views with a prior reflecting the global CAPM Equilibrium: m = P + ee P is the n-vector of equilibrium risk premia from Fischer’s ―Universal Hedging‖ global CAPM.The Black-Litterman formula Using the Theil-Goldberger formula. tS. ee reflects the degree of uncertainty in the prior that expected returns have equilibrium values We assume the uncertainty about the means has a covariance structure. the covariance matrix of asset returns The result is a vector of expected returns: m* = [(tS )-1 + P’W-1P] -1 [(tS )-1P + P’W-1Q] which can be used as input to an optimizer. proportional to S. Fundamentals Drive Alpha 6 .

Japan/Germany = .0% 40.3. Corrs: US/Japan = .3 Optimal Portfolio Weights 60.45.Traditional asset allocation optimization We illustrate the traditional approach to asset allocation in a world with 4 equity markets.45. Germany = 3%.4.0% 30.0% US Japan UK Germany Fundamentals Drive Alpha 7 .0% -10. Japan.0% 10. US/Germany = . UK/Germany = . 2) Estimate Volatilities and Correlations: Vols: US = 15%. Germany) 1) Make assumptions about expected returns  Attempt to express a bullish view on the US market  Expected Returns Above the Risk Free Rate US = 4%. US/UK = .0% 50. UK = 3%. Germany = 15%. The equity markets: ( US. Japan = 3%.0% 20. UK.25 Japan/UK = . UK = 16%. Japan = 17%.0% 0.

-1.0% 5. Japan.Black-Litterman and asset allocation We illustrate two views in a world with 4 equity markets.0% 1. 0.0% 3. 1. Germany) 1) Bullish US equities (1 percent above equilibrium ) (1. 0) * m = (p1 + .0% 4.0% 0. UK.0% 2. 0.01) + e1 2) Japan equities to outperform UK equities by 1 percent (0. 0) * m = . The equity markets: ( US.0% US Japan UK Germany Equilibrium Black-Litterman Fundamentals Drive Alpha 8 .01 + e2 Equilibrium Expected Returns vs The Black-Litterman Expected Return Vector: m* 6.

00 -0.04 0.06 US Japan UK Germany Portfolio Deviations Based on View Portfolio 2 Optimal Tilt Portfolio 0. the OTP is a linear combination of the View Portfolios and the Market Portfolio Portfolio Deviations Based on View Portfolio 1 0.02 -0.10 0.02 0.12 0.04 -0.04 -0.06 US Japan UK Germany Fundamentals Drive Alpha 9 .02 -0.00 -0.00 -0.08 0.08 0.04 0.06 0.02 0.02 -0.‖ As shown in He and Litterman(1999). We call the deviations from market capitalization weights the ―Optimal Tilt Portfolio.12 0.10 0.06 US Japan UK Germany 0.12 0.04 -0.08 0.The Optimal Tilt Portfolio The mean-variance optimal portfolio in an unconstrained context based on the BlackLitterman expected returns is a tilt away from a scaled Market portfolio toward a linear combination of the View Portfolios.02 0.06 0.06 0.10 0.04 0.

―Where’s the Juice?‖ Equilibrium returns are no longer even part of the equation. You might well ask. Fundamentals Drive Alpha 10 . (and assuming there are no other binding constraints) the optimal active weights are proportional to the Optimal Tilt Portfolio. In this case.Black-Litterman and active stock selection If (1) the View Portfolios are uncorrelated with the Market and (2) the Optimal Portfolio is constrained to have zero beta. Then the Optimal Tilt Portfolio is simply a weighted average of the View Portfolios.

Capturing views in client stock portfolios: The Black-Litterman framework 11 .

economic environments.Fundamentals drive alpha!  Capital markets are competitive.  Fundamental characteristics should be robust. beating the market is not easy. characteristics should demonstrate that they identify stocks with superior returns over time in different regions.  Superior returns are captured through careful portfolio construction and trading — We use the Black-Litterman framework and customized quantitative tools to enhance portfolio efficiency and minimize trading costs Fundamentals Drive Alpha 12 . and market segments. then we conduct empirical tests — To be considered an alpha driver. but not entirely efficient.  We believe the key driver of superior investment performance is superior fundamental research. — We start with characteristics that are Economically Intuitive.  However.

Lots of fundamental stock characteristics help determine value Interest Coverage Price Momentum Beta Return on Equity Earnings Surprise Accruals Price/Earnings Payout Ratio P/E to Growth Earnings Momentum Size XYZ’s Value Dividend Discount Model Price to Cash Flow Price / Book Debt / Equity Dividend Yield Long Term Growth Expected Growth Fundamentals Drive Alpha 13 .

A few stock characteristics also help to forecast returns This is a surprise: It should not happen in efficient markets Accruals Price Momentum P/E to Growth Price/Earnings Return on Equity XYZ’s Alpha Earnings Momentum Price / Book Price to Cash Flow Dividend Discount Model Fundamentals Drive Alpha 14 .

Most stock characteristics don’t forecast returns The information they contain is. on average. fully reflected in current prices Beta Payout Ratio Size Interest Coverage Debt / Equity XYZ’s Value Dividend Yield Expected Growth Long Term Growth Fundamentals Drive Alpha 15 .

Individual stocks have unequal. fundamental characteristics. not individual stocks. Many investors use a simplistic approach that ignores risk: The stronger a stock’s fundamentals The larger the view The bigger the stock’s position  Our process combines fundamental characteristics to maximize portfolios’ information ratio. and sometimes offsetting.We express our investment insights as “views” We have views about fundamental characteristics.    The alpha drivers have different expected returns and risks. Translating views into portfolios is not easy. Fundamentals Drive Alpha 16 .  We believe portfolios of stocks with positive alpha drivers will outperform portfolios of stocks with negative alpha drivers.

one for each alpha driver The view portfolios are long (short) stocks with positive (negative) values for the corresponding alpha drivers Each view portfolio has a given exposure to the corresponding alpha driver and minimizes exposure to other sources of risk View portfolios have superior returns because they have attractive fundamentals and limited risk • • Fundamentals Drive Alpha 17 .View portfolios capture the information in the alpha drivers Our process over-weights stocks with good fundamentals and under-weights stocks with poor fundamentals • • We form multiple view portfolios.

50 1.50) (2.00) AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP CITIGROUP INC EXXON MOBIL CORPORATION WAL-MART STORES INC PFIZER INC BANK OF AMERICA CORP GENERAL ELECTRIC CO MICROSOFT CORP JOHNSON & JOHNSON (2.00 0. Fundamentals Drive Alpha 18 .50 0. for example.‖ Industry Normalized Operating Efficiency Standardized Exposures 1. We think View Portfolios should represent fundamental characteristics that forecast returns.50) (1. ―operating efficiency‖ If you believe this characteristic forecasts higher future returns.What does a stock selection “view portfolio” look like? It’s really up to the investor.00 (0. then you can imbed this belief in a ―View Portfolio.50) The data above is for illustrative purposes only and is not a recommendation of any security.00) (1.

5 EXXON MOBIL CORPORATION JOHNSON & JOHNSON WAL-MART STORES INC BANK OF AMERICA CORP AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP PFIZER INC CITIGROUP INC MICROSOFT CORP GENERAL ELECTRIC CO EXXON MOBIL CORPORATION JOHNSON & JOHNSON WAL-MART STORES INC BANK OF AMERICA CORP AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP PFIZER INC CITIGROUP INC MICROSOFT CORP GENERAL ELECTRIC CO .00) (0.50) EXXON MOBIL CORPORATION JOHNSON & JOHNSON WAL-MART STORES INC BANK OF AMERICA CORP AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP Weights Based on Factor Values Weights Based on Factor Ranks Minimum Risk Exposure to Factor The data above is for illustrative purposes only and is not a recommendation of any security.5 1 0.500 1.00) (1. PFIZER INC CITIGROUP INC MICROSOFT CORP There are different approaches to setting the weights in view portfolios Fundamentals Drive Alpha 19 GENERAL ELECTRIC CO 1.00 0.000 -1.00 1.Active Weight 1.500 Active Weights Active Weights 0.50) (2.5 0 -0.500 0.50 (2.500 -1.50) (1.5 -2 -2.000 -0.50 1.000 0.5 -1 -1.

The backtested performance results depicted above reflect the reinvestment of dividends and other earnings. The performance results disclosed herein do not represent the results of actual trading using client assets.Historical effectiveness of each alpha driver Simulated excess returns to CORE themes (June 1977 to September 2004) 70% Valuation 60% 50% Earnings Quality Momentum Analyst Sentiment Profitability Cumulative Return 40% 30% 20% 10% 0% -10% Management Impact 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 The performance results stated above are backtested based on a methodology that is derived from an analysis of past market data with the benefit of hindsight. 2004 Fundamentals Drive Alpha 20 . Source: Goldman Sachs. These results do not reflect the performance of a GSAM managed account or composite and are being shown for informational purposes only. brokerage or other commissions or exchange fees or any other expenses a client would have to pay. If GSAM had managed your account during the period shown above it is highly improbable that your account would have been managed in a similar fashion due to differences in economic and market conditions. but do not reflect the deduction of advisory fees.

Combining view portfolios The Black-Litterman framework delivers a robust combination of view portfolios The weights in the Optimal Tilt Portfolio (OTP) are driven by a number of considerations. We allocate more risk to view portfolios (alpha drivers) with: • • • • • Better historical results More consistent results Stronger confidence (lower uncertainty) Greater diversification benefits Longer signal persistence • Lower required turnover Fundamentals Drive Alpha 21 .

Limitations of the optimal tilt portfolio In an ideal world. a client’s portfolio would be the benchmark plus the OTP Portfolio weight = Benchmark weight + OTP weight = + Unfortunately. the OTP is not appropriate for most clients: • • • The OTP is a zero-investment. long-short portfolio The OTP does not reflect client-specific guidelines and restrictions The OTP ignores transaction costs Fundamentals Drive Alpha 22 .

constraints. How else could one expect to accurately allocate risk across those factors?  Comparing two managers who have the same fundamental views. through better risk modeling and portfolio construction. will be more successful Fundamentals Drive Alpha 23 . and we use shrinkage estimators  Our risk models are customized and proprietary: they measure the unique risks in our view portfolios. the one who captures those views most efficiently. They are. a reverse-optimization of the OTP based on the same risk model. based on the OTP. in effect. that are consistent with the risk model. as well as in the final portfolio optimization step with client objectives. and transactions costs  They should be robust: We estimate our risk models using a parsimonious factor structure. we use daily data. We believe that risk models play a central part throughout the investment process  They should be applied consistently when creating the OTP and stock alphas.Consistency with the risk model The Black-Litterman framework produces individual stock alphas.

This diagram shows where Black-Litterman fits into our Quantitative Equity process Quantitative Analysis of Fundamental Factors View Portfolios P Risk Allocation W Risk Model Current Portfolio BlackLitterman Optimal Tilt Portfolio Transaction cost estimates m* Reverse Optimization Implied stock alphas Optimization Optimal Trades Client objectives Constraints Fundamentals Drive Alpha 24 .

Goldberger. A.‖ Goldman Sachs Investment Management Series. Theil.S. International Economic Review 2. 1961. 1992.References Black. ―Global Portfolio Optimization. On pure and mixed estimation in econometrics.. R. 1999. and Litterman.. G. and Litterman. References 25 . R. F.. ―The Intuition behind Black-Litterman Model Portfolios.‖ Financial Analysts Journal 48 (September/October): 28-43 He. 65–78.. H.

Accordingly. Copyright 2004 Goldman. or the model may not be updated to reflect current economic or market conditions. results are likely to vary substantially from the examples shown herein. Expected return models apply statistical methods and a series of fixed assumptions to derive estimates of hypothetical average asset class performance. Expected returns are statistical estimates of hypothetical average returns of economic asset classes. or the solicitation of offers to buy. without Goldman Sachs Asset Management’s prior written consent. These examples are for illustrative purposes only and do not purport to show actual results. No part of this material may. All Rights Reserved Review #04-3856 Additional Information 26 . director. these models should not be relied upon to make predictions of actual future account performance. This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell. as the assumptions may not be consensus views. Reasonable people may disagree about the appropriate statistical model and fixed assumptions. photocopied or duplicated in any form. These models have limitations.Additional information General Opinions expressed are current opinions as of the date appearing in this material only. Actual returns are likely to vary from expected returns. In the event any of the assumptions used in this presentation do not prove to be true. officer. Goldman Sachs has no obligation to provide recipients hereof with updates or changes to such data. or (ii) distributed to any person that is not an employee. be (i) copied. or authorized agent of the recipient. Sachs & Co. any security. Opinions expressed herein are current as of the date appearing in this material. by any means. derived from statistical models.

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