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Table of Contents 1. 2. 3. 4. 5. 6.

Executive Summary Return Calculations and Sample Statistics Value at Risk Calculations Rolling Analysis of CER Model Parameters Portfolio Theory Asset Allocation

Executive Summary Dataset: This project looks at monthly closing prices from end of May 2007 through end of May 2012. Mutual fund descriptions S&P500 index: vfinx The mutual fund holds stocks in the same proportion as in SP500 index. European stock index: veurx Mutual fund invests in all of stocks in MSCI Europe index. Emerging Markets fund: veiex Mutual fund invests in all of stocks in MSCI emerging market index. Long term bond fund: vbltx Mutual fund tracks performance of market-weighted bond index called Barclays Capital US Long Government/Credit Float Adjusted Index. Short term bond fund: vbisx Tracks performance of market weighted bond index called Barclays Capital U.S. 1-5 Year Government/Credit Float Adjusted Index Pacific Stock Index: VPACX Mutual fund attempts to replicate performance of MSCI Pacific Index (Japan, Australia, Hong Kong, Singapore and New Zealand) Observations Mutual funds that index groups of countries their returns were negative and saw a drastic drop around mid-2008 to 2009. Only the 2 bond funds VBLTX and VBISX escaped the crisis. None of the 6 mutual funds have returns that are normally distributed and rolling analysis suggests that expected returns and standard deviations are not stationary. VEIEX had the highest risk and VBLTX had the highest returns. VBISX had the lowest risk and VEURX had the lowest return. Expected returns are not measured as precisely as standard deviations. Generally, it is true that higher risk leads to higher returns but that was not necessarily the case during the period under analysis. Bond funds had higher returns with lower amount of risk as compared to the equity funds.

VBISX had the highest sharpe ratio and VEURX had the lowest sharpe ratio. This implies VBISX had the highest excess returns per unit of risk whereas VEURX had the lowest. Stock index funds have strong positive linear relationship with each other. Whereas stock index funds and bond funds have very small correlation. Thus bonds can be used to diversify the portfolio. Global Minimum portfolio with no short sales allowed has a higher standad deviation and higher expected return than global min variance portfolio with short sales. Thus the risk is a lot more without short sale. Tangency portfolio with no short sales allowed has lower expected return, higher standard deviation and lower Sharpe ratio than tangency with short sales allowed. By introducing risk free asset to out portfolio we can achieve target return with a lower variance. Thus reducing the VaR and standard deviation (both risk measures). Return Calculation and Sample Statistics

The mutual funds that replicate indexes of different countries like S&P 500 index (vfinx), European stock index (veurx), emerging markets fund (veiex) and Pacific stock Index (vpacx) have prices and continuously compounded returns that seem to move together. For example, prices peaked at mid-2007 and then the prices dipped until 2008, then rose briefly, then plummeted until 2009. After 2009, these stock indexes rose again. 2009 onwards, the prices have been in an uptrend with corrections encountered in mid 2010 and mid 2011. The cc returns dropped drastically in mid 2008 until 2009. They have since then recovered and have hovered around their respective means until 2011. Mid-2011 again saw a dramatic drop in returns which was soon accompanied by a spike in returns in 2012. But it seems like returns have turned sharply negative in 2012. The two bond funds, long-term bond fund (vbltx) and short term bond fund (vbisx) move together. Their prices have been in a steady uptrend during the financial crisis. There was a minor correction (drop in price) that was observed around mid-2008. Compared to the country stock indexes, the movements of bond indexes are smoother, with short term bond index having smoothest upward trending in price. The plummet in county stock indexes can be attributed to the financial crisis that the global economy is facing. Generally, historical prices indicate that stocks plummet during the crisis and bonds end up doing well. A negative correlation between stocks and bonds has been observed based on historical data. As we can see in the figure above, from mid-2008 to 2009 when the stocks gave sharp negative returns,

bonds performed really well and had positive returns. Another point worth observing is that VBISX has shown positive growth with the least amount of volatility.

If we had invested $1 in VBLTX we would have observed the highest future value. This is consistent with the time series plot of prices and returns that we observed and can be attributed to the fact that bonds do really well and based on historical data are generally negatively correlated to stocks. The next best investment would have been short term bond fund (vbisx), thus proving the theory that bonds have performed really well in the past 4-5 years. One can see from the above graph that our $1 investment would have depreciated in value had we invested in any of the country stock indexes. Four panel diagnostic plots Determine if returns are normally distributed?

The distribution of returns on VFINX look negatively skewed and show fatter left tails thus not particularly normally distributed. The histogram and boxplot indicate the mean to be around 0 with a SD around 0.05 with 1 negative outlier. The QQ-plot looks normally distributed around the mean and in the right tail but deviates from the normal distribution in the left tail.

The distribution of returns on VEURX look negatively skewed and show fatter left tails thus not normally distributed. The box plot indicates that the mean is negative. The QQ-plot deviates from normal distribution in the tails. The box plot shows a large negative outlier that can also be observed in the histogram.

The distribution of returns on VEIEX look negatively skewed and has a fatter left tail. The box plot indicates a large negative outlier which resulted in a mean for a particular month to be extremely negative (lies between -30 and 40%). There is strong negative skewness that can be observed in smoothed density curve. QQ-plot indicates that in the left tail the returns deviate from the normal. The right tail appears to be normally distributed.

The distribution of returns on VBLTX look positively skewed. The mean in the box plot is on the positive side. There are extreme positive outliers and a couple of negative outliers that can be observed. One can see from the normal QQ-plot that it deviates from the normal in the tails. Thus VBLTX is not normally distributed.

The distribution of returns on VBISX look positively skewed. The mean in the box plot is on the positive side. Extreme positive outliers can be observed in the box plot. The normal QQ plot indicates that it deviates from normal distribution in the right tail.

The distribution of returns on VPACX look negatively skewed. The box plot indicates there is a negative outlier which can also be observed in the smoothed density curve and the histogram. The right tail looks to be following normal distribution but deviates from the normal in the left tail based on the QQ plot. Univariate Descriptive Statistics Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Mean Estimate -0.07984% -0.70847% -0.03446% 0.84045% 0.37033% -0.45439% SD Estimate 5.6104% 7.7615% 8.9828% 3.1101% 0.6547% 6.1112% Variance Estimate 3.148e-3 6.024e-3 8.069e-3 9.673e-4 4.287e-5 3.735e-3 Skew -0.6253 -0.453 -0.6985 0.3313 0.2947 -0.5694 Excess Kurtosis 0.452 0.1214 1.3144 1.5341 0.6201 0.4661 1% Quantile -0.1418 -0.1876 -0.2373 -0.06864 -0.011006 -0.1518 5% Quantile -0.08848 -0.1315 -0.1231 -0.03628 -0.006927 -0.1091

Highest Average Return : VBLTX Highest Standard Deviation: VEIEX

Lowest Average Return: VEURX Lowest Standard Deviation: VBISX

As can be seen above, VFINX, VEURX, VEIEX and VPACX have negative skewness and the two bond funds have positive skewness and all the six mutual funds have fat tails. Sharpe Slope: VFINX VEURX VEIEX VBLTX VBISX VPACX -0.021658 -0.096649 -0.008476 0.256832 0.501994 -0.081171

VBISX has the highest Sharpe slope, thus indicating that per unit risk taken the excess returns observed are the best among all the assets. This can be attributed to the fact that the estimated Standard Deviation is the lowest among all the assets as can be observed in the Univariate Descriptive Statistics table above. VBISX has the second highest mean and the lowest standard deviation among all the assets thus resulting in a larger numerator and a smaller denominator giving a higher slope.

Estimated Standard Errors and 95% Confidence Interval Asset Mean Estimate -0.0007984 -0.0070847 -0.0003446 0.0084045 0.0037033 -0.0045439 Mean Estimate SE 0.007243 0.01002 0.0115968 1.766e-4 7.826e-6 6.819e-4 95% Confidence Interval -0.0152844, 0.013688 -0.0271247, 0.012955 -0.0235382, 0.022849 0.0003742, 0.016435 0.0020129, 0.005394 -0.0203230, 0.011235 SD Estimate 0.056104 0.077615 0.089828 0.031101 0.006547 0.061112 SD Estimated SE 0.005122 0.007085 0.0082 0.002839 0.0005977 0.005579 95% Confidence Interval 0.045861, 0.066347 0.063444, 0.091785 0.073428, 0.106229 0.025423,0.036780 0.005352, 0.007742 0.049955, 0.07227

VFINX EURX VEIEX VBLTX VBISX VPACX

For all series, the mean is not estimated very precisely. 95% Confidence interval for mean contains both positive and negative values and mean estimate Standard Error is only slightly smaller than mean. This indicates uncertainty about the true value of expected returns. For VBLTX and VBISX the 95% CI only contains positive values which is a good thing but the size of confidence interval is still pretty large. The Standard Deviation Standard Error is more than 10 times smaller than estimated standard deviation. Therefore, standard deviation values are estimated much more precisely.

Annual Estimates Asset VFINX EURX VEIEX VBLTX VBISX VPACX Annual Mean Estimate -0.9581% -8.5017% -0.4136% 10.0854% 4.444% -5.426% Annual SD Estimate 19.435% 26.886% 31.117% 10.774% 2.268% 21.17% Growth of $1 after 5 years exp(rt) 0.9532 0.6537 0.9795 1.6558 1.2488 0.7614

Pairwise Scatterplots

Based on the scatterplot above, one can say that VFINX, VEURX, VEIEX and VPACX have positive linear relationship. Similarly, VBLTX and VBISX seem to have positive linear relationship. Also, the correlation and covariance matrix below suggests that VEURX and VFINX have the highest correlation. Hence adding them to a portfolio would not diversify risk by much. Whereas VBISX and VFINX have the least correlation. Therefore, one can diversify and reduce risk by adding VFINX and VBISX to the portfolio.

Covariance Matrix sigma VFINX VEURX VEIEX VBLTX VBISX VPACX

VFINX 0.003147662 0.004039969 0.004335293 7.85E-05 2.88E-06 0.003067766

VEURX 0.00404 0.006024 0.006383 0.000309 7.33E-05 0.004434

VEIEX 0.004335 0.006383 0.008069 0.000321 6.76E-05 0.004925

VBLTX 7.85E-05 0.000309 0.000321 0.000967 0.00012 0.000356

VBISX 2.88E-06 7.33E-05 6.76E-05 0.00012 4.29E-05 5.38E-05

VPACX 0.003068 0.004434 0.004925 0.000356 5.38E-05 0.003735

Correlation matrix

VFINX VEURX VEIEX VBLTX VBISX VPACX

VFINX VEURX VEIEX VBLTX VBISX VPACX 100.00% 92.78% 86.02% 4.50% 0.78% 89.47% 92.78% 100.00% 91.55% 12.82% 14.42% 93.48% 86.02% 91.55% 100.00% 11.49% 11.49% 89.71% 4.50% 12.82% 11.49% 100.00% 59.15% 18.71% 0.78% 14.42% 11.49% 59.15% 100.00% 13.44% 89.47% 93.48% 89.71% 18.71% 13.44% 100.00%

SE(correlation)

VFINX VFINX VEURX VEIEX VBLTX VBISX VPACX


rho 95% CI

VEURX VEIEX VBLTX 0 0.01798 0.03357 0.12884 0 0.02091 0.12698 0 0.1274 0

VBISX 0.12909 0.12641 0.12739 0.08393 0

VPACX 0.02575 0.1629 0.02521 0.12458 0.12677 0

VFINX VEURX VEIEX VBLTX VBISX

VEURX (0.8918, 0.9637)

VEIEX (0.7931, 0.9274) (0.8736, 0.9573)

VBLTX (-0.21269,0.3027) (-0.12579, 0.3821) (-0.1399, 0.3697)

VBISX (-0.2504,0.2660) (-0.1086,0.3971) (-0.1399,0.3697) (0.4237, 0.7594)

VPACX (0.84325, 0.9462) (0.90221, 0.9674) (0.84667,0.9475) (-0.06211,0.4362) (-0.11908,0.388)

Since the estimated correlation is within the confidence interval for all six assets, the correlations for all assets are statistically significant and reliable. Value-at-Risk Calculations VaR of $100,000 over a One Month Investment Horizon Asset VFINX VEURX VEIEX VBLTX VBISX VPACX VaR 1% -$12306 -$17109 -$18886 -$6195 -$1146 -$13646 VaR 5% -$8888.1 -$12606.5 -$13765.4 -$4185.1 -$704.1 -$9973.4

The short term bond VBISX has the lowest value at risk, while the emerging markets fund VEIEX has the highest value at risk. VaR of $100,000 over a One Year Investment Horizon Asset VFINX VEURX VEIEX VBLTX VBISX VPACX VaR 1% -$36979 -$50859.7 -$51714.4 -$13910.4 -$828.7 -$42132.5 VaR 5% -$28054 -$40978 -$40308 -$7352 -$716 -$33152

Empirical VaR of $100,000 over a One Month Investment Horizon Asset VFINX VEURX VEIEX VBLTX VBISX VPACX VaR 1% -$13220 -$17108 -$21126 -$6634 -$1095 -$14083 VaR 5% -$8467.7 -$12320.3 -$11584.9 -$3562.9 -$690.3 -$10337.6

Empirical VaR of $100,000 over a One Year Investment Horizon Asset VFINX VEURX VEIEX VBLTX VBISX VPACX VaR 1% -$39226.1 -$50858.2 -$56179.1 -$15299 -$649.4 -$43141.1 VaR 5% -$26897.8 -$40305.7 -$34914.5 -$5250.6 -$764.5 -$34083.7

The results from empirical VaR calculations are pretty close to the results based on normal distribution.

Bootstrapped Standard Errors and 95% Confidence Intervals for 5% Value at Risk 5% VaR of $100,000 over a One Month Investment Horizon Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Bootstrapped SE $1270 $1544 $2092 $625.7 $129.4 $1320 95% Confidence Interval (Percentile) (-$11418, -$6438) (-$15545, -$9525) (-$17774, -$9834) (-$5420, -$2867) (-$937.3, -$414.7) (-$12513, -$7237) 95% Confidence Interval (Normal) (-$11311, -$6373) (-$15832, -$9778) (-$18019, -$9821) (-$5483, -$3030) (-$975, -$467.6) (-$12754, -$7579)

Since the estimated 5% VaR is within the confidence interval for all six assets, the 5% VaR for all assets are statistically significant and are reliable measures. Rolling analysis of CER Model parameters

The rolling means for VFINX before mid-2010 were negative and have now turned positive. The means show quite a lot of variability. They started negative, then in mid 2010 turned positive and then began to decrease in early 2011. Clearly, the mean is not constant over time. The rolling standard deviations also show time variation. They decrease rather dramatically in mid 2010. The CER Model with constant parameters is not very good for VFINX.

The rolling means for VEURX before mid-2010 were negative and then turned positive and are pretty much close to zero currently. The means show quite a lot of variability. They started negative, then in mid 2010 turned positive and then began to decrease in early 2011 and have now settled at around 0%.. Clearly, the mean is not constant over time. The rolling standard deviation also show time variation. They decrease rather dramatically in mid 2010. The CER Model with constant parameters is not very good for VEURX.

The rolling means for VEIEX before mid-2010 were negative and then turned positive and are pretty much close to zero currently. The means show quite a lot of variability. They started negative, then in mid 2010 turned positive and then began to decrease in early 2011 and have now settled at around 0%.. Clearly, the mean is not constant over time. The rolling standard deviation also show time variation. They decrease rather dramatically in mid 2010. The CER Model with constant parameters is not very good for VEIEX.

The rolling means for the bond returns are always positive. They had a sharp increase in mid 2010 but since then they seem to be mean reverting and appear fairly constant. The rolling standard deviations show some variation. In particular, the standard deviation increased sharply toward the end of 2008. The crisis period had a large impact on the rolling estimates of volatility.

The rolling means for VBISX returns are always positive. They appear to be approximately constant.

The rolling means for VPACX before mid-2010 were negative and then turned positive and are pretty much close to zero currently. The means show quite a lot of variability. They started negative, then in mid 2010 turned positive and then began to decrease in early 2011 and have now settled at around 0%.. Clearly, the mean is not constant over time. The rolling standard deviation also show time variation. They decrease rather dramatically in mid 2010. The CER Model with constant parameters is not very good for VEURX.

Portfolio Theory Global Minimum Variance Portfolio with Short Sale Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Weights 10.28% -8.61% -0.17% -8.86% 105.24% 2.11%

E[Rp] SD(Rp) VaR 5% VaR 1%

Monthly Returns 0.36% 0.54% -$532.6 -$899.8

Annualized Returns 4.3% 1.88% $1218 $-70.7

Since there are negative weights in this portfolio, it means this global minimum variance portfolio was constructed by shorting mutual funds. Since mutual funds cannot be shorted, this global min portfolio that allows for short sales is not replicable. Comparing the annualized return statistics with those of the six assets, the annual mean for global minimum variance portfolio is within the range of expected returns of the six assets, but the annual standard deviation of the global minimum variance portfolio is lower than the standard deviation of any individual assets. VaR is much smaller (in absolute value) for the global minimum variance portfolio than any individual asset, implying that the probability of losing money holding this portfolio is much lower than holding any one asset.

Global Minimum Variance Portfolio with No Short Sale Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Weights 1.26% 0% 0% 0% 98.74% 0%

E[Rp] SD(Rp) VaR 5% VaR 1%

Monthly Returns 0.36% 0.65% -$703.4 -$1143

Annualized Returns 4.38% 2.25% $669.8 $-865.2

Global Min Portfolio with no short sales


100.00% 80.00% 60.00% 40.00% 20.00% 0.00% VFINX VEURX VEIEX VBLTX VBISX VPACX

Comparing the portfolio with no short sales with the portfolio that allowed short sales, one would have to live with slightly higher standard deviation for almost the same mean. Also, the global minimum variance portfolio with no short sales is not diversified enough. Almost all the eggs are in one basket, i.e. VBISX has the largest share of the portfolio and only a small amount of the portfolio is in VFINX. Rest of the assets have 0% weight. Most of the risk contribution is from VBISX and only a slight bit is being shared by VFINX. Nevertheless, since it is a portfolio with minimum variance that has been diversified to an extent the risk is much lesser than the risk associated with any individual asset in the portfolio. If we choose VaR as our risk measure instead of standard deviation, we see similar results. VaR numbers also suggest the extra risk associated with the portfolio due to ban in short sales.

Markowitz Bullet Computation

z
2.94461E-05 0.000113207 0.000364488 0.000783291 0.001369615 0.00212346 0.003044825 0.004133713 0.005390121 0.00681405 0.0084055 0.010164471 0.012090964 0.014184977 0.016446512 0.018875567 0.021472144 0.024236242 0.027167861 0.030267001 0.033533662

m (1
SD(Rp,z)
0.54% 1.06% 1.91% 2.80% 3.70% 4.61% 5.52% 6.43% 7.34% 8.25% 9.17% 10.08% 11.00% 11.91% 12.82% 13.74% 14.65% 15.57% 16.48% 17.40% 18.31%

) y

alpha 1-alpha E[Rp,z] var(Rp,z)


1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 0.36% 0.41% 0.45% 0.50% 0.55% 0.60% 0.65% 0.70% 0.74% 0.79% 0.84% 0.89% 0.94% 0.99% 1.03% 1.08% 1.13% 1.18% 1.23% 1.27% 1.32%

Portfolio Frontier 2.00%


Efficient Frontier Portfolios

VFINX VEURX VEIEX VBLTX GlobalMinVariancePortfolio

1.50% Efficient Frontier


of Tangency + Tbills

1.00%
VBLTX

Efficient Frontier Portfolios Tangency Efficient Frontier of Tangency + T-bills VBISX

0.50% 0.00% -0.50% -1.00% 0.00%

Tangency VBISX GlobalMinVarianc ePortfolio VFINX VPACX

VEIEX

VPACX

VEURX

2.00%

4.00%

6.00%

8.00% 10.00%

Tangency Portfolio with Short Sales Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Weights 18.71% -17.31% 6.01% -0.61% 98.54% -5.33%

E[Rp] SD(Rp) Sharpe Var(Rp)

Monthly Returns 0.4896% 0.65% 0.694298 4.16e-5

Annualized Returns 5.875% 2.235% 2.40 0.0004995

100.00% 80.00% 60.00% 40.00% 20.00% 0.00% VFINX -20.00% VEURX VEIEX VBLTX VBISX VPACX

Tangency Portfolio with No Short Sales Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Weights 0% 0% 0% 0% 100% 0%

E[Rp] SD(Rp) Sharpe Var(Rp)

Monthly Returns 0.37% 0.65% 0.501995 4.29e-5

Annualized Returns 4.44% 2.268% 2.40 0.0004995

Tangency Portfolio Not Allowing Short sales


100.00% 80.00% 60.00% 40.00% 20.00% 0.00% VFINX VEURX VEIEX VBLTX VBISX VPACX

Tangency portfolio with no short sales allowed has lower expected return, higher standard deviation and lower Sharpe ratio than tangency with short sales allowed.

Asset Allocation Target return = 6%.Below Asset VFINX VEURX VEIEX VBLTX VBISX VPACX Weights 59.49% 0% 0% 0% 40.51% 0%

Monthly Standard Deviation: 3.35%

VaR 1% = -$7034

VaR 5% = -$4887

Traget Expected Return 6%


60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% e_vfinx e_veurx e_veiex e_vbltx e_vbisx e_vpacx

Combination of T-bills and tangency portfolio with target expected return = 6% annually and no short sales of risky assets allowed We know that with no short sales allowed in the tangency portfolio, all of the investment is in VBISX based on the weights table above. From the excel file, we calculated that the share of wealth to be invested in tangency portfolio will be 1.3945. It means that T-bills will have to be borrowed. The share of T-bills that are borrowed will be 0.3945 to satisfy the constraint that the total share of wealth is not greater than 1. This implies that 139% of the portfolio is made up of VBISX shares (leveraging VBISX) and -39% of the portfolio has Tbills shorted. Rest of the assets have 0% contribution in the asset to achieve a target expected return of 6%. The monthly Standard deviation of the portfolio is 0.913% which can be computed by multiplying share of wealth in tangency portfolio with the standard deviation of tangency portfolio. Monthly Standard Deviation: 0.913% VaR 1% = -$996.8 VaR 5% = -$1611

Adding a risk free asset has brought down the volatility of the portfolio by a large extent. Also if we consider VaR as our risk measure, the loss has been reduced drastically by the inclusion of risk free asset in the portfolio.

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