Investment Symposium March 2012

P2: Portfolio Construction: Asset Allocation versus Risk/Strategy Buckets

Marc Carhart Radu Gabudean

Moderator
Timothy Wilson

Beyond Modern Portfolio Theory

Radu C. Gabudean Barclays Research

Asset Allocation: Historical Evolution

Portfolio Building Blocks Market Risk Premia Alternative Risk Premia Today Geographical Diversification Equity Rates Credit .. Alt Assets 2000s Portfolio Construction Method 4. Risk Parity, Most Diversified Portfolio, Equal Volatility, 3. Capacity & liquidity constraints: Constrained optimization 2. Estimation error: Black Litt Litterman, shrinkage, hi k robust optimization

Equity Rates Credit Commods EM

1990s

1980s 1. Tail-risk: Sortino Equity Fixed Income Commods 1970s Equity Fixed Income 60/40 Modern Portfolio Theory - MVO

Building a Portfolio
The objective of any portfolio: M i i Performance Maximize P f vs Risk Ri k Requires forecast of building blocks properties
Performance (E.g. Expected Returns) Risk (E.g. Volatilities) Joint behavior (E.g. Correlations)

If Risk Ri k = Volatility V l tilit then th Mean M Variance V i O Optimization ti i ti (MVO)

Why Portfolio Building Blocks Matter

If forecasts are perfect, building blocks do not matter Historical data often produces unreliable forecasts
Particularly for building blocks with unstable properties and high correlations

Check historical estimates against intuition

Must be able to form views on future performance and risk Combine historical estimates with pre-defined views

For clarity and practicality, define building blocks based on sources of performance Risk Premia = Sources of Performance

Risk Premia as Portfolio Building Blocks

Intuitive performance May M h have l low correlation l ti More stable correlations and volatilities
Easier to forecast from historical data More stable portfolio weights

Offer a systematic way to cover all sources of performance

Views about various premia differ across investors

Portfolio differs across investors Market-cap portfolio is not optimal

Asset Allocation Example: Building Blocks

Liquid risks that carry a premium, diversified across geography & style
BetaFactors GlobalEquityMarkets
Russell1000 MSCIEAFE MSCIEM

AlternativeBetaFactors Carry/Curve/ValuePremia
Rates2/10USD Rates2/10EU Commodities Curve Commodities Value RatesLiquidity FXCarry Volatility Curve EquityValue EquityM&A

Diversifiers TailHedge
LongVolatility Gold

GlobalRatesMarkets
USRates USTIPS EURates EULinkers

CommoditiesMarkets
Energy Industrials Agriculture Livestock

CreditSpreads
CDXIG EMSovUSD CDXHY iTraxxIG

Which Portfolio Construction Method?

Many alternative methods to Mean-Variance Optimization
E E.g. g Most Diversified Diversified, Equal Volatility Volatility, Risk Parity Parity, Equal Weights Still use estimates of performance and/or risk

All may be interpreted as robust MVO

The properties forecasts combine estimates with pre-defined values

Hard to give them another interpretation without departing from the objective of Maximize Performance vs Risk Allows for clear comparison and selection across methods The pre-defined values must be appropriate
Robust Mean Variance
Mean Variance Most Diversified Minimum Volatility Risk Parity Equal Weights ...

Robust MVO Construction Methods: Examples

Name
EqualVolatility MaxDiversified Portfolio RiskParity MinimumVolatility Shrinkage(Ledoit& Wolf) BlackLitterman Yourown

Volatility forecast
Historical Historical Historical Historical Historical Historical& Predefined Historical&/or Predefined

Correlation forecast
Thesame Historical Historical& Zero Historical Historical&The same Historical& Predefined Historical&/or Predefined

Sharpe forecast
Thesame Thesame Thesame Inverseof volatility Historical Historical& Predefined Historical&/or Predefined

From MVO to Tail-Risk

Maximize Performance / Risk; Risk =Tail-Risk Issue: Joint behavior = Multivariate joint distribution Portfolio construction with tail-risk hedges:
Robust Mean-Variance Optimization on nonhedges Overlay tail-hedges using tail-risk criteria

Account for tail-hedges in MVO

Capacity and the Market-weight Portfolio

Capacity constraints:
Tilts the portfolio towards market-cap market cap weights because of trading costs
Optimum Portfolio w/out Trading Costs Market-Cap Portfolio

Optimum Portfolio with Trading Costs

Market-cap portfolio is not always optimal, but it is still special Implement capacity constraints with a layered approach:
Group risks into buckets of comparable importance

Asset Allocation Example: Methodology

Compare models:
1. 1 2. 3. 60/40 on US Equity and US Fixed Income MVO on US Equity, US Fixed Income and Commodities using historical estimates for performance and risk Robust methodology to historical estimates, tail-hedge and capacity constraints on Global Liquid Risk Premia
Average Weight Equities 60% 23% 5% FI / Rates Commodities Spreads 40% 59% 18% 30% 7% 25% Standard Deviation of Weights Equities 30% 1% FI / Rates Commodities Spreads 37% 24% 5% 2% 5% Alternative Premia Tail-Hedge 5% 0%
Source:Barclays,Bloomberg

Alternative Premia Tail-Hedge

60/40 Historical MVO Robust Risk-premia

27%

6%

Historical MVO Robust Risk-premia

Asset Allocation Example: Results

60/40
PieCharts:Realized RiskContributions
190
FI Commods Equities FI Equities

Historical MVO

Diversified,Tailhedged, RiskParity
Hedge Alt Alternat t Spreads Equities Rates

Vol=2.4% Vol=6.9%

Commods

160

130

Vol=10%

100

70 J an 1999 J an 2000 J an 2001 J an 2002 J an 2003 J an 2004 J an 2005 J an 2006 J an 2007 J an 2008 J an 2009

Source:Barclays,Bloomberg

J an 2010

J an 2011

J an 2012

Conclusion
Standard approach is a good theoretical start Practical P ti l adjustments dj t t
Risk premia instead of assets Methodology robust to estimation errors Tail-risk included in the picture Capacity constraints: tilt towards market portfolio

Appendix

Risk-Parity and MVO

MVO Portfolio weights w:

w 1 1S Volatilities; Correlation Matrix; S Sharpe Ratios

MVO assuming all Sharpes are the same = Most Diversified Portfolio:

w 11iN w iN
1 w 1I N iN I N w iN

iN

Is a vector of ones

MVO assuming all Sharpes are the same and all correlations are 0 = Equal Volatility Portfolio:

IN

Is the identity matrix

Risk Parity weights satisfy the equation:

Is the element-byelement product Risk-parity equations are a product of the equations satisfied by the MD Portfolio with the equations satisfied by the EV Portfolio

I N w w iN iN

A particular combination between the historically-estimated correlation matrix and the identity one It penalizes more correlations that cause larger deviations from vol-weights

From Risk-Parity to Risk Budgeting

GeneralizeRiskParitywhenSharperatiosarenotthesame:

I N w w S S
LeftsideisTotalContributionstoPortfolioRisk(TRC) Foranasseti wehave:

TRCi Si2

TheriskbudgetofapositionisproportionaltotheSharperatiosquared

Risk Premia & Alpha: Evolution Over Time

Before bond & equity market indices After bond & equity market indices After other asset class indices After risk premia strategy indices

Manager Alpha

Manager Alpha

Manager Alpha

All returns are Manager Alpha Returns of market portfolio of bond&equity are risk premia Beta

Additional market risk premia Other Market Beta

Alternative Risk Premia

Other Market Beta

Beta

Beta

Risk Premia: A Taxonomy

Merger-arbitrage in equities (deal-failure risk premium)

Market Equities Commodities Rates Credit Currencies Volatility X

Carry

Curve

Value

Momentum Liquidity

Event

Currency carry (crash-risk premium in high yielding currencies)

Term premium in global interest rate markets (duration risk premium)

Roll congestion strategies in commodity markets (liquidity risk premium)

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