1.

Returns, Risks and Correlations

(1.1) Returns and Risks

Assets
T Bill

US Equity
Foreign EQ
Emerging
EQ
US Bond
Foreign
Bond
HY Bond

Commodity

Real Estate
Hedge
Fund

Returns and Risks

Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation
Average monthly
returns
Standard Deviation

1990 2012

1990 - 1997

1998-2005

2006-2012

0.002742754 0.003773256

0.00266875

0.001336905

0.001831875 0.001223021 0.001491683 0.001698815

0.00809855

0.01610349

0.00572708

0.00527143

0.04489217

0.03484379

0.04853944

0.05048901

0.00489493

0.00672197

0.00640814

0.00399461

0.05120087

0.04997919

0.04482077

0.05935742

0.010309051 0.012401488 0.010398096 0.010006664

0.069219473

0.05984253

0.071781392 0.076670525

0.00650875

0.00889093

0.0055477

0.00514824

0.01237953

0.01444483

0.01170122

0.0101949

0.006057514 0.007009532 0.004977818 0.005489031

0.024915609 0.025501335 0.024672835 0.024721921
0.007588

0.013669

0.004877

0.023781

0.017877

0.024664

0.009635936

0.0157582

0.00944851

0.006203

0.02799
0.005393449 0.002284137 0.010173074
0.000810613
0.062202375 0.046374007 0.065331583 0.073530824
0.007662154

0.053251652 0.032266043 0.041568024 0.078854049

0.00894676

0.01585236

0.00788728

0.00370033

0.02021389

0.01638774

0.02206437

0.0205697

(1.2) Correlation between US Equity and US Bond

Period (1990-2012)
1990-2012

US Equity

US Bond

US Equity

0.12089571

US Bond

0.12089571

Period (1990-1997)

1990-1997

US Equity

US Bond

US Equity

0.52957445

US Bond

0.52957445

Period (1998-2005)

1998-2005

US Equity

US Bond

US Equity

-0.203912

US Bond

-0.203912

Period (2006-2012)
2006-2012

US Equity

US Bond

US Equity

0.06120625

US Bond

0.06120625

2. Portfolio Returns
(2.1)
Portfolio A: Buy and Hold - Initial allocation of 60 / 40 mix (60% in Stocks, 40% in Bonds), no
rebalancing.
Portfolio B: Constant 60 / 40 mix 60% in Stocks, 40% in Bonds at the beginning of each
month.

Average Monthly Return of Portfolio A and B

Sample Period
1990 - 1997
1998 - 2005
2006 - 2012

Average Monthly Return of

Portfolio A
1.932405885
0.627914526
0.549755841

Average Monthly Return of

Portfolio B
1.917770452
0.665669596
0.553003223

Standard Deviation of Portfolio A and B

Sample Period

Std. Dev. of Portfolio A

Std. Dev. of Portfolio B

1990 - 1997
1998 - 2005
2006 - 2012

2.459110477
3.212583823
3.144285532

2.446214833
7.227591809
5.210350211

Inference:

Period 1 (1990-1997)

It can be seen that buy and hold strategy dominates over the constant rebalancing strategy, with
slightly higher returns.

Period 2 and 3 (1998-2012):

It can be seen that the Portfolio B with the constant rebalancing strategy results into higher
returns when compared to Portfolio A. However these returns are comparatively negligible when
compared to the risk associated with Portfolio B.
Also, assuming transaction costs to be associated for every transaction involved with respect to
constant rebalancing in Portfolio B, the returns in Portfolio B would be overshadowed by this
cost resulting in almost the same or even lesser returns compared to Portfolio A.
Hence, it can be concluded that over long run Buy and Hold Strategy will prove to be
comparatively cost effective with considerable less risk.

(2.2) and (2.3)

Sample Period
1990 2012
1990 2012
1990 2012
1990 2012

Portfolio
Higher return in subsequent
month (Market Timing)
Higher return in previous month
(Stop Loss)
Only Stocks
Only Bonds

Value (USD)

Average Monthly
Return

782668.0861

283.2130747

11323.87802

3.740535514

7004.646809
5869.415

2.17559667
1.764280629

(2.2) Market Timing

Investing on the basis of Market Timing Strategy results in to an average monthly return close to
283.21% when compared to the average monthly return of 2.17% and 1.76% for investing in
Stocks and Bonds respectively.

(2.3) Stop Loss

Investing on the basis of Stop Loss Strategy results in to an average monthly return close to
3.74% when compared to the average monthly return of 2.17% and 1.76% for investing in
Stocks and Bonds respectively.
Mentioned below are the reasons for outperformance of the above mentioned strategy:

During periods of market instability and general negative sentiment in market, stocks
markets may provide negative return for longer periods. Also, there may be drastic fall in
the prices of the stocks in highly volatile markets. During such periods, the stop loss
strategy provides a cushion, i.e. if the investor suffers a loss in the first month he has the
option to shift to debt and thereby hedge his risk.

Once the confidence in the market improves the investor has the option to shift back to
equity and thereby enjoy higher return when compared to those earned by investing in
bonds.

3. Leveraged Portfolios
(3.1)
Cumulative returns for the 4 ETFs over the entire period
Ultra-market

Ultrashort-market

Ultra-bond

Ultrashort-bond

Cumulative returns

25.972729621

-0.9963801412

31.6928607407

-0.9756927405

Explanation for Divergence from the 2x returns when calculated over the Long term
The cumulative return for the market index over the entire period is 6.004647, whereas the
cumulative Ultra-market return over the same period is 25.972729621.
The cumulative return if we short the market index is -0.9196312724, and if we use the
Ultrashort-market index, our long terms returns will be -0.9963801412.
Hence we can infer that the long term returns for the leveraged index is NOT twice that of the
actual index. This can be explained by the fact that the cumulative returns are reached at not by
adding the returns for each period but by multiplying them. Thus we can infer that even a small
change in each term will lead to a huge change when we multiplied each months returns.
(3.2)

When we use the market-timing strategy in the Ultra-market ETFs, the cumulative return over
the entire period 1990-2012 is 162601049. In (2.2), the market timing strategy gave a cumulative
return of 782668. We can see that the return increases almost 207 times when we use the
market-timing strategy in the Ultra-market/Ultrashort-market ETFs as compared to Stock/Bond
strategy.
We see that the returns are extremely high, however this is very unlikely. The exact probability of
this occurring is (1/2)^276, which is very close to zero. This means that getting such returns are
impossible.

4. Optimal Risky Portfolios: Two Risky Assets

PERIOD 1998-2005(WEIGHTS BASED ON 1990-1997 DATA)

Period
19982005

Mean

Covariance Matrix

Weights

Mean Return

Portfolio
Variance

T-bill Rate
Mean

Sharpe Ratio

0.008660248

0.00020648

0.004046875

0.321055385

Equity

0.01294375

0.0012014

0.00026

Bond

0.00866024
8

0.0002638

0.00021

RETURN ON 1998-2005(%)

RETURN ON 60-40 PORTFOLIO (%)

SHARPE
60-40

0.718588678

0.627

0.20158

PERIOD 2006-2012(WEIGHTS BASED ON 1998-2005 DATA)

Period
20062012

Mean

Covariance Matrix

Weights

Mean Return

Portfolio
Variance

T-bill Rate
Mean

Sharpe Ratio

0.005564341

0.00011229
3

0.00266875

0.27325043

Equity

0.00572708
3

0.0023315

-0.0001

0.09276

Bond

0.00554770
1

-0.000115

0.00014

0.90724

RETURN 2006-2012(%)

RETURN ON 60-40 PORTFOLIO (%)

SHARPE
60-40

0.619168802

0.549

0.188508

Observation:
The efficient frontier is based on minimizing variance of the portfolio.
Comparison:

Period: 1998-2005

Based on the 1990-1997 data, the optimum weights for equity and bond are 0 and 1 respectively.
For this period the portfolio monthly return (constant weights) comes to 0.7185%, compared to
0.627% returns calculated on 60/40 portfolio.
Sharpe Ratio for new portfolio comes out to 0.32 compared to 0.27 for 60/40 portfolio. This is
the result of optimizing the weights to reduce variance to minimum.

Period: 2006-2012

Weights of new portfolio are based on the returns on two assets during period 1992-2005.
The optimum weights come out to 0.09276 and 0.90724 for equity and bond respectively.
Monthly portfolio returns for this period comes out to be 0.619% compared to 0.549% for 60/40
portfolio. Again the Sharpe ratio for the optimized portfolio is higher because it has been
optimized to have minimum variance.
Hence, it is better to invest in the minimum variance portfolio compared to 60/40 portfolio.

5. Optimal Risky Portfolios: Many Risky Assets

(5.1) SHORT SELLING ALLOWED

Asset

Weight

US Equity

-0.207254654

Foreign EQ

-0.03917032

Emerging EQ

-0.021863883

US Bond

0.401169894

Foreign Bond

0.133083649

HY Bond

0.090863327

Commodity

0.033715376

Real Estate

-0.005120493

PERIOD 1998-2005(WEIGHT BASED ON 1990-1997)

Portfolio
Portfolio Variance
Std
Returns (%)
0.011576565

8.83495E-05

0.00939944

T-bill rate

Sharpe
Ratio

0.004046875

0.801078567

Hedge Fund

0.614577105

Asset

Weight

US Equity

-0.074654538

Foreign EQ

0.068666615

Emerging EQ

-0.060220939

US Bond

0.666524392

Foreign Bond

-0.042840908

HY Bond

0.034993162

Commodity

0.001025493

Real Estate

0.021857374

Hedge Fund

0.384649349

PERIOD 2006-2012(WEIGHT BASED ON 1998-2005)

Portfolio
Portfolio Variance
Std
Returns (%)
0.006292159

8.68621E-05

0.009319981

T-bill rate

Sharpe
Ratio

0.00266875

0.388778564

Comparison with Sharpe Ratio in Question 4

Period: 1998-2005

The Sharpe Ratio for portfolio with 9 risky assets comes out to be 0.8 which is significantly
higher compared to portfolio with only 2 risky assets which has Sharpe ratio to be 0.32.
The reason for this is the diversification in the portfolio. Here all assets have less correlation and
as a result they have almost independent movements, resulting in diversification.

Period: 2006-2012

The Sharpe Ratio is higher for portfolio with 9 risky assets compared to the one with 2 risky
assets. The reason is again the diversification involved in constructing the portfolio.

(5.2) SHORT SELLING NOT ALLOWED

Asset
US Equity
Foreign EQ
Emerging EQ
US Bond
Foreign Bond
HY Bond
Commodity
Real Estate
Hedge Fund

Asset
US Equity
Foreign EQ
Emerging

PERIOD 1998-2005(WEIGHTS BASED ON 1990-1997)

Portfolio
Weight
Returns (%)
Portfolio Variance Std
0
0.01049666
0.000122296 0.011058758
0
0
0.342908829
0.13194087
0.145691587
0.081413192
0
0.298045522

Weight

T-bill rate
0.004046875

PERIOD 2006-2012(WEIGHTS BASED ON 1998-2005)

Portfolio
Returns (%)
Portfolio Variance
Std
T-bill rate
0
0.006101852
9.45528E-05 0.009723825 0.00266875
0
0

Sharpe
Ratio
0.5832287

Sharpe
Ratio
0.353060825

EQ
US Bond
Foreign
Bond
HY Bond
Commodity
Real Estate
Hedge Fund

0.751641612
0
0.010262956
0
0.002556777
0.235538655

Comparison with Table 5.1

In 5.2 short-selling is not allowed which gives lesser returns. It can also be seen that when no
short selling is allowed the portfolio has less diversification, which results in higher variance.
Hence, portfolio is not hedged against the risk of market downfall. Also, the Sharpe ratio in this
case is low compared to portfolio where short-selling is allowed.
Hence, short selling plays an important role in creating a portfolio and helps to hedge against risk
of market downfalls. This results in less variance and higher Sharpe ratio.