IModern Portfolio Optimization:
A Practical Approach Using an
JEFF GROVER
is an associate professor at
Indiana Wesleyan Univer-
sity in Marion, IN.
jeff.grover@indwes.edu
ANGELINE M . LAVIN
is an associate professor at
Beacom School of Business,
University of South Dakota
in Verniillion, SD.
angeline.lavin@u$d.edu
60 MODERN PORTFOLIO OPTIMIZATION: A PR^ACTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL
Excel Solver Single-Index Model
JEFF GROVER AND ANGELINE M . LAVIN
odern Portfolio Theory (MPT)
M is based on the idea that com-
binations of assets have the
potential to provide better
returns with less risk than individual assets.
While MPT provides excellent insights into
which assets should be included in an investor's
optimal portfolio, understanding the under-
lying statistical techniques in portfolio opti-
mization presents a rigorous challenge. This is
especially true in determining the standard
deviation of a portfolio using the Markowitz
methodology The investor's knowledge of the
theoretical basis of MPT presents a concep-
tual constraint on his/her ability to understand
the underlying constructs of MPT, which is
required to determine the asset investment
strategy that will optimize the portfoho.
One solution to overcoming such investor
constraints is to provide a rule-based hierar-
chal system as a primer to establishing an equiv-
alent linear form of the Markowitz [1959]
quadratic objective function which, when opti-
mized, affords an optimal solution for an invest-
ment portfolio. Due to the complexities of
calculating the variance-covariance matrix and
the computer memory resources required to
solve this quadratic objective function, Sharpe
[1972] devised a single-index model that nicely
replicates the Markowitz function. The single-
index model allows for the computation of betas,
expected returns, and residual variances with a
market index return and variance. The solu-
tions to this rule-based system, in conjunction
with Sharpe's methodology and the Sharpe
Ratio, can be simply implemented using the
Microsoft Excel Solver function. This process
provides an excellent example of how the Excel
Solver can be used to solve a mathematical
optimization problem, which is especially ben-
eficial to investors as they face the challenge of
determining how to efficiently optimize their
mutual fund portfolios. This article uses TIAA-
CREF mutual fund data as an example to illus-
trate the MPT concept as a practical approach
to optimizing an investment portfolio to obtain
maximum return with minimal risk. However,
the model can be applied to any set of mutual
fund options to create an optimal fund alloca-
tion. The process outlined in this article may
also prove useful for defined contribution plan
providers as they work to implement the pro-
visions outlined in the Pension Protection Act
passed by the U.S. Congress in 2006. The Act
calls for greater access to professional advice
about retirement for investors and gives workers
greater control over how to invest their retire-
ment account funds. The model presented in
this article has the potential to provide useful
information to professional advisors as well as
individual investors.
In 1952, Markowitz first proposed a
method by which an investor could optimize
the individual components of a portfolio to
generate portfolio returns greater than the
sum of the returns on the individual portfolio
SUMMER 2007
components. In 1959 he wrote a textbook on efficient
diversification of investments. In a review of this text-
book, Tintner [1959] pointed out that Markowitz's key
concept is the efficient portfoHo. "If a portfolio is efficient,
it is impossible to obtain a greater average return without
incurring greater standard deviation; it is impossible to
obtain smaller standard deviation without giving up return
on average" Markowitz [1959, p. 22]. This optimization
process is a rare economic phenomenon that exists only
when a portfolio is established in return-risk space so that
the optimal mix of the securities results in optimal port-
foho returns. Use of the Markowitz methodology, which
is quadratic in nature, requires an understanding of oper-
ations research methodologies. Sharpe [1972] introduced
a single-index model that overcame the difficulties asso-
ciated with implementing the quadratic algorithm. The
latter methodology suggests a linear framework that pro-
vides a more simplistic method for the practical imple-
mentation of portfolio optimization using the Microsoft
Excel Solver. This method can be used to demonstrate the
optimization process for mutual fund investors and enable
them to take control of their future wealth accumulation.
Motivation
A search of current software available to perform
portfolio optimizations returns a limited number of cost
effective alternatives. The method developed in this article
yields a user-fi^iendly mechanism with which investors can
perform the portfolio optimization process using Microsoft
Solver in its Excel application. The intent is to have the
investor download mutual fund daily closing prices, the
13-week U.S. Treasury Bill annual percentage returns, and
a market index return, and then have the Excel applica-
tion calculate the optimal portfolio combination of these
funds. The goal of this article is to provide a rigorous
approach to the theoretical application of this optimiza-
tion process using techniques proposed by Sharpe [1972].
Literature Review
The decision of how to allocate capital across dif-
ferent asset classes is a key issue that all investors face.
Markowitz is widely considered to be the father of MPT.
His early work was the first to frame portfolio choice as
a mean-variance (M-V) optimization problem that yields
an efficient frontier of potential investment choices for a
rational investor. His critical insight was the realization
SUMMER 2007
that the co-movement of assets with each other is more
important than the individual security characteristics when
forming portfolios of assets. According to Elton and
Gruber [1997], who provide an excellent overview of
portfolio theory, the M-V framework has remained the
cornerstone of MPT
The development of M-V portfolio theory created
a need to estimate model inputs such as correlation coef-
ficients, and index models became the principal tool for
estimating covariance. Sharpe [1967] popularized the
market model, a variant of the single-index model, for
evaluating the risk and return characteristics of portfolios.
Two of the most basic questions in portfoho analysis
are the number and specific types of securities to include
in the portfolio. Mao [1970] was the first to use theoret-
ical analysis, in the form of a heuristic switching algo-
rithm, to solve this optimization problem. However, Mao's
procedure could not be used for negative or zero beta
securities, it did not determine the optimal allocation
among the various securities, and it would potentially
require enormous amounts of computer time. Sharpe
[1972] proposed a slight modification to Mao's method-
ology that would allow for negative betas and for the
selection of securities as well as the allocation of funds
among them. Sharpe and Stone [1973] extended Sharpe's
study to include non-market risk, which was a limitation
of Sharpe's single-index model, and captured the essence
of portfolio selection as a linear program.
Elton, Gruber, and Padberg [1976] set out to oper-
ationalize MPT, which although meant to be a practical
tool, had primarily developed as a normative, theoretical
construct. They suggested that the implementation dif-
ficulties lay in: 1) estimating the correlation matrices,
2) the time and costs in generating efficient quadratic
portfolios, and 3) educating portfolio managers to relate
to risk-return tradeoffs expressed as covariances and stan-
dard deviations. They continued to expand the body of
knowledge and proposed a constant correlation model.
Bawa, Elton, and Gruber [1979] extended their study and
introduced simple procedures for multivariate portfoho
optimization. Chen [1983] challenged the Bawa et al.
[1979] study's limitation of standard error estimation tech-
niques, but Alexander [1985] later refuted these claims
and supported the Elton et al. [1976] study. Kwan [1984]
further extended MPT by including the three existing
portfolio optimization techniques—the single, multiple
and correlation index models—in a single common algo-
rithm. Green and Burton [1992] offered a solution to
THE JOURNAL OF WEALTH MANAGEMENT 61
extreme weightings caused by a dominant single factor
in equity returns, thus reducing residual risks.
Both the theoretical construct of portfolio opti-
mization and its practical apphcation have continued to
evolve since Markowitz first proposed the M-V frame-
work in the 1950s. While ever more sophisticated methods
are continually developed, it is important to recognize that
simplicity may be the key to assisting individual investors
who are faced with asset allocation decisions in their
defined contribution retirement plans. In fact, a recent
study by Iyengar, Huberman, and Jiang [2004] quoted on
the TIAA-CREF website offers evidence that the com-
plexity of the asset allocation decision often leads employees
to delay savings plan enrollment. Rugh [2003] reports that
the majority of TIAA-CREF participants direct at least
half of their contributions to equity and make no changes
in their allocations over the ten to twelve year periods of
time studied. He also notes that the average participant
allocation has become more diverse over the past ten years.
Data
The TIAA-CREF defined contribution variable
annuity retirement plan flinds were selected for this analysis
because the company is a well-known provider of low-
cost mutual funds as well as a major provider of defined
contribution retirement plans. In fact, Rugh [2003] reports
that TIAA-CREF is the largest pension provider in the
U.S., managing $300 billion in total assets for more than
two million individuals. The plans, which are provided
through the employer of the respective investor, are
referred to as retirement (or group retirement) annuity
contracts. Investment amounts are dependent on con-
tractual agreements between the employee and employer.
Typically, contributions are made on a tax-deferred basis,
which means that pre-tax dollars fund the accounts, but
the employees pay taxes on withdrawals. Information
about the funds can be obtained from the TIAA-CREF
website, http://tiaa-cref.org/product_profiles/ras.htnil.
The purpose of this article is to demonstrate the concepts
of MPT in portfoHo optimization using this TIAA-CREF
fund data. However, the model developed in this article
can be applied to optimize any mutual fund portfolio.
Tax Implications of Portfolio Rebalancing
The specific example employed in this article assumes
that the fund portfolio being optimized is a tax-deferred
62 MODERN PORTFOLIO OPTIMIZATION: A PKJVCTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL
portfoHo of funds inside of a defined contribution retire-
ment plan. In the context of a tax-deferred or tax-exempt
portfolio, there are no tax imphcations associated with
portfoHo rebalancing, and periodic asset allocation changes
can be made without creating taxable gains. The model
developed in this article can be used to optimize any
mutual fund portfoHo, regardless of whether the portfoho
is held in a tax-deferred, tax-exempt or taxable account.
It is important to note that rebalancing a taxable fund
portfolio may create tax consequences, which can either
be positive or negative. Despite the fact that rebalancing
a taxable fund portfolio has the potential to create taxable
gains, periodic portfolio balancing is stiU recommended.
In fact, studies have shown that periodic rebalancing can
actually improve portfolio returns by forcing investors to
sell assets that have appreciated in value and buy assets
that have underperformed. Most financial advisors rec-
ommend that clients review their portfolios at least annu-
ally and rebalance as needed upon review. This is especially
true when one considers the effects of inflation on the
portfolio. Reilly and Brown [2006] suggest that inflation
is the major cause of reductions in investment value.
Simple Techniques for Determining an
Optimal Portfolio
The portfolio optimization challenge, as suggested
by Mao [1970], is to maximize an objective function such
that an investor can create an optimal portfolio providing
the maximum return for the minimum risk. Mao sug-
gested such an algorithm, but it was Hmited by the inability
to solve for a negative beta. Although negative betas appear
less frequently than positive ones, they do exist, and a
mathematical resolution is required to efficiently opti-
mize a given sample of securities. The proper selection
of the market index is critical to minimizing the number
of securities with negative betas. Sharpe [1972] resolved
this issue using his single-index methodology. The process
developed in this article applies Sharpe's methodology to
identify undervalued and overvalued securities using the
capital asset pricing model (CAPM) as the screening tool
for the portfolio optimization process. This study wiU
consider only undervalued securities as input variables for
portfoho optimization. After screening out overvalued
securities, the Sharpe Ratio is operationalized as an objec-
tive function and the portfolio returns and standard devi-
ations are used to establish an optimal or tangent portfoHo
following the Sharpe [1972] CAPM methodology. We
SUMMER 2007
compute this objective function by maximizing the Sharpe
Ratio. This tangent or optimal portfolio, i.e., the port-
folio with minimum risk and maximum return, will be
a linear combination of the portfolios along the trace of
the efficient frontier of portfoHo combinations. We defme
the Sharpe Ratio in Equation (1) as:
(1)
The Sharpe Ratio, which measures the excess return
per unit of total risk, is the return of the portfolio minus
the risk-free rate divided by the standard deviation of the
portfoho. We calculate the tangent portfolio using the
Sharpe Ratio as the maximization objective function,
given in Equation (2), which takes the form:
e = (2)
Maximize
The constraints for this function include the
following:
2. X. >0, for i = 1, ... n.
The first constraint requires the sum of all weighted
coefficients to be equal to one and the second requires
these weights to be greater than or equal to zero because
short-selling of securities is not allowed.
Equation (3) gives the portfolio return using the
Sharpe method (Elton, Gruber, Brown, and Goetzmann
[2003]). The portfoHo return is the sum of products of the
security alphas and their respective weights, plus the sum
of products of the security betas and their respective
weights with the product of the market index return.
(3)
where the security weights are designated by X., the
portfolio alpha is computed as OIp = S^^j^,-«, the port-
folio beta is computed as Pp = Z^jX. p., and the average
return on the market index is designated as R^.
SUMMER 2007
Equation (4) computes a portfolio standard devia-
tion using the Sharpe method. This function minimizes
the square of the sum of products of the security betas
and their respective weights summed with the security
residual variances.
(4)
where (J^^. is computed as O~ - p. (7^, is the residual vari-
ance of the portfolio.
Substituting in the classical Sharpe Ratio, as pre-
sented in Equation (2), for Rp and Op, we present our
modified Sharpe Ratio as:
e= (5)
where R^is the risk-free rate of return as determined by
the 13-week U.S. Treasury-biU.
Since the goal is to maximize return while mini-
mizing risk, we use the Sharpe method for computing
returns and standard deviation to determine the global
minimum variance portfoHo. We operationaHze the Sharpe
Ratio presented in Equation (2) with the maximization
function presented in Equation (5).
THE SINGLE-INDEX MODEL
While many investors will be most interested in the
outcome of the optimization process described in this
section, we suspect that some will be interested in the
actual process and how it is achieved using the Microsoft
Excel Solver. Therefore, this article both reports the out-
come and details the process.
The method presented and demonstrated in this
article gives the optimal procedure for selecting a port-
foHo when the single-index model is accepted as the best
w^ay to forecast the covariance structure of returns. The
input variables for the objective function are the calcu-
lated betas, residual variances, and alphas for the indi-
vidual securities and the market index. The optimization
process, which utilizes five years of monthly return data
from December 2000 to December 2005, is outlined in
steps below so that it can be replicated by interested
THE JOURNAL OP WEALTH MANAGEMENT 63
investors using readily available mutual fund, market index,
and risk-free rate data.
The optimization process uses an eight-step method,
which is conducted as follows:
Step 1: Compute natural log returns ofa market
index and the selected set of mutual funds (either TIAA-
CREF funds or another group of mutual funds) using
end-of-month closing prices, and normalize the returns
of the 13-week U.S. Treasury-bill into monthly returns.
Step 2: Compute security averages, variances, covari-
ances, and betas as follows:
a. Compute averages as "TT
h. Compute Betas as ^' ~ ^ , computed as the covari-
ance of security i returns with the returns ofa market
index divided by the population variance of the
market index.
c. Compute the market variance as <T^ = "' ^——
d. Compute the cc^yariances ofjthe individual mutual
funds as G = '"'"" '.,'—-——
Step 3: Use the CAPM methodology to compute
excess returns, identify individual fund valuations and
retain those that are undervalued. Funds that are over-
valued should not enter into the optimization process
unless short-selling is aHowed. Since most mutual funds
do not aHow short-selling due to legal constraints, this
study does not include this option. We will evaluate this
process by computing the CAPM required or expected
return, the excess returns, and the valuation of the indi-
vidual mutual funds as follows:
a. Compute the CAPM as i^^/iPM ~ Rf'^ (^m "~ Rf)
p., where Rr is derived from 60 months of returns
using the 13-week U.S. Treasury-biU. The market
index average return is derived from the average of
60 monthly returns, and /?. is derived from Step 2b.
b. Compute excess returns, (R. — R^^^pj^), where R. is
computed as in Step 2a.
c. Determine individual fund valuations as either under,
over, or fairly valued using the CAPM methodology.
Thus, if the excess return is greater than zero, the
fund is selected for inclusion in the optimal port-
folio mix.
Step 4: Compute the individual mutual fund alphas
and residual variances as foHows:
64 MODERN PORTFOLIO OPTIMIZATION: A PRJ\CTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL
a. Compute alphas as a. = R. - p. R^^, where R ^^ is the
average return on the market index and p. and R.
are the beta and average return on the Jth fund.
b. Compute residual variances as G^. — O^. — P^G^ ,
which is the variance of the fund minus the product
of the beta squared of the individual fund and the
variance of the market index.
Step 5: Set up the Microsoft Excel Solver by:
a. Establishing the objective function to maximize the
modified Sharpe Ratio as presented in Equation (5).
b. Equally weighting the starting values for X. and
establishing the foHowing initial constraints:
i. The weights are greater than or equal to zero,
ii. The sum of the starting values of X. is equal to one.
Step 6: Compute the optimal or tangent portfolio
by using Tangent Estimates, Forward Derivatives, and
Newton Search for the Solver Options, and the default
values for Max Time, Iterations, Tolerance, and Conver-
gence in the Solver dialog box.
Step 7: EstabHsh the portfolio return, beta, and stan-
dard deviation as presented in Equations (3) and (4).
Step 8: Optimize the mutual fund portfoHo by max-
imizing Equation (5) and deterinine the optimum or tan-
gent portfolio by using the computed weights of the
undervalued mutual funds.
THE OPTIMAL TIAA-CREF PORTFOLIO
PRACTICUM IN EXCEL
This section reports the specific findings developed
using the TIAA-CREF defined contribution variable
annuity retirement plan funds as a practicum in evalu-
ating the eight-step optimization process outlined in the
previous section. End of month closing prices of the
TIAA-CREF funds and the RusseU 3000 market index,
RUA, from December 2000 through December 2005,
are used in the optimization. The TIAA-CREF closing
prices were downloaded from www.tiaa-cref.org, the
RUA prices from http://finance.yahoo.com, and the US.
Treasury-bill returns from www.treasurydirect.gov.
Step 1: The monthly natural log returns of RUA
and TIAA-CREF funds were computed and reported in
Exhibit 1.
SUMMER 2007
EXHIBIT 1
Monthly Percentage Returns Computed from Monthly Fund Closing Prices

CREF TIAA
CREF CREF CREF CREF CREF CREF CREF Real
Date ^RUA Bond Equity Global Growth Bond Money Social Stock Estate
1/25/01 1.30 0.76 1.31 0.16 3.92 1.71 0.50 1.21 1.02 0.51
2/22/01 -7.96 0.53 -7.82 -8.94 -16.51 1.35 0.43 -4.85 -7.70 0.29
3/29/01 -8.98 1.23 -8.85 -8.09 -16.19 1.08 0.50 -4.36 -8.72 0.65
4/26/01 7.33 0.22 7.37 6.51 10.53 1.37 0.37 3.97 7.14 0.76
5/31/01 2.12 0.21 2.25 -0.31 1.38 0.93 0.41 1.15 1.29 0.88
6/28/01 -2.05 0.59 -2.02 -4.12 -2.21 0.23 0.29 -1.34 -2.71 0.69
7/26/01 -2.36 1.35 -2.27 -3.07 -4.24 0.22 0.27 -0.25 -2.51 0.51
8/30/01 -5.95 1.83 -5.79 -3.96 -8.80 1.04 0.33 -2.70 -4.69 0.77
9/27/01 -11.17 1.23 -11.06 -11.38 -12.86 0.68 0.28 -5.30 -11.29 0.15
10/25/01 8.02 0.93 8.02 7.57 11.81 0.70 0.25 5.10 7.62 0.21
11/29/01 3.86 -0.48 3.97 2.59 5.28 -0.96 0.20 1.71 3.47 0.88
12/27/01 1.85 -1.16 1.93 0.99 0.78 -0.70 0.14 0.44 1.70 -0.04
1/31/02 -2.10 1.25 -2.03 -3.61 -3.18 0.32 0.15 -0.76 -2.59 -0.13
2/28/02 -2.22 1.04 -2.09 -1.71 -5.20 1.48 0.11 -0.84 -1.60 0.40
3/28/02 4.20 -1.72 4.23 4.83 3.76 -0.73 0.07 1.71 4.47 0.27
4/25/02 -4.33 1.95 -4.27 -2.70 -6.83 2.64 0.17 -1.59 -3.39 0.49
5/30/02 -2.64 0.79 -2.48 -1.48 -4.53 1.71 0.16 -1.09 -1.88 0.10
mim -7.52 0.66 -7.42 -7.51 -10.29 1.34 0.13 -4.16 -7.74 0.58
7/25/02 -16.27 1.36 -16.15 -13.79 -15.64 1.95 0.12 -8.92 -14.80 -0.48
8/29/02 8.54 1.50 8.67 5.57 9.49 2.97 0.14 5.85 7.70 0.96
9/26/02 -7.12 1.25 -6.97 -7.54 -6.49 1.96 0.11 -3.42 -7.38 0.36
10/31/02 3.12 -0.12 3.23 3.41 3.82 -2.04 0.15 2.46 3.40 -0.27
11/29/02 5.69 -0.05 5.82 4.96 5.46 -0.14 0.11 3.28 5.60 0.46
12/26/02 -4.85 1.76 -4.74 -4.34 -6.26 2.47 0.08 -1.92 -4.54 0.29
1/30/03 -5.09 0.48 -4.91 -4.37 -4.69 1.47 0.09 -2.53 -4.59 0.50
2/27/03 -0.95 1.42 -0.78 -1.35 0.35 3.25 0.06 -0.02 -0.99 0.36
3/27/03 3.51 -0.37 3.59 2.51 4.63 -1.95 0.06 1.79 3.05 0.69
4/24/03 4.81 0.97 4.87 5.45 4.65 -0.16 0.06 3.51 5.00 0.49
5/29/03 4.88 2.38 5.01 5.45 3.61 5.19 0.08 4.38 5.48 0.58
6/26/03 3.78 -0.31 3.86 2.65 3.51 -0.92 0.06 2.02 3.51 0.50
7/31/03 1.10 -3.56 1.14 1.29 0.51 -5.37 0.05 -0.66 1.31 1.00
8/28/03 1.52 0.73 1.63 2.00 1.69 1.81 0.04 1.16 1.74 0.48
9/25/03 0.03 1.98 0.14 2.10 0.49 2.60 0.06 0.91 1.01 1.07
10/30/03 4.70 -0.50 4.80 5.40 4.12 0.83 0.07 2.90 4.88 0.68
11/28/03 1.51 0.47 1.63 1.49 1.59 0.50 0.05 1.07 1.46 0.26
12/26/03 8.52 1.30 3.06 3.91 1.56 1.53 0.06 2.18 3.50 0.58
1/29/04 -2.08 0.29 3.57 3.10 3.74 0.15 0.07 2.48 3.56 0.80
2/26/04 0.94 0.97 1.07 1.66 0.24 2.08 0.06 1.03 1.12 0.34
3/25/04 -2.98 1.25 -2.89 -2.08 -2.98 2.64 0.06 -0.86 -2.61 0.93
4/29/04 0.17 -2.99 0.28 0.52 0.90 -5.74 0.04 -1.14 0.30 0.08
5/27/04 0.63 -0.06 0.77 0.48 0.77 2.38 0.05 0.55 0.55 0.83

SUMMER 2007 THE JOURNAL OF WEALTH MANAGEMENT 65

EXHIBIT 1 (Continued)

CREF TIAA
CREF CREF CREF CREF IL CREF CREF CREF Real
Date ^RUA Bond Equity Global Growth Bond Money Social Stock Estate
6/24/04 1.63 0.05 1.72 2.11 0.63 -0.63 0.05 1.01 1.84 1.14
7/29/04 -3.93 0.75 -3.80 -3.92 -6.17 0.65 0.10 -2.04 -3.76 1.41
8/26/04 0.41 1.79 0.53 0.47 0.63 2.31 0.09 1.05 0.48 0.92
9/30/04 1.38 0.76 1.50 1.29 1.03 1.04 0.12 0.99 1.75 2.26
10/28/04 1.32 0.57 1.40 2.36 1.43 0.69 0.11 0.99 1.94 0.93
11/26/04 5.15 -0.15 5.27 5.30 4.22 0.55 0.12 3.17 5.44 0.80
12/30/04 2.88 0.35 3.02 3.21 3.27 0.97 0.17 2.10 3.27 1.56
1/27/05 -3.58 0.56 -3.52 -2.75 -4.82 -0.24 0.15 -1.90 -3.19 0.05
2/24/05 2.27 0.01 2.41 2.73 1.47 0.55 0.15 1.12 2.48 0.60
3/31/05 -1.47 -0.92 -1.37 -1.21 -2.07 -0.50 0.20 -1.16 -1.26 0.89
4/28/05 -3.41 1.44 -3.31 -3.15 -2.53 2.04 0.19 -1.48 -3.30 1.15
5/26/05 4.99 0.53 5.11 2.94 6.17 -0.16 0.21 3.36 4.27 1.23
6/30/05 0.21 0.97 0.32 0.70 -0.94 1.01 0.26 0.64 0.54 1.90
7/28/05 4.58 -0.55 4.66 3.64 5.51 -1.85 0.23 3.10 4.34 1.02
8/25/05 -2.61 0.32 -2.49 0.13 -2.60 0.84 0.24 -1.27 -1.37 0.74
9/29/05 1.32 -0.27 1.45 3.12 1.51 1.16 0.31 0.82 2.06 1.95
10/27/05 -4.33 -0.99 -4.26 -4.62 -2.72 -1.71 0.26 -2.59 -4.32 1.23
11/25/05 7.59 0.68 7.74 6.04 8.74 0.63 0.29 4.89 7.03 1.01
12/29/05 -1.00 0.68 -0.85 2.18 -2.00 0.79 0.35 -0.37 0.42 1.32
Notes:
1) CRJSF IL-Bond is an itiflcition linked bond fund.
2) ^RUA is the Rtdssell 3000 Index.
3) These returns do not iticlude distributed dividends.
4) End of month closing price security data for the variable annuities were obtained from http: / /u>u'w.tiaacref.org/product_profiles/ras.html and the end of
month closing fund data for ^RUAfrom http://fmance.yahoo.com.

Step 2: Fund averages, variances, covariances, and
betas were computed and are reported in Exhibit 2.
Step 3: Fund valuations were identified using the
CAPM, and undervalued funds were retained and are
reported in Exhibit 2.
Step 4: The TIAA-CREF fund alphas and residual
variances were computed and are reported in Exhibit 3.
Step S: The Excel Solver is set up as follows:
a. The objective function is established to maximize the
modified Sharpe Ratio presented in Equation 5.
b. The starting values for X. are equally weighted, and
the following initial constraints were established:
i. The weights are set to values greater than or equal
to zero.
ii. The sum of the starting values of X is equal
to one.
These values are reported in Exhibit 3.
Step 6: The Solver was then loaded with the fol-
lowing inputs:
a. "Set Target Cell:" Input the Tangent or Sharpe
Ratio in Cell F17.
b. "Equal to: 'Max'"
c. "By Changing Cells" Input Cell Range E6:E12.
d. "Subject to the Constraints:"
i. Set Cell El5 = 1. This sums the individual
weights to 1 or 100%, satisfying the first con-
straint to Equation (2).

66 MODEKN PORTFOLIO OI'TIMIZATION: A PI<J\CTICAL APPROACH USING AN EXCEL SOLVER. SINGLE-INIJEX MODEL SUMMER 2007
EXHIBIT 2
Monthly Data to Determine Undervaluation or Overvaluation of Funds

R.
Fund i Valuation

CREF Bond 1.161 -1.290 0.466 -0.053 0.199 0.267 Undervalued

CREF Equity 23.237 23.228 0.087 0.958 -0.009 0.096 Undervalued

CREF Global 20.280 21.158 0.080 0.872 0.009 0.072 Undervalued

CREF Growth 36.357 27.776 -0.459 1.145 -0.048 -0.411 Overvalued

CREF IL-Bond 3.123 -1.280 0.666 -0.053 0.199 0.467 Undervalued

CREF Money 0.014 -0.101 0.168 -0.004 0.189 -0.021 Overvalued

CREF Social 7.520 12.979 0.277 0.535 0.078 0.199 Undervalued

CREF Stock 21.559 22.301 0.147 0.920 -0.001 0.148 Undervalued

TIAA Real Estate 0.261 0.601 0.693 0.025 0.183 0.510 Undervalued

Notes:
8%, Rj^^ — 0 . 0 i 8 % , C^— 24.251. The monthly average risk-free rate was computed by dividing each monthly U.S. Treasury-bill annual
investment rate percentage by 72 to convert the APR to monthly returns.
2) The Russell 3000 Index (^RUA) was used as the market index fund. This is the index that TIAA-CREF uses to evaluate and benchmark their funds.
3) CREF IL-Bond is an inflation linked bond fund.

ii. Set Range E6:E12 > = 0, which satisfies the
second constraint to Equation (2).
iii.Used Tangent Estimates, Forward Derivatives,
and Newton Search for the Solver Options
and the default values for Max Time, Itera-
tions, Tolerance, and Convergence in the
Solver dialog box.
Note: These weights would need to be adjusted
if future undervalued securities change. These
values are reported in Exhibit 3.
Step 7: The portfolio return, beta, and standard
deviation as presented in Equations (3) and (4) were com-
puted and are reported in Exhibit 4.
Step 8: The TIAA-CREF portfolio was optimized
by maximizing Equation (5) and determining the
optimum or tangent portfolio using the computed weights
of the undervalued TIAA-CREF funds. These values are
reported in Exhibit 4.
EXCEL SOLVER PRACTICUM RESULTS
The proportional investment percentages of the
selected undervalued funds in the tangent portfolio using
the hybrid Sharpe [1972] approach outlined in this article
suggests that the TIAA-CREF investor should purchase
81.484% of the TIAA Real Estate fund, 11.658% of the
CREF Bond fund, and 6.859 % of the CREF Inflation-
Linked Bond fund. Even though the CREF Social Choice,
Stock, Global, and Equity funds were undervalued
according to the CAPM results, the funds did not opti-
mize due to minimal residual variances. The suggested
allocation of funds optimizes the return and minimizes
the risk ofa retirement portfoho of TIAA-CREF funds.
This allocation strategy is the outcome of the historical

SUMMER 2007 THE JOURNAL OF WEALTH MANAGEMENT 67

EXHIBIT 3
Solver Optimization Results

1 A B C D E F G H I

Risk-free Market
2 rate 0.188 Variance 24.251
Market
Rate of Maximum
3 Return -0.018 Weight 100.0%
4

Residual Residual
5 Fund Beta Variance Alpha Weight Beta* Vatiance* Alpha* Valuation

6 CREF Bond -0.053 1.092 0.465 0.117 -0.006 0.015 0.054 Undervalued

7 CREF Equity 0.958 0.988 0.104 0.000 0.000 0.000 0.000 Undervalued

8 CREF Global 0.872 1.821 0.096 0.000 0.000 0.000 0.000 Undervalued
CREF IL-
9 Bond -0.053 3.056 0.666 0.069 -0.004 0.014 0.046 Undervalued

10 CREF Social 0.535 0.574 0.286 0.000 0.000 0.000 0.000 Undervalued

11 CREF Stock 0.920 1.052 0.163 0.000 0.000 0.000 0.000 Undervalued
TIAA Real
17. Estate 0.025 0.247 0.693 0.815 0.020 0.164 0.565 Undervalued

n CREF Growth 1.145 Overvalued

14 CREF Monev -0.004 Overvalued

15 Total 1.000 0.010 0.193 0.665

Portfolio Sharpe
16 Totals: Return Ratio Variance

17 0.665 1.077 0.442 0.196

Notes:
1) This exhibit reports the results of the Microsoft Solver optimization calculation which includes the nine TIAA-CREF funds together with the information
required to execute the Solver application, the valuation results (overvalued or undervalued) according to the Capital Asset Pricing Model, and the Sharpe Ratio,
which was maximized to obtain the tangent or efficient portfolio.
2) Only undervalued funds were used for the optimization process.
3) Beta* was computed as Fund i's beta times its weight, Residual Variance* as the residual variance times its weight, and Alpha* as Alpha times its weight.
4) Undervalued funds are those with an actual 60-month average return that exceeded the expected CAPM return.

data period chosen for this analysis. The real estate market
demonstrated outstanding performance during the equity
bear market of 2000—2002, and this performance drove
the allocation model, which was based on the historical
return data from December 2000 to December 2005.
Indeed, a TIAA-CREF investor who might have actu-
ally employed the optimal mix of the tangent portfolio
in the TIAA Real Estate fimd, the CREF Inflation-Linked
Bond fund, and the CREF Bond fund as suggested, would
have enjoyed excellent returns from December 2000 to
December 2005. However, we caution the reader that
past performance is not necessarily indicative of future

68 MODERN PORTFOLIO OPTIMIZATION: A PRACTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL SUMMER 2007
EXHIBIT 4
Efficient Frontier Results

Weights
CREF TIAA
Sharpe Std CREF IL- Real
Return Ratio Dev. Bond Bond Estate Totals

Min Variance
Portfolio 0.641 1.046 0.433 0.188 0.067 0.728 1.000

0.655 1.070 0.436 0.154 0.067 0.776 1.000

0.660 1.076 0.439 0.135 0.067 0.797 1.000

0.664 1.077 0.442 0.119 0.068 0.812 1.000

•Efficient Portfolio 0.665 1.077 0.442 0.117 0.069 0.815 1.000

0.667 1.077 0.444 0.107 0.069 0.824 1.000

0.669 1.075 0.447 0.096 0.070 0.834 1.000

0.671 1.074 0.450 0.087 0.071 0.843 1.000

0.673 1.071 0.453 0.078 0.071 0.851 1.000

0.675 1.069 0.455 0.070 0.072 0.859 1.000

0.677 1.066 0.458 0.062 0.072 0.865 1.000

0.678 1.064 0.461 0.055 0.073 0.872 1.000

0.680 1.061 0.463 0.049 0.073 0.878 1.000

0.681 1.058 0.466 0.043 0.073 0.884 1.000

0.683 1.055 0.469 0.037 0.074 0.890 1.000

0.684 1.052 0.471 0.031 0.074 0.895 1.000

0.685 1.048 0.474 0.025 0.074 0.900 1.000

0.686 1.045 0.476 0.020 0.075 0.905 1.000

0.688 1.042 0.479 0.015 0.075 0.910 1.000

0.689 1.039 0.482 0.010 0.075 0.915 1.000

0.690 1.036 0.484 0.005 0.076 0.920 1.000

0.691 1.033 0.487 0.000 0.075 0.925 1.000

0.691 1.028 0.489 0.000 0.057 0.943 1.000

SUMMER 2007 THE JOURNAL OF WEALTH MANAGEMENT 69

EXHIBIT 4 (Continued)
Weights
CREF TIAA
Sharpe Std CREF IL- Real
Return Ratio Dev. Bond Bond Estate Totals

0.692 1.024 0.492 0.000 0.046 0.954 1.000

0.692 1.019 0.494 0.000 0.038 0.962 1.000

0.692 1.014 0.497 0.000 0.031 0.969 1.000

0.692 1.009 0.499 0.000 0.025 0.975 1.000

0.692 1.005 0.502 0.000 0.019 0.981 1.000

0.693 1.000 0.504 0.000 0.014 0.986 1.000

0.693 0.996 0.507 0.000 0.009 0.991 1.000
0.693 0.991 0.509 0.000 0.004 0.996 1.000

Maximum Return
Portfolio 0.693 0.987 0.511 0.000 0.000 1.000 1.000

Note: This exhibit reports the results of the Microsoft Solver maximization optimization process including the minimum mriance portfolio, the maximum return
portfolio, and the Tangent or Efficient Portfolio, designated as*.

results. Indeed, an 82% real estate allocation going for-
ward may not prove to be optimal. It is important to keep
in mind that a critical assumption in this work is that the
variance-covariance structure of these securities over the
past five years will continue for the next five years. In prac-
tice, that assumption will be violated. Therefore, investors
should re-optimize their portfolios quarterly, at a min-
imum. Periodic rebalancing is feasible within the TIAA-
CREF fund family because there is no charge to the
investor for rebalancing within the plan.
As a check on the Solver model, we validated that
the tangent portfolio computed using the Excel Solver
is, in fact, the optimal portfolio from the efficient fron-
tier that includes all possible combinations of tangent
portfolios. We computed the two endpoints of the effi-
cient frontier as the minimum variance and maximum
return portfolios. To evaluate the efficient frontier across
the return range, we increased the minimum portfolio
variance in relationship to the difference between the
maximum and minimum portfolio variances and divided
this difference by 30, the number of possible efficient
portfolios. The number 30 was arbitrarily selected to
capture the complete maximum-minimum portfolio
return range. The weights of successive tangent portfo-
lios at each increment along the frontier were recorded
along with the respective Sharpe Ratios, returns, and
standard deviations. We recorded these iterative steps in
Exhibit 4 and then identified the portfolio with the max-
imum Sharpe Ratio. This trace method identified the
portfolio with the maximum Sharpe Ratio as having the
same weights as the portfolio identified by the Solver
process, thus validating that the computed weights cor-
rectly represent the optimal portfolio. This validation
provides confidence that subsequent Solver calculations
will produce the optimal portfolio combination given a
specified set of mutual funds.
The efficient frontier, with the optimal portfolio
identified for visual reference, is shown in Exhibit 5. From
an investing point of view, the beauty of this Excel Solver
program is that it allows investors to easily optimize their
portfolio on a monthly or quarterly basis, if desired, by
following the simple steps described and illustrated above.

70 MODERN PORTFOLIO OPTIMIZATION: A PRACTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL SUMMER 2007
 EXHIBIT 5
Efficient Frontier Graph

Efficient Frontier

0.70-
•
0.69-
0.68-
^ 0.67 -
1 0.66 -
• \.
0.65-
0.64- • ^
Efficient Portfolio
1 1 1 1
U.DO '
0.42 0.44 0.46 0.48 0.50 0.52
Standard Deviation

Note: The efficient frontier is developed using the monthly average natural log returns and standard deviations. The arrow points to the optimal or tangent port-
folio, which is the portfolio with the maximum return and minimum risk.

CONCLUSION loading current monthly mutual fund, index fund, and

This article details a user-friendly Excel optimiza-
tion tool that mutual funds investors can use to maxi-
mize their retirement wealth. Use of this tool iteratively
to periodically rebalance a mutual fund portfoho has the
potential to enhance retirement w^ealth. The ability to
optimize on a regular basis may be especially beneficial
in a national economy that is questioning the viability of
future allocations of social security to retirees. This article
provides a straightforward computational method that uti-
lizes the Microsoft Excel Solver to solve a classic port-
folio optimization problem. The optimization is outlined
in detail for ease of replication. Implementation of the
model is relatively straight-forward and requires down-
Treasury-biU raw data into Excel, and implementing the
M-V efficient portfolio optimization process explained
in Sections 2 and 3 of this article.
The spreadsheet model developed in this analysis
provides an optimal mutual fund mix for this portfolio
based on the historical data for the mutual funds in the
tax-deferred TIAA-CREF defined contribution variable
annuity retirement plan. The optimization process can be
applied to any set of mutual funds, whether the funds are
held in tax-advantage or taxable accounts. However, rebal-
ancing of taxable fund portfohos must take into account
tax consequences created by the rebalancing process. The
process outlined in this article is a useful and easy tool for
investors to use in periodically optimizing their retirement

SUMMER 2007 THE JOURNAL OF WEALTH MANAGEMENT 71

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72 MODERN PORTFOLIO OPTIMIZATION: A PRACTICAL APPROACH USING AN EXCEL SOLVER SINGLE-INDEX MODEL SUMMER 2007