PORTFOLIO CONCEPTS

MEANVARIANCE ANALYSIS
Meanvariance analysis is the fundamental implementation of modern portfolio
theory, and describes the optimal allocation of assets between risky and risk-free
assets when the investor knows the expected return and standard deviation of those
assets.

Assumptions necessary for meanvariance efficiency analysis:

1.

All investors are risk averse; they prefer less risk to more for the same level
of expected return.

2.

Expected returns for all assets are known.

3.

The variances and covariances of all asset returns are known.

4.

Investors need know only the expected returns, variances, and covariances
of returns to determine optimal portfolios. They can ignore skewness,
kurtosis, and other attributes of a distribution.

5.

There are no transaction costs or taxes.

EFFICIENT PORTFOLIOS
Efficient portfolios (assets) offer the highest level of return for a given level
of risk as measured by standard deviation in modern portfolio theory.
Because investors are risk-averse, by assumption, they will choose to allocate
their assets to portfolios that have the highest possible level of expected return
for a given level of risk.
These portfolios are known as efficient portfolios.
- We can use optimization techniques to determine the necessary weights to
minimize the portfolio standard deviation for a specified set of expected
returns, standard deviations, and correlations for the assets comprising the
portfolio.

PORTFOLIO EXPECTED RETURN AND RISK

We can calculate the expected return and variance of a two asset portfolio as:

We can calculate the expected return and variance of a three asset portfolio as:

Standard deviation is, of course, the positive square root of variance in both
cases.

PORTFOLIO EXPECTED RETURN AND RISK

Focus On: Calculations
You are examining three international indices. What is the expected return and
standard deviation of a portfolio composed of 50% French equities, 25%
English equities, and 25% German equities?
Correlation with:
Portfolio Exp Ret Std Dev French

English

French

7.028

17.447

English

0.724

5.870

0.2390

German

0.077

7.431

0.2894

0.5830

German

The E(r) is 3.6758%,

and the standard deviation
is 10.0191.
5

THE EFFICIENT FRONTIER

The efficient frontier is a plot of the set of expected returns and standard
deviations for all efficient portfolios (assets) above the global minimumvariance portfolio.
The minimum-variance frontier
(solid green line) is the set of
all portfolios that represent the
lowest level of risk that can be
achieved for each possible level
of return.
- The portfolio with the lowest
variance of all the portfolios,
with the lowest level of risk
that can be achieved, is
known as the global
minimum-variance portfolio.

Efficient Frontier

E(r)

Standard Deviation

THE EFFICIENT FRONTIER

Portfolios on the efficient frontier provide the highest possible level of
return for a given level of risk.
Because portfolios on the
efficient frontier use risk
efficiently to generate returns,
investors can restrict their
selection process to portfolios
lying on the frontier.
- This approach simplifies the
risky-asset selection process
and reduces selection cost.
- The light green portfolios in
the figure are inefficient
portfolios.

Efficient Frontier

E(r)

Standard Deviation

DIVERSIFICATION AND CORRELATION

The trade-off between portfolio risk as measured by standard deviation and
portfolio expected return is affected by asset returns, variances, and
correlations.
Recall the expected return and variance
of a two-asset portfolio.
All the terms in the variance calculation
are strictly positive, except the last
term, which includes the correlation,
which ranges from perfect negative (1:
blue) to perfect positive (+1: purple)
with zero correlation in between (0:
green).
- As a correlation moves from perfect
positive toward perfect negative,
diversification benefits increase.

Range of Correlation Effects

30
25
20

E(r) 15
10
5
0
0

10

15

20

25

30

Standard Deviation
8

FINDING THE MINIMUM-VARIANCE FRONTIER

We can use an optimizer, such as the Solver in Excel, to solve for the
weights in the minimum-variance portfolios and thus the minimum-variance
frontier.
n

Recall that the set of weights in any portfolio must

sum to 1 and, if there are no short sales, must all
be positive.
The expected return and variance for a given set of
weights are
For every return, z, between zmin and zmax,

we solve for the set of weights that

minimizes the portfolio variance subject to
E(rp) = z.

w
i 1

E rp wi E ri
n

i 1

Var rp wi w j
i 1 j 1

j i, j

- If we do so iteratively, we begin at zmin and iterate

by a fixed amount of E(rp) until we reach zmax.

EQUAL-WEIGHTED PORTFOLIOS
The expected return to an equally weighted portfolio is just the sum of the
expected returns to the assets divided by the number of assets.
It can be shown that the variance of an equally weighted portfolio is:
where n is the number of assets in the portfolio, is the average variance of
those assets, and is the average covariance of the assets.
Consider a 10-asset portfolio with average variance of 0.0225 and average
covariance of 0.04. The variance of such a portfolio will be

10

THE CAPITAL ALLOCATION LINE

The capital allocation line (CAL) describes the optimal expected return and
standard deviation combinations available from combining risky assets
with a risk-free asset.
This is a line originating at the expected returnstandard deviation coordinates
of the risk-free asset and lying tangent to the efficient frontier.
- The slope of this line is known as the Sharpe ratio, and it represents the best
possible riskreturn trade-off by construction.
- As can be seen from the equation for the CAL:

- The intercept is the riskreturn coordinate for the risk-free asset or [RF,0].
- The slope is the excess return E(RT) RF per unit of risk RT.

11

THE CAPITAL ALLOCATION LINE

CAL

E(r)
Efficient Frontier

Standard Deviation

12

THE CAPITAL ALLOCATION LINE

Focus On: Calculations
Consider an investor facing a 3% risk-free rate with access to a tangency
portfolio with a 12% return and an 18% standard deviation.
- If the investor requires a 10% return, how much risk will she have to bear?
14%

13

THE CAPITAL MARKET LINE

When all investors share identical expectations about the expected
returns, variances, and covariances of assets, the CAL becomes the CML.
The capital market line (CML) represents the case in which all investors have the
same expectations and, therefore, hold the same risky portfolio as the tangency
portfolio.
- In equilibrium, this will be all risky assets in their market value weights;
hence, all investors will hold the market portfolio as part of their portfolio.

- The slope of the CML is known as the market price of risk and is the Sharpe
ratio for the market portfolio.

14

CAPITAL ASSET PRICING MODEL

The capital asset pricing model, or CAPM, describes the expected return to
any asset as a linear function of its beta.

The CAPM proposes that all security expected returns can be broken down into two
components:
-

A risk-free component (in red).

A component received for bearing market risk (in blue).

-

This component is the amount of risk, i, times the price of risk, E(RM) RF.

i is a measure of the assets sensitivity to market movements (market risk).

i = 1 is the beta for the market, or M.

i > 1 is greater than the beta for the market and we would expect returns in
excess of market returns.

i < 1 is less than the beta for the market and we would expect returns lower
than market returns.

i = 0 is zero market risk (risk free) and we would expect the risk-free return.
E(RM) RF is known as the market risk premium.
15

CAPM ASSUMPTIONS
1. Investors need only know the expected returns, the variances, and the
covariances of returns to determine which portfolios are optimal for them.
-

This assumption appears throughout all of meanvariance theory.

2. Investors have identical views about risky assets mean returns, variances of
returns, and correlations.
3. Investors can buy and sell assets in any quantity without affecting price, and
all assets are marketable (can be traded).
4. Investors can borrow and lend at the risk-free rate without limit, and they can
sell short any asset in any quantity.
5. Investors pay no taxes on returns and pay no transaction costs on trades.

16

THE SECURITY MARKET LINE

The graphical depiction of the CAPM is often known as the security market
line, or SML.

SML

E(r)

E(rm)

rf

m=1

17

MARKOWITZ DECISION RULE

The Markowitz decision rule provides several principles by which investors
can determine how to allocate their assets.
When choosing to allocate all of your money to Asset A or Asset B, choose A
when
- The mean return on A is greater than or equal to that of B, but A has a
smaller standard deviation than B, or
- The mean return of A is strictly larger than that of B, and A and B have the
same standard deviation.
- When either of these is the case, we say that A meanvariance dominates
B.
If we can borrow and lend at the risk-free rate, then
- The portfolio with the higher Sharpe ratio meanvariance dominates the
asset with the lower Sharpe ratio and should be chosen.

18

ADDING AN ASSET CLASS

We will add a new asset class to our existing portfolio when making that
addition provides a higher Sharpe ratio for the resulting portfolio.
In order to determine whether we will have a higher Sharpe ratio, we need
- The Sharpe ratio of the new asset class;
- The Sharpe ratio of the existing portfolio, p; and
- The correlation between the new investments returns and those of our
existing portfolio.

- If this condition is true, our riskreturn relationship is improved by adding the

new asset class.

19

LIMITATIONS OF MEANVARIANCE ANALYSIS

Historical estimates of model parameters involve two potential problems: (1) the
large number of estimates needed, and (2) the quality of such estimates.

The number of parameters needed for meanvariance efficiency analysis is n2/2

+ 3n/2.
- For even a small set of assets, this number is very large.
- For example, if we have 28 assets, that is 434 parameters that must be used in
the optimization process.
The quality of the estimates themselves is generally low.
- The estimate of mean return has a large variance, and small changes can
dramatically effect meanvariance estimation outcomes.
- The estimate of the variance has a smaller relative variance, but is also
measured with error.
- The estimates of the covariance also have a large amount of measurement
error.
20

THE MARKET MODEL

The market model can be estimated via linear regression and is often used
to estimate unadjusted firm betas.
The estimated regression equation for the market model is:
From this, we can calculate the expected return, variance, and standard deviation of
any stock as:

Using the market model to determine the necessary meanvariance parameters

reduces the set of parameter estimates to 3n + 2.
21

THE MARKET MODEL

Focus On: Calculations
We are examining two industry indices, one of which has a beta of 1.87 and a
residual standard deviation of 14.56. The other has a beta of 1.24 and a
residual standard deviation of 9.46.
If the market portfolio has a variance of 30.2, what is the correlation between
the two assets?

22

BETA: TO ADJUST OR NOT ADJUST

Historical betas may not be as useful for predicting future behavior
because we know that betas change over time.
We can model beta itself from past values of beta.
- Beta can be modeled as an AR(1) process as in Chapter 10, where

- We know that adjusted betas predict better than unadjusted betas, and that they
are typically mean reverting (see Chapter 10).
- One common adjustment is

which can easily be shown to mean revert to a beta of 1.

23

ADJUSTED BETA
Focus On: Calculations
Use the beta adjustment model:
What is the adjusted beta for a firm whose unadjusted beta is 1.87?

24

INSTABILITY IN THE EFFICIENT FRONTIER

When small changes in the input values lead to large changes in the
efficient frontier, it is called instability in the efficient frontier.
Instability arises because we use parameter estimates as inputs rather than the
true underlying parameter values.
- If the differences in parameters are small (statistically or economically
insignificant), the optimization process will likely overfit the model.
- Large negative weights in the absence of short-selling restrictions may be
indicative of this problem.
- The model may indicate frequent rebalancing in response to only small
variable changes.
Instability may also arise across time because of true changes in the underlying
parameters or because of the same estimation problem as already noted.

25

MULTIFACTOR MODELS
Models of asset returns that use more than one underlying source of risk,
known as a factor, are known as multifactor models.
Features of multifactor models:
- The underlying sources of risk are known as systematic factors and referred to
as priced risks.
- Multifactor models explain asset returns better than the market model.
- Multifactor models provide a more detailed analysis of risk than single-factor
models.
Categories of multifactor models:
1. Macroeconomic The factors are surprises in macroeconomic variables.
2. Fundamental The factors are attributes of stocks or companies.
3. Statistical The factors are determined statistically and are often the
return on differing portfolios.

26

MACROECONOMIC FACTOR MODELS

A macroeconomic factor surprise is the component of the factors return
that was unexpected.
The surprise is generally measured as the difference between the realized
value and the predicted value prior to realization.
A k-factor macroeconomic model is expressed as:

where a is the expected return to the asset, the b terms are factor
sensitivities, and the F terms are the surprises in the macroeconomic
factors.

27

MACROECONOMIC FACTOR MODELS

Focus On: Calculations
Suppose I believe a multifactor asset pricing model is a correct description of
the riskreturn relationship for equity returns. The model takes the following
form:
Ri = ai + bi,f Forex + bi,dDefault + bi,sSize + i
I plan on buying two stocks with the following factor sensitivities:
bi,m
bi,s
bi,v
Stock
ai
1.1
1.4
.6
X
0.05
Y

0.02

0.8

1.2

1.0

What is the expected return to a portfolio of 25% Stock X and 75% Stock Y?
ri = 0.0290 + 0.908Forex + 1.292Default + 0.9180Size

28

ARBITRAGE PRICING THEORY

The APT, as it is known, describes the expected return to an asset as a
linear function of the risk of the asset with respect to a set of factors.
The APT is an equilibrium model
where the s represent factor sensitivities and the s represent risk premiums.
The APT relies on three assumptions:
1. A factor model describes asset returns.
2. There are many assets, so investors can form well-diversified portfolios that
eliminate asset-specific risk.
3. No arbitrage opportunities exist among well-diversified portfolios.

In contrast to multifactor models, the APT models the expected return in

equilibrium (the first term of the equation), in essence restricting the first term
in the general multifactor expression to the APT value for that term.
29

ARBITRAGE PRICING THEORY

Focus On: Calculations
You are considering purchasing shares in Cleveland Corp., and you believe the
APT with three priced risk factors is an accurate description of the expected
return to Cleveland Corp. The first risk factor, Macro, has a risk premium of 3%
and Cleveland Corp. has a for this risk factor of 1.1. The second risk factor,
Term, has a risk premium of 2% and Cleveland has a of 0.74. Finally, the last
risk factor, Inflation, has a risk premium of 1.3% and Cleveland has a of 0.27.
If the current risk-free rate is 3.5%, what is the APT three-factor expected
return to Cleveland Corp. shares?

30

THE APT AND ARBITRAGE

Focus On: Calculations
Consider the following stock returns and factor sensitivities for a single factor
APT.
Stock

Expected Return

Sensitivity

0.10

1.625

0.14

2.625

0.11

2.375

Can we combine X and Y to achieve an arbitrage possibility with Z?

- What weights create a portfolio with equal sensitivities so that the sensitivity
of the portfolio = the sensitivity of Z?
- Is the expected return to this portfolio the same as the expected return to Z?

31

THE APT AND ARBITRAGE

Focus On: Calculations
- What weights create a portfolio with equal sensitivities so that the sensitivity
of the portfolio = the sensitivity of Z?

- Is the expected return to this portfolio the same as the expected return to Z?

- No. Therefore, if we go short Z, we can use the proceeds to go long X

and Y in weights 25% and 75%, respectively. We will generate a riskfree profit of 2% = 13% 11%.
32

FUNDAMENTAL FACTOR MODELS

In contrast to macroeconomic models, fundamental models use expected
returns (instead of surprises) as factors.
Because the expected returns no longer have an expected value of zero, as do the
surprises in macroeconomic factor models, the intercept, ai, is no longer an expected
return but the intercept term from a regression.

The bi terms are typically factor sensitivities that have been standardized by the
sensitivity across all stocks.
- This is done by subtracting the average sensitivity across all stocks and then dividing the
result by the standard deviation of the attribute across all stocks.
- Doing this enables us to interpret all factor sensitivities as unitless and by comparison
with the typical stock.
- A factor sensitivity of 0.75 would then be interpreted as a sensitivity that is standard
deviations above average.
33

THE INFORMATION RATIO

Often denoted IR, the information ratio takes a form similar to the Sharpe
ratio.
The information ratio can be used to capture the mean active return

per unit of active risk.

- The historical IR is
where the subscripts p and B indicate the portfolio being evaluated
and the benchmark, respectively.
- The information ratio is the difference in mean return for the
portfolio and the benchmark divided by the standard deviation of
the difference in return for the portfolio and the benchmark.
This can be used to set guidelines for the amount by which the
portfolio performance can deviate from its benchmark (tracking risk).
34

ASSESSING ACTIVE RETURN

Focus On: Calculations
Returning to our previous example, consider a firm that uses the following
asset pricing model to determine expected return:
This is an empirical model such that the factor sensitivities used are
determined via regression and are not standardized.
If the portfolio factor sensitivities, benchmark sensitivities, and factor returns
are as follows, how would you decompose the sources of active return for the
portfolio?
Factor Sensitivity
Factor
Factor
Portfolio Benchmark Difference
Return
Macro

1.1

0.1

3%

Term

0.74

1.1

0.36

2%

Inflation

0.27

0.9

0.63

1%
35

ASSESSING ACTIVE RETURN

Focus On: Calculations
If the manager achieved 3.4% active return from asset selection, the active
return sources are then:
Return Components

Absolute
Contribution

% of Total Active

Macro

0.30%

13.9%

Term

0.72%

33.3%

Inflation

0.82%

37.9%

Return from Factor Tilts

1.24%

57.3%

Asset Selection

3.40%

157.3%

Active Return

2.16%

100.0%

This is an active asset selection manager, as seen by the large proportion of

return attributable to asset selection. The manager also had a positive
contribution from a macro tilt, but did poorly with the inflation and term tilts.
36

ASSESSING ACTIVE RISK

Focus On: Calculations
Recall that Active risk squared = Active factor risk + Active specific risk
Consider the following portfolios and their risk calculations:
Active Factor
Risk
Total
Portfolio Industry Index
Factor

Active
Specific

Active Risk
Squared

12.25

17.15

29.4

19.6

49

1.25

13.75

15

10

25

1.25

17.5

18.75

6.25

25

0.03

0.47

0.5

0.5

37

ASSESSING ACTIVE RISK

Focus On: Calculations
Active Factor (% of total active)
Risk
% Active
Portfolio Industry Index Total Factor Specific
A
B
C
D

25%
5%
5%
3%

35%
55%
70%
47%

60%
60%
75%
50%

40%
40%
25%
50%

Active Risk

7%
5%
5%
1%

Portfolio D is effectively a passive portfolio with little or no tracking risk (last

column).
Portfolio A gets most of its active risk from an industry component followed by a
stock-specific component, then a risk-index component.
Portfolios B and C have similar levels of tracking error, but C has more from risk
factor selection and B from a stock-specific component.
38

ACTIVE RISK: MULTIFACTOR MODELS

Focus On: Calculations
Factor marginal contribution to active risk squared is

Recall our three-factor model with active factor exposures of 0.1, 0.36, and
0.63.
You have calculated the variancecovariance matrix as:

Macro

Term

Inflation

Macro

128

Term

16

89

Inflation

18

24

67
39

ACTIVE RISK: MULTIFACTOR MODELS

Focus On: Calculations
What are the factor marginal contributions to active risk squared if total active
risk squared is 158.87?
Factor

Num FMCAR

FMCAR

Macro

0.43

0.27%

Term

16.4016

10.32%

Inflation

30.9015

19.45%

Total

46.8731

29.50%

Ex. calculation: NumFMCAR(Term) = 0.36[0.1(16) + 0.36(89) + 0.63(24)]

Ex. calculation: FMCAR (Inflation) = 30.9015/158.87
If 29.50% of the active risk is attributable to factor tilts, then (1 0.2950) =
0.705, or 70.5% of the active risk is attributable to security selection.
40

TRACKING RISK
Focus On: Calculations
Consider that a mutual fund
and its relevant benchmark
have the returns and tracking
error shown in the table.
The client is a foundation that
wants to earn an active return
above the cost of managing its
account and keep tracking risk
below 5%. We currently
receive 1.5% for managing the
account.
Evaluate the performance of
the fund, calculate the IR, and
interpret it.

Date
Jan 2001
Jan 2002
Jan 2003
Jan 2004
Jan 2005
Jan 2006
Jan 2007
Jan 2008
Jan 2009
Jan 2010

Index
Return

Fund
Return

Tracking
Error

0.0960

0.0334

0.0626

0.0913 0.1374

0.0461

0.0472

0.1812

0.134

0.1495 0.1951

0.0456

0.0684

0.0169

0.0853

0.1154

0.1896

0.0742

0.0221

0.0000

0.0221

0.0208

0.0954

0.0746

0.0242

0.0494

0.0736

0.0868 0.1302

0.0434

Avg 0.0115

0.0004

0.0119

StdDev 0.0868

0.1315

0.0751
41

TRACKING RISK
Focus On: Calculations
Evaluate the performance of the fund.
- The fund is currently earning slightly in excess of its benchmark, but it is
currently not meeting its active return objective because its average tracking
error is below current management fees (1.19 < 1.5).
- It is also not meeting its tracking risk objective because the tracking risk
calculated as the active risk of 7.5% in the prior example is greater than 5%.
The information ratio for this portfolio is

The client is earning 15.83 bps per unit of active risk accepted.

42

FORMING A TRACKING PORTFOLIO

Focus On: Calculations
Tracking portfolios are portfolios with factor sensitivities that match those of the
benchmark portfolio.
We can formulate the weights for a tracking portfolio of n factors as long as we
have n + 1 well-diversified portfolios.
Consider the following three well-diversified portfolios and target benchmark
weights:
Factors
Portfolio

Business
Cycle

Term

0.75

1.0

1.0

0.6

1.3

0.8

Benchmark

1.1

0.9
43

FORMING A TRACKING PORTFOLIO

Focus On: Calculations
What are the weights for a tracking portfolio that has the benchmarks
sensitivities? Solve this set of equations:

which gives weights of w1 = 0.4117, w 2 = 0.0882, and w 3 = 0.6765.

Confirming this matches the desired factor sensitivities:

44

MARKET RISK AND NONMARKET RISK PREMIUMS

Investors can earn substantial premiums from exposure to risks
unrelated to market risk when his or her factor risk exposures to other
sources of income and his or her risk aversion differs from the average
investor.
- In such cases, tilts away from indexed investments may be optimal.
- For example, human capital risk increases the factor sensitivity of an
investor who relies on earned employment income to recession risk.
Such an investor will bid up the price of countercyclical stocks and
sell down the price of countercyclical stocks, causing a recession risk
premium to exist for procyclical stocks.

45

SUMMARY
Portfolio management has a host of quantitative techniques that are used to
- Select assets
- Assess expected returns and risks
- Track performance
Meanvariance efficient analysis forms the foundation of modern portfolio
theory and describes how investors will choose between risky assets and how
they will weight a portfolio of risky and risk-free assets.
Asset pricing models generally describe the expected return to assets
(portfolios) as a function of the types and levels of risk they bear and the
rewards due for bearing each type of risk.

46