Foundations of Investment Management

How to Pick a Portfolio

Professor Christopher C. Geczy, PH.D.

A Framework - MPT
• Then the question is: “How do we pick a portfolio?”
• Investor has a required expected rate of return
• Account for Risk Aversion
• Risk Tolerance Questionnaires, Behavioral or Psychometric
Evaluations
• Volatility and Risk Space with Capital Market Line
A Framework - MPT

Expected Return

rf
Standard Deviation

Grandma Aggressive Trader

Foundations of Investment Management
Introduction to Asset Allocation

Professor Christopher C. Geczy, PH.D.

Asset Allocation

• Classical setting of Modern Portfolio Theory (MPT) omits individual

investments
• Securities, stocks, bonds, contracts, etc.
• Modern Practice of MPT Strategic Allocation Asset Classes
• Asset Allocation, Tactical Planning, Implementation, Monitoring MPT
• Investments start at the asset class level (long or short term horizons)
Asset Allocation

• Asset Class
• Varies by setting
• Investments are best thought of in the aggregate
• Instead of (Stock A & Stock B) think of (Stock A & Commodity C)
• Enables broad diversification across classes
• Sub assets classes might be represented by easily available &
understandable indexes
Asset Allocation

• Fundamental Empirical in Modern Investment Management considers asset

allocation as a possible driver of investment performance
• Beebower 80’s studies show that asset allocation is responsible for the
risk in portfolio performance
• 93.6% of the variability of a portfolio comes from asset allocation
• The choice of asset allocation equates to the choice of risk
• Example
• Apple – or – Yahoo
• Class of Asset Stocks (Apple, Yahoo, Google) vs. Bonds
 Asset Allocation

• Performance of Strategic Asset Classes To Which Many Institutions

Allocate (or want to)
Annualized Returns of a Sample of Asset Class Benchmarks
January 1980 – December 2016
MSCI Citigrou
EM MSCI p World Real Dow
DJ U.S.10 - Mortgag Small MSCI Europe Emergin Govern Estate Jones Commo
Corporat Yr Gov e Russell Russell Stocks EM and g ment (REIT Credit dities
US T-Bill e Bonds Bond Master 1000 1000 Russell (Russell MSCI MSCI Latin MSCI Middle Markets Bond Total Suisse (Dow
(GFD) (GFD) (GFD) Index Value Growth Midcap 2000) EAFE World America EM Asia East Index Index Return) HF Index UBS)
Jan 80 – Oct 16 2.43***
Return (%) 4.54 9.45 8.18 7.96 11.97 10.61 12.82 10.90 9.06 10.09 15.05* 7.37* 6.28* 10.54* 7.09** 10.84 7.74 14.78**
*
Std Dev (%) 1.05 6.67 9.15 6.25 14.57 17.06 16.62 19.37 17.28 14.92 30.47* 23.96* 28.10* 23.01* 6.98** 16.60 6.94*** **
Jan 80 - Dec 99 14.07** 4.48***
Return (%) 7.06 11.70 10.49 10.45 16.78 17.82 16.65 13.96 14.79 15.87 26.25* 9.92* 10.77* 17.04* 10.33** 10.28 * *
10.42**
Std Dev (%) 0.85 7.27 10.36 8.08 14.12 17.02 16.29 18.90 17.41 14.34 34.44* 25.65* 29.96* 23.91* 6.96** 12.46 9.87*** **
Jan 00 – Oct 16
Return (%) 1.66 6.86 5.53 5.10 6.57 2.69 8.48 7.41 2.68 3.66 7.74 5.60 3.23 6.18 4.23 11.50 5.58 1.38
Std Dev (%) 0.56 5.84 7.47 2.72 15.02 16.94 17.00 19.97 17.05 15.47 27.28 22.80 26.81 22.39 6.93 20.48 5.46 16.67
*Jan 1988 - Dec 1999/Oct 2016 **Jan 1985 - Dec 1999/Oct 2016
***Jan 1994 - Dec 1999/Oct 2016 ****Feb 1991 - Dec 1999/Oct 2016
Asset Allocation

• Advantages of Strategic Asset Classes

• Provides global diversification, investing in markets and not individual
inputs
• Focuses on span of assets classes, primary drivers of risk and avoids
noise in signals
• Portfolios divided from asset class allocation tend to be more stable and
predictable over individual investment inputs
• Better forecasting for investors
Asset Allocation

• Performance of Strategic Asset Classes

Asset Class Risk and Rewards
January 1980 - December 2016
16%

MSCI EM Latin America *

14%
Russell Midcap

12% Russell 1000 Value

Russell 1000 Growth
Real Estate (REIT Total Return) MSCI Emerging Markets Index *
10% US Corporate Bond Small Stocks (Russell 2000)
Annualized Return

MSCI World
US 10-Year Gov Bond
MSCI EAFE
8% Mortgage Master Index
Dow Jones Credit Suisse HF
Index *** MSCI EM Asia *
6% Citigroup World Government MSCI EM Europe and Middle East *
Bond Index **

4% US T-Bill

2% Commodities (Dow UBS) ****

* Jan 1988 – Dec 2016
** Jan 1985 – Dec 2016
0%
0% 5% 10% 15% 20% 25% 30% 35% *** Jan 1994 – Dec 2016
Annualized Volatility **** Feb 1991 – Dec 2016
Asset Allocation

• Performance of Strategic Asset Classes

Monthly Correlations of a Sample of Asset Class Benchmarks
January 1994 – December 2016
Asset Allocation
Efficient Frontier
January 1980 - December 2016
16%

MSCI EM Latin America *

14%
Russell Midcap

12% Russell 1000 Value

Russell 1000 Growth
Real Estate (REIT Total Return) MSCI Emerging Markets Index *
10% US Corporate Bond Small Stocks (Russell 2000)
Annualized Return

MSCI World
US 10-Year Gov Bond
MSCI EAFE
8% Mortgage Master Index
Dow Jones Credit Suisse HF
Index *** MSCI EM Asia *
6% Citigroup World Government MSCI EM Europe and Middle East *
Bond Index **

4% US T-Bill

2% Commodities (Dow UBS) ****

* Jan 1988 – Dec 2016

0%
** Jan 1985 – Dec 2016
0% 5% 10% 15% 20% 25% 30% 35%
Annualized Volatility
*** Jan 1994 – Dec 2016
**** Feb 1991 – Dec 2016
Foundations of Investment Management
Introduction to Alpha and Beta

Professor Christopher C. Geczy, PH.D.

Modern Portfolio Theory: Systematic Risk and Value Added

• Two More Important Concepts

• Beta: Market (or systematic) exposure and a measure of market risk
of an investment; related to correlation to the market
• Measures expected movement in an investment vs. the market
• The beta of the market itself is 1.0
• Most domestic (long-only) fund managers have betas between
0.90 and 1.0
• The average hedge fund beta is about 0.3
• Most investors pay too much for beta that is too high
• Beta relative to other exposures certainly exists (e.g., foreign
markets, interest rates, etc.)
Modern Portfolio Theory: Systematic Risk and Value Added

• Two More Important Concepts

• Alpha: Value-added accounting for market (or systematic risk)
• For a portfolio manager, a measure of investment skill
• “Pure alpha” has a very high Sharpe ratio
• The alpha of the market itself is zero
• Most (long-only) managers have negative alphas, largely due to
fees
• That is, they destroy value
• E.g., 80% of U.S. active mutual fund managers cannot beat the
market
Foundations of Investment Management
Alpha and Beta Example

Professor Christopher C. Geczy, PH.D.

Modern Portfolio Theory: Systematic Risk and Value Added

Risk Measures
Vanguard Growth Index VIGRX

Volatility Measurements Trailing 3-Yr through 1-13-2017

Standard Deviation 14.20%
Mean 8.10%

Modern Portfolio Theory Statistics

Standard Index Best Fit Index
S&P 500 TR Morningstar Large Growth TR USD
R-Squared 94.6% 98.0%
Beta 1.033 0.947
Alpha -0.046 -0.025

Source: Bloomberg
Foundations of Investment Management
Introduction to CAPM

Professor Christopher C. Geczy, PH.D.

Beta, Alpha and the CAPM: The Theory

• When all investors use MPT, they hold the market portfolio
• They have well diversified portfolios (must be priced to do so)
• The CAPM says expected returns are functions of asset exposure to the market.
For any asset i: E[r ] – r = β {E[r ] – r }
i f i M f
where: βi = Cov(ri,rM) / Var[rM]
• β measures how sensitive an asset’s return is to the market return
• The average β of all securities is 1
• The β of the market is 1
• The risk (Std. dev.) of a well diversified portfolio is proportional to its β
• β measures how much variation in the market contributes to variation in an
asset’s return
• The CAPM says that E(r) is proportional to β (and that everyone holds the
optimal tangency portfolio….The Market
Foundations of Investment Management
Security Market Line

Professor Christopher C. Geczy, PH.D.

Beta, Alpha and the CAPM: The Theory

• Alternatively (using some rules of stats), we can specify beta as

Cov(ri , rM ) s ri ,rM r xys ri s rM r xys ri
bi = = 2 = =
Var (rM ) s rM s rM
2
s rM
• Graphically, the CAPM says
Expected
Return

E(Rm)

Rf

Beta
0.0 0.5 1.0 1.5
It is possible to have a negative beta.
Beta, Alpha and the CAPM: The Theory

• Key feature of history

• Capital Asset Pricing model testing have found the slope tends to be flat
• As Beta or risk goes up the Alpha or return is not as high as expected
• Low Beta investments have higher Alpha characteristics
• High Beta investments have lower Alpha characteristics
• Low Beta, Smart Beta, or Factor Based Investments
• Low Beta is associated with High Alpha (non benchmark value added)
Foundations of Investment Management
Estimating Alpha and Beta

Professor Christopher C. Geczy, PH.D.

Beta, Alpha and the CAPM: The Theory

• Capital Allocation Line

• Infinity

• Capital Market Line

• Highest sloping allocation (Sharpe Ratio)

• Security Market Line

• CAPM expected returns are functions of asset exposure to the market

• Security Characteristic Line

Beta, Alpha and the CAPM: The Theory

• Graphically, the market model says the following:

Excess return on
an asset (ri-rf) • •
•
•
•
• •
•
•
• •
Slope= b
• •
• •
•
• •
•
e •
• •
•
• • i
•
Intercept = a
•
• •

• • •
• Excess return on
0.0 5% 10% 15%
the market (rm-rf)
Note that for hedge funds, this line is often thought to be flat since – at least in theory – if market risk (as measured by beta) is “hedged”
out by the hedge fund, beta should be equal to zero. Hence, even if expected returns vary, betas will not, again, theoretically. However,
this idea is highly debatable.
Foundations of Investment Management
An Empirical Example of Estimating Beta and Alpha

Professor Christopher C. Geczy, PH.D.

Modern Portfolio Theory: Systematic Risk and Value Added
Market Model Relationship for The Acorn Fund

0.2000

0.1500

Excess Returns on the Acorn Fund, Monthly y = 0.9859x + 0.0106

2 0.1000
R = 0.8101
0.0500

0.0000
-0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15
-0.0500

-0.1000

-0.1500

-0.2000

-0.2500

-0.3000
Excess Returns on the U.S. Equity Market, Monthly
Foundations of Investment Management
An Empirical Distribution of Alphas

Professor Christopher C. Geczy, PH.D.

Beta, Alpha and the CAPM: The Theory

• Alpha
• Alpha can be thought of as an underpricing or excess performance:

Alpha is:

• It can be estimated using data as:

Estimated Alpha is:

29

© 2016 Christopher C. Geczy Where Applicable- Do Not Reproduce Without Permission

Estimates of Individual Mutual Fund Alphas, 1972-1991
Foundations of Investment Management
The Endowment Model

Professor Christopher C. Geczy, PH.D.

Asset Allocation
Institutional Portfolios: Endowment Allocations
Average Asset Class Allocation of Total Assets (2015 NACUBO-Commonfund Study of Endowments)
100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
Under $25 Million $25 Million to $50 $51 Million to $100 $101 Million to $500 $501 Million to $1 Over $1 Billion Total Institutions
Million Million Million Billion

Domestic Equities Fixed Income International Equities Alternative Strategies Short-term Securities/Cash/Other

All data are dollar-weighted unless otherwise specified. Alternative strategies are categorized in the NCSE as follows: Private equity (LBOs, mezzanine, M&A funds, and international private equity); Marketable
alternative strategies (hedge funds, absolute return, market neutral, long/short, 130/30, and event-driven and derivatives); Venture capital; Private equity real estate (non-campus); Energy and natural resources
(oil, gas, timber, commodities and managed futures); and Distressed debt. On-campus real estate is included in the Short-term Securities/Cash/Other category
Foundations of Investment Management
Putting It All Together

Professor Christopher C. Geczy, PH.D.

Optimal Capital Allocation
• Put it all together
• What investments are available
• Characterize expected returns, volatilities in the classic case
• Open Investor Optimal Portfolio
• Target the Tangency Portfolio
• Maximize return for a given level of risk or Minimize risk for a given
return
• Define the Mean Variance Frontier
• Tangency Portfolio arises
• Combine the Tangency Portfolio with a Risk free investment
• Invest in the treasury bill to delever or short it along the capital
market line (Sharpe Ratio)
Optimal Capital Allocation

• Putting it all together

E(R)
Shorting TBill

CML = CAL(optimal)

Rf
Investor
Optimal Portfolio

StdDev(R)
Optimal Capital Allocation
• Put it all together
• How does an investor choose his/her portfolio
• Optimize utility by maximizing your return per unit of risk
• Consider aversion for risk
• Invest above or below the tangency portfolio expected return but
always on the Capital Market Line
• Consider risk and investment opportunities over time
• Investor constraints (cash, safety margins, social responsibility,
home or foreign investment etc.)
Foundations of Investment Management
Naïve Diversification

Professor Christopher C. Geczy, PH.D.

Diversification: The Risk of a Portfolio

Adding assets to a portfolio in general will lower the portfolio’s risk (variance
or standard deviation)
• Asset specific risk will eventually be washed away
• What remains is systematic risk
• Under basic modern portfolio theory, this systematic risk is market risk
• Diversification reduces the standard deviation of a portfolio since the
prices of different securities do not move exactly together. Securities
are not perfectly correlated. Portfolio Unique Risk
Standard (also called idiosyncratic, unsystematic, diversifyable)
Deviation

20%

Market or Systematic Risk

Number of Securities in Portfolio
Diversification: The Risk of a Portfolio

Portfolio Unique Risk

Standard (also called idiosyncratic, unsystematic, diversifyable)
Deviation

20%

Market or Systematic Risk

Number of Securities in Portfolio
Portfolio Diversification: The Case of U.S. Equities
Disclaimer and Notes
This is an educational presentation. Information contained in this document cannot disclose all risks. The material is based upon information that we consider
reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. The presenter and any associated entities an
organizations do not make any representation that any strategies will or are likely to achieve results similar to those shown in this document. Past
performance is not necessarily indicative of future results. Diversification does not ensure against loss.

Many analyses are conducted with index or asset class data. It is not possible to invest directly in an unmanaged index or many of these representative
data. Many analyses are conducted with zero-investment portfolios, which are constructed with their own set of assumptions, including, but not limited to,
liquidity, transactions costs, and the cost of managing the portfolio. Historical fees associated with index data and/or zero-investment portfolios may not be
representative of future fees associated with such data.

Where we deem it appropriate, we econometrically "unsmooth" historical data due to volatilities and correlations being likely underestimated with likely high
return auto-correlations as a result of illiquidity, infrequent mark-to-market pricing of underlying assets or other reasons. We make no representation that
this process is effective.

The hypothetical example portfolios presented herein have several inherent limitations. Unlike an actual performance record, simulated results do not
represent actual performance. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by
any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of
certain market risks such as lack of liquidity. Rebalancing at the frequencies indicated in this presentation may not be possible in a managed portfolio. We do
not claim that all constraints that may be important to the management of the portfolio(s) have been accounted for, and the lack or presence of such
constraints may dictate different weightings of investments. There are numerous other factors related to the markets in general or the implementation of any
specific investment strategy, which cannot be fully accounted for in the preparation of simulated results, all of which can adversely affect actual results. This
presentation is made for your benefit only and where appropriate is proprietary and confidential.

Past performance is not indicative of future returns, which may vary. Future returns are not guaranteed, and a loss of principal may occur. The attribution
information shown will change over time based on market and other conditions. Any portfolio risk management processes discussed include an effort to
monitor and manage risk, but should not be confused with and do not imply low risk or the ability to control risk.

Statements that are nonfactual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and
constitute only current opinions that are subject to change without notice. Information contained herein is based on data obtained from statistical services,
company reports or communications, or other sources, believed reliable. However, we have not verified this information, and we make no representations
whatsoever as to its accuracy or completeness.
Disclaimer and Notes
Alternative investments by their nature involve a substantial degree of risk, including the risk of total loss of an investor’s capital. Further, alternative investments are
subject to less regulation than other types of pooled investment vehicles, may be illiquid and can assume that investments in the asset classes identified will be profitable or
that decisions we make in the future will be profitable. It should involve a significant use of leverage, making them substantially riskier than the other investments.

It should not be assumed that recommendations in the future will equal the performance of any asset class referenced in this presentation. It is possible that an investor
may lose money by investing in the manner the projections suggest. There can be no assurance that historical volatilities and correlations will remain valid or that our
forecasts are adequate or that they will be adequately utilized.

The term “60/40 portfolio” is defined as a 60% allocation to the S&P 500 Index and 40% allocation to the Barclay’s US Aggregate Bond Index for the purposes of the this
presentation and is used throughout as such. The appearance of “equity” in any chart implies the S&P 500 Index.

The portfolios and their performance are hypothetical, not real. They do not represent the investment performance or the actual accounts of any investors. The securities in
these hypothetical portfolios were selected with the full benefit of hindsight, after their performance over the period shown was known. It is not likely that similar results
could be achieved in the future. The hypothetical portfolios presented here are purely illustrative, and representative only of a small sample of possible future scenarios.

The model performance information in this presentation is based on the back-tested performance of a hypothetical investment over the time period indicated. “Back-
testing” is a process of objectively simulating historical investment returns by applying a set of rules for buying and selling fund shares backward in time, testing those rules,
and hypothetically investing in the shares that are chosen. Back-testing is designed to allow investors to understand and evaluate certain strategies by seeing how they
would have performed hypothetically during certain time periods.

It is possible that the markets will perform better or worse than shown in the projections, the actual results of an investor who invests in the manner these projections
suggest will be better or worse than the projections, and an investor may lose money by investing in the manner the projections suggest. The projections assume the
reinvestment of dividends, no deduction for advisory or brokerage fees, and that assets are allocated in the manner the projections suggest for the time period and are
rebalanced at a given frequency. Although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness cannot
be guaranteed. While back-testing results reflect the rigorous application of the investment strategy selected, back-tested results have certain limitations and should not be
considered indicative of future results. In particular, they do not reflect actual trading in an account, so there is no guarantee that, in fact, an actual account would have
achieved the results shown. Back-tested results also assume that asset allocations would not have changed over time and in response to market conditions, which might
have occurred if an actual account had been managed during the time period shown.

The presenter and any affiliated entities may have a different investment perspective and maintain different asset allocation or other recommendations from those shown
here. These scenarios are based on multiple assumptions some or all of which may be violated in practice.