Foundations of Investment Management

A Word Before We Begin

Professor Christopher C. Geczy, PH.D.

A Word Before We Begin

This presentation is expressly educational in its nature, purpose and scope to be

presented at The Wharton School in an academic setting.
It is not an offer to sell any product or services of any kind in any way.
All opinions contained herein are those of the presenter and not of any associated
entity including The Wharton School.
As usual, past performance is not indicative of future results, and all historical data
or analysis presented here based on such data should not solely be relied upon to
form any investment opinion, position or portfolio. Such analysis may have no
relevance for or relation whatsoever to the real world, investor portfolios or in
general to any for of actual implementation.
Foundations of Investment Management
Important Concepts

Professor Christopher C. Geczy, PH.D.

Important Concepts in Investments

1. The Context: Modern Portfolio Theory and Optimal Investing

• First principles: Average return, volatility, diversification and why we care
• The reward-risk tradeoff and optimal portfolios: The Sharpe Ratio
2. Systematic Risk
• Beta, Alpha
• Why beta is important (hint: it drives returns)
• Why alpha is important (hint: it drives returns, but most managers don’t
have it)
Foundations of Investment Management
A Framework- MPT

Professor Christopher C. Geczy, PH.D.

A Framework - MPT

Starting Point: A Framework

• Modern Portfolio Theory

• Risk-reward relation
• Frames most relevant issues
• Even if, at the end of the day, you don’t think MPT is useful (for some
reason)
• Intimately connected to asset allocation and investment style analysis
• Techniques used by professional investors
• Investor Centric Model
A Framework – MPT Investor Model

• Asset Allocation
• Long term view of what financial market and asset classes can offer investors by way of reward risk
and diversification
• Tactical Planning
• Happenings in market place, Geo-Political events, Change in expectations, Short term views from
investors, advisors and portfolio managers
• Implementation
• Expression of investment allocations that arrive from strategic and tactical planning (How to buy and
sell)
• Monitoring MPT
• Assets allocation, dynamics and implementation, advantages and disadvantages of historic track
record, and portfolio rebalancing
A Framework - MPT

Starting Point: A Framework

• Modern Portfolio Theory

• Risk-reward relation
• Frames most relevant issues
• Even if, at the end of the day, you don’t think MPT is useful (for some
reason)
• Intimately connected to asset allocation and investment style analysis
• Techniques used by professional investors
• Investor Centric Model
• Provides structure for investment decisions
A Framework – MPT Effects of Investment over time

• Inflation impinges upon wealth

• Purchasing power is not constant

• Use of Wealth
• Spending, Consumption, Distributions i.e. Retirement, College or any future liability

• Taxes
• Death and taxes are among life’s certainties
• Government taxes- sales, income etc., print money, amscot money, expropriate

• Relationships
• Marriages, divorces, children cause divisors of a pool of assets
• N (number of people clutching towards wealth) goes up as T (time) goes up
A Framework - MPT

• Modern Portfolio Theory Just Says

For risky assets
Maximize return for a given level of risk
- or -
Minimize risk for a given return
• How?
• Optimize
• Various Quantitative Methods
• Even Some Qualitative Methods
• The result is known as the “mean-variance frontier” or “minimum variance
frontier” or some variant
Foundations of Investment Management
Useful Statistics: Part A

Professor Christopher C. Geczy, PH.D.

Useful Statistics for Risk/Return

• Random Variables
• We can use random variables to characterize quantities that are uncertain
(like asset payoffs or returns)
• A random variable is a variable that takes on particular values with a
certain probability. This value represents an event or the state of the world.
• Example: A “fair” coin that is flipped can be either “heads” or tails”, each
with 50% probability.
We can represent this numerically (e.g. heads = 0, tails = 1).
Foundations of Investment Management
Useful Statistics: Part B

Professor Christopher C. Geczy, PH.D.

Useful Statistics

• Random Variables
• Example: IOMEGA (NYSE:IOM) is going to preview a new high capacity
disk drive.
• The state of the world for IOM on that day can be modeled as a random
variable (good, bad, neutral).
• Since IOMEGA’s announcement would arguably result in particular states of
the world with different likelihoods, we can think of the probabilities (pi) as:
 Useful Statistics

• Random Variables

State Probability
i = 1 good 25% = p1
i = 2 neutral 50% = p2
i = 3 bad 25% = p3
100%
Useful Statistics

• Random Variables
• Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if
we wanted. Then we can think of a histogram:

The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Useful Statistics
The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability
75
50
(%)
Risk Free Investment
25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability Level of uncertainty

75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Useful Statistics
The Distribution of X
Probability
75
50
(%)

25
0
-1 0 1
Value of X
Note that we could call good (X=1), neutral (X = 0), bad (X = -1) if we wanted.
Foundations of Investment Management
Useful Statistics: Part C

Professor Christopher C. Geczy, PH.D.

Useful Statistics

• Random Variables
• We can characterize the shape of the distribution of payoffs or returns
from investing using various measures
• Central tendency: Expected Value (in units of time)
• The mean or average (μ)
• Dispersion or how spread out the distribution is
• Variance (σ2) or standard deviation (σ)
Useful Statistics

• Dispersion or how spread out the distribution is

• Variance (σ2) or standard deviation (σ)
• Using dispersion as a measure of risk is controversial
• Maybe not be complete
• Might only care about extreme loss or extreme gain
• Permanent loss of capital, Asymmetry, Bankruptcy or credit
event
Useful Statistics

• Random Variables
• We can characterize the shape of the distribution of payoffs or returns
from investing using various measures
• Central tendency: Expected Value
• The mean or average (μ)
• Dispersion or how spread out the distribution is
• Variance (σ2) or standard deviation (σ)
• Other measures:
• How asymmetric it is
• Skewness – measure of tails
• Kurtosis – How “heavy” the “tails” are relative to the center
• Leptokurtosis – Extra heavy tails
Useful Statistics
Useful Statistics

• Central tendency
• Pay off or benefit or reward
• Dispersion
• Risk
• Skewness
• Risk
• Kurtosis
• Risk
Foundations of Investment Management
Useful Statistics: Part D

Professor Christopher C. Geczy, PH.D.

Useful Statistics

• Important Interpretation
• How likely a given value is (for a discrete distribution)
• How likely a given range of values is (for infinite possible outcomes;
known as “continuous”)
• Example: In the standard normal on the previous page (a bell curve or
Gaussian distribution), we know
• That approximately 95% of the observations fall between +/- 2
standard deviations from the mean (1.96 to be exact)
• The specific values of returns that give us that range
Risk and Reward

• The Bell Curve or Normal Distribution

“Equity-Like” distribution
Foundations of Investment Management
Risk and Reward: Part A

Professor Christopher C. Geczy, PH.D.

Risk and Reward

• Different asset have different shapes, and we associate risk and

reward with them

Stock T-Bill

High Variance/High Standard Deviation Low Variance/Low Standard Deviation

Higher Expected Return Lower Expected Return
History of Rates of Returns of Asset Classes for Generations,
Dec 1921 – Dec 2016
Compound Average
Standard
Annual Rate Annual Skewness Kurtosis Distribution
Deviation
of Return Return

Large Cap Stocks 10.55% 11.77% 18.47% 0.34 10.05

Corporate Bonds 6.78% 6.76% 5.96% 0.45 6.63

Long-Term Government Bonds 5.19% 5.28% 6.55% 0.86 6.54

Intermediate-Term Government
4.82% 4.82% 4.61% 0.88 9.96
Bonds

U.S. Treasury Bills 3.66% 3.60% 0.87% 1.01 1.46

Inflation 2.81% 2.79% 1.89% 0.88 12.39

Source: Global Financial Data

Foundations of Investment Management
Risk and Reward: Part B

Professor Christopher C. Geczy, PH.D.

 1200

Expected Return = 8% and Std Dev = 8%

1000

800
5th
25th
Assets

600
Medium
Mean
400 75th
95th

200

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Year
 1200

Expected Return = 8% and Std Dev = 20%

1000

800
5th
25th
Assets

600
Medium
Mean
400 75th
95th

200

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Year
© 2016 Christopher C. Geczy Where Applicable- 38
Do Not Reproduce Without Permission
Foundations of Investment Management
A Framework- MPT: A Deeper Dive

Professor Christopher C. Geczy, PH.D.

A Framework - MPT
• We can characterize the shape of the distribution of payoffs or returns
from investing using various measures
• Central tendency: Expected Value
• The mean or average (μ)
• Dispersion or how spread out the distribution is
• Variance (σ2) or standard deviation (σ)
• Asymmetry
• Skewness – measure of tails
• Kurtosis – How “heavy” the “tails” are relative to the center
A Framework - MPT

• Modern Portfolio Theory Just Says

For risky assets
Maximize return for a given level of risk
- or -
Minimize risk for a given return
• How?
• Optimize
• Various Quantitative Methods
• Even Some Qualitative Methods
• The result is known as the “mean-variance frontier” or “minimum
variance frontier”
A Framework - MPT
E(r) or μ For risky assets
(Reward) Maximize return for a given level of risk
- or -
Minimize risk for a given return

Hedge Funds

MSFT

GE

r NE
f E(r) = 0.76%/month STO
e.g. (T -Bill)
StdDev(r) = 5.7%/month

StdDev(r) or σ
(Risk )
A Framework - MPT
• The Risk/Reward Relation: The Mean-Variance Frontier
E(r)

“Expected” or
Average Return Frontier of Risky
Assets

Hedge Funds

MSFT
GE
MVP
r NE
f STO
e.g., Treasury Bills

“Risk” or volatility of return

StdDev(r)
Foundations of Investment Management
A Framework- MPT: Correlations

Professor Christopher C. Geczy, PH.D.

A Framework - MPT

• The Intuition
• Risk and reward
• We prefer more expected return than less
• We prefer less risk than more
• The amount of the improvement over any given asset or set of assets
depends on a number of things including
• Asset expected returns (reward)
• Asset return volatilities (risk)
• Asset return correlations (or how an asset return moves with
another’s)
A Framework - MPT

• The Intuition
• The “better” the correlation, the “better” the frontier.
• By “better the frontier” we mean that it extends further to the
Northwest portion of the chart
• Think about diversification
• As you add more assets to a portfolio in general, its variance
decreases
• even if assets individually have high risk (variance)
• MPT gives a specific way of putting assets into portfolios that
theoretically minimizes risk/maximizes reward
A Framework - MPT

• The Intuition
• A variable that ranges from -100% and +100% representing the
proportion of observations that an assets payoff moves in the same
direction with respect to its central tendency (expected value) as does
another
 A Framework - MPT

• The Intuition
+100% • Positive correlation – When the return on one asset is above its
average, the return on the other is likely to be above its average.

0% • Zero correlation –The return on one asset is unrelated to the return on

the other asset.

-100% • Negative correlation – When the return on one asset is above its
average, the return on the other asset is likely to be below its average.
Foundations of Investment Management
Correlation and Diversification

Professor Christopher C. Geczy, PH.D.

Example: Two Mutual Funds

• Example: Two mutual funds, an Equity fund and a Debt fund

Portfolio Expected Return as a Function of Standard Deviation
Foundations of Investment Management
Adding the Riskless Asset

Professor Christopher C. Geczy, PH.D.

A Framework - MPT

• Yet, we also have a low-risk asset (e.g., Treasury Bills), sometimes called
the “riskless asset”

• Modern Portfolio Theory Just Says

Invest in Both Risky Assets and Treasury Bills in Some Proportion

• The investment opportunity set is much expanded as a result of this

possibility

• Interestingly, the model suggests investors will want to hold a particular

portfolio - The Tangency Portfolio

53

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

A Framework - MPT
The Risk/Reward Relation: Trading off Risky Securities and Bonds:
The Capital Allocation Relations
E(r)

“Expected” or
Average Return

Frontier of Risky
Hedge Funds
Assets

MSFT
STO
MVP
r IBM
f Capital Allocation
e.g., Treasury Bills Possibilities

“Risk” or volatility of return

StdDev(r)
A Framework - MPT
The Risk/Reward Relation: Trading off Stocks and Bonds

E(r) Allocation Possibilities

known as the Capital Market Line
Optimal Risky-only or “CML”
“Expected” or
Average Return Portfolio

Frontier of Risky
Assets
Hedge Funds
MSFT

GE
MVP
r NE
f STO

e.g., Treasury Bills

“Risk” or volatility of return

StdDev (r)
Foundations of Investment Management
The Sharpe Ratio: Part A

Professor Christopher C. Geczy, PH.D.

A Framework - MPT

• Every risky security can be combined with the riskless asset

• These (infinite) combinations are made on the line connecting the riskless
rate and a given risky security
• One measure of the quality of these combinations is how much expected
return for a give level or risk they provide
• The slope of this line is known as the Sharpe Ratio:

risk premium of an asset

Sharpe Ratio =
asset volatility
E(rp ) - rf
=
sp
Foundations of Investment Management
The Sharpe Ratio: Part B

Professor Christopher C. Geczy, PH.D.

Example of Sharpe Ratios and Why It Matters…

Simulation Portfolios over 20 Years: $5 million Initial Investment

Scenario 1: Equity Portfolio Scenario 2: Traditional 60/40 Scenario 3: Diversified Portfolio

Stocks/Bonds Portfolio 100% Tangible Assets
100% 100% (2%)
80% Real Estate (3%)
80% 80%
60%
Private Equity
60% 60% (7%)
Hedge Funds (8%)
40% 40% 40%
Fixed Income
20% 20% 20% (37%)
0%
Equities (43%)
0%
Equities (100%) Equities (60%) 0%

Expected Return 8.50% Expected Return 7.40% Expected Return 8.31%

Expected SD 15.80% Expected SD 9.70% Expected SD 9.97%
Expected Yield 2.80% Expected Yield 3.60% Expected Yield 3.20%
Sharpe Ratio 0.33 Sharpe Ratio 0.42 Sharpe Ratio 0.56
Median End Wealth $9,639,221 Median End Wealth $7,890,702 Median End Wealth $9,080,325
95 Percentile $3,195,783 95 Percentile $4,049,449 95 Percentile $5,623,564
5 Percentile $28,360,554 5 Percentile $15,419,696 5 Percentile $16,965,143
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.