Solution Slides PDF

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Strategic Asset Allocation - Harvard Endowment Fund Case -

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Financial Analysis and Investor Behavior (Tilburg University)
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Harvard Management Company and

Inflation-Linked Bonds
September 2020
Lieven Baele, Tilburg University
This document provides an outline of class presentations. It is

incomplete without the accompanying commentary.

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Harvard Management Company
 Harvard Management Company manages the endowment fund of

Harvard University.
 In 2000, the total assets under management was US$19 billion.
 68 percent is managed internally, 32 percent by outside asset

managers.
Check https://www.hmc.harvard.edu/ for recent numbers…

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Harvard Management Company
 Income from the endowment fund is important to the different

schools (25%, compared to 30 percent from tuition fees)
 Real return growth objective between 6% - 7%:

Annual Distribution : 4% - 5%
- income (gifts) 1%
+ real spending growth 3%
Target real return : 6% - 7%
 Their strategic asset allocation should help them accomplish this.

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Strategic Asset Allocation
 The Strategic Asset Allocation corresponds to the weights that the

investor allocates to various asset classes.
 Example: long term target allocation of 60% equities and 40% bonds
 The Tactical Asset Allocation: active strategy to (temporarily)

overweight/underweight asset classes or individual stocks/bonds,
depending on market circumstances.
 Example 1: Given the recent surge in US equities and the uncertainty

surrounding the presidential elections, the stake in equities is reduced
from 60% to 40% (and hence the allocation to bonds increases to 60%)
 Example 2: Within my equity portfolio, I underweight Tesla and

Facebook but overweight Johnson & Johnson.

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 Why is strategic asset allocation important?
 Brinson et al. results (1986, 1996): Over 90% of the variability

in a typical pension fund’s performance over time is the result of
asset allocation policy.
 Update by Ibbotson and Kaplan (FAJ, 2000) confirms this:
Time-Series Cross-Sectional
Variation Variation
Mutual Funds 81.4% 40%
Pension Funds 88.0% 35%
Endowments* 72.3% 12.8%

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 Illustration for single mutual fund (from Ibbotson and Kaplan)

(time-series dimension)

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 Across Mutual Fund Variation (from Ibbotson and Kaplan)

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HMC: Current Policy Portfolio
Minimum Policy Maximum Benchmark
1 Domestic Equity 22 32 42 80% S&P 500; 16% S&P Mid Cap;

4% Russell 2000
2 Foreign Equity 10 15 20 93% EAFEb; 7% Salomon Extended
Market Index (excluding US and EAFE overlap)
3 Emerging Markets 3 9 13 IFC Global Index and EMBI+ c
4 Private Equity 10 15 20 Cambridge Associates Weighted Composite
5 Absolute Return 0 4 8 LIBOR + 5%
6 High Yield 0 2 4 Salomon High Yield and Bankrupt
7 Commodities 2 5 8 60% GSCId; 40% NCREIFe Timber Index
8 Real Estate 4 7 10 NCREIF Property Index
9 Domestic Bonds 6 11 22 Lehman 5 + Year Treasury Index
10 Foreign Bonds 0 5 10 J.P. Morgan Non U.S.
11 Cash -10 -5 20 3-month LIBOR
Total 100

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What is the role of the policy portfolio for HMC?
1. Long-run (or ‘strategic’) asset allocation of the endowment over

main asset classes.
2. Benchmark for performance measurement

• Endowment
• Managers
3. How is the policy portfolio determined?

Quantitative techniques!

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Objectives
Inputs: Portfolio
-Data Allocation Constraints
-Analysis Model
Optimal
Portfolio
Weights
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 Different steps:
1. Objective function specification (Utility Function)
2. Specify Asset Classes
3. Capital Market Assumptions (ER, Volatility, correlation,..)
4. Optimization
(1)-(4) : use mean-variance analysis
1. Backtesting – simulation
2. Implementation (portfolio manager selection)
3. Follow up (performance measurement)
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Lecture Structure
 Main question is this case:

“Should HMC add inflation-linked bonds as an additional
asset class?”
 Before trying to answer that question, let us reflect on the

rationale for the current allocation:
 Importance of Equity Exposure
 Importance of Diversification:
 Across individual stocks
 Across countries
 Alternative Assets
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Rule 1: Do not neglect Equities
 Equities have consistently outperformed T-bills and bonds
EP= 5,5%
Source: Estrada, Javier. “Stocks, Bonds, Risk, and the Holding Period: An Real returns in local currency
International Perspective”, Dec. 2011. including dividends from
1900 till 2003

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Percentage of households in PSID (Panel Study of Income Dynamics)

and SCF (Survey of Consumer Finances) holdings stocks:
=> Around 50% of US households with positive wealth do NOT hold stocks

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… and it is even worse in Europe…

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 For standard preferences: Need unrealistically high risk aversion to

motivate “small stock allocations”
 Mean-Variance Utility, risk-aversion of 2.5
 Excess bond return = 1%, Market Risk premium of 5.5%
 Eq vol: 20%, Bond vol: 11%, stock-bond correlation: +0,2
 Optimization Problem:
 Solution: ± 60% equity, 40 bonds

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 Even for (unrealistically) high risk risk aversion, we still get a 20%
allocation to equities.

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 What about non-standard (“behavioral”) preferences?

 (Myopic) Loss Aversion:
 Investors feel relatively worse about losses than they feel good about gains.
 Investors tend to check the value of their portfolio (far too) regularly
(‘vigilance’)
-> avoid assets with large negative tails, such as stocks.

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 What about non-standard preferences?

 (Myopic) Loss Aversion: Investors feel relatively worse about losses that
they feel good about gains -> avoid assets with large negative tails, such as
stocks.
 Probability Overweighting: Investors tend to overweight extreme events
(relative to the ‘objective’ or ‘observed’ probablility).
 Think over both overestimating the likelihood of winning the lottery and
dying in a plane crash.

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 (Myopic) Loss Aversion & Probability Overweighting:

Probability overweighting inceases the perceived likelihood of both extreme positive
and negative events. For sufficiently loss aversion investors thought, only the increased
likelihood in the left tail will matter, and they will avoid equities all together.
Low objective probability

Utility Probability distorted upwards
Small marginal utility
Underweighting of
high probability events
Distorted Probability
Overweighting of
low probability events
Low objective probability Objective Probability

Probability distorted upwards
Very high marginal disutility

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Rule 2: Thou Shalt Diversify

(Review of Financial Studies)

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Rule 2: Thou Shalt Diversify

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Rule 2a: Diversify Idiosyncratic Risk
 Harry Markowitz: Two types of Risks

 Systematic Risk
 Firm-specific or “Idiosyncratic Risk”
 Key difference: firm-specific risk can be diversified, while systematic risk cannot.
between 30 and 50 different

stocks necessary to
eliminate most firm-
specific risk!

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 Examples of firm-specific risk?

 Lernaut and Hauspie, a leader in speech technology, went bankrupt in 2001 following an accounting
scandal, ruining the savings of many (typically Belgian retail) investors.
 Facebook after the Cambridge Analytica scandal lost $35 Billion
 Danske Bank fell 15% in one week following a money laundering scandal
 Bitcoin dropped with more than 70% in 2018
 The Tweets by Elon Musk are a constant source of idiosyncratic risk for Tesla stock
 August 2020: Biotech firm “Galapagos” stock price dropped from €192 to €140 following request for
additional tests by the US Food and Drug administration on side effects for its new medicine against
rheumatism.

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 Portfolios with large amounts of idiosyncratic risk are “inefficient”

 Stock index has volatility of 20%, and beta of 1 (by construction)
 Individual stock has beta of 1, and total volatility of 38%
 CAPM: both have same expected return! Yet, Individual stock has much larger total
risk.
Return Distribution, Market, Individual Stock
2,5
ER
market 1,5
Inefficiency
1
MRP
0,5
stock
1
0,1
0,2
0,3
0,4
0,5
0,6
0,7
0,8
0,9
1,1
1,2
1,3
-1
-0,9
-0,8
-0,7
-0,6
-0,5
-0,4
-0,3
-0,2
-0,1
20% Risk
Inefficiency

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 Idiosyncratic Volatility is large, varies substantially over time, and seems to have a
common component…
Average idiosyncratic
volatilty amongst the
20% smallest US stocks
Link to presentation: https://www.youtube.com/watch?v=3tOsCfs2j00

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 So everybody agrees we should diversify?
If you truly want to become

rich, you should do the exact
opposite of diversifying, and
concentrate all your wealth in
a single (positively skewed)
stock!

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Rule 2b: Diversify Internationally?
 Diversifying between stocks within the same country may be sub-

optimal:
 All stocks within a country may be exposed to the same local
economic shocks.
 Nevertheless, evidence of extreme home bias in investment
portfolios (>80% in home stocks)
 Local index may be concentrated in limited number of
industries (e.g. financial services)
 (Indirect international diversification through multinationals)

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 Volatility of returns for country and the global market (1970-2018)
Volatility of the Global Equity Portfolio is lowest,

suggesting substantial benefits to international
diversification.
Link to source (“Global Equity Investing: The Benefits of

Diversification and sizing your allocation”):
https://www.vanguard.com/pdf/ISGGEB.pdf

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 How much should you allocate to foreign stocks?
An allocation of between 40-50% to

foreign stocks seems appropriate
Reduction in volatility is smaller for

the US than for other markets
Source: “Global Equity Investing: The Benefits of Diversification and sizing your allocation”

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 Results in previous slides are based on data from 1970 till 2018. But to
what extent do these alleged benefits still hold more recently?
 International equity market returns have become more and more
correlated:
 Economic Integration: economies have become more and more
economically interlinked (think about Netherlands and Germany), and hence also
firms’ cash flows.
 Financial Integration: cross-country cash flows are discounted at the same
‘global discount rate’, set by a global representative investor (rather than by a
local discount rate)
 Effect of financial integration stronger than that of economic integration (Baele

& Soriano, Review of World Economics, 2010)

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Average within-region correlations
Source: E. Eiling & B. Gerard (2015). Emerging equity market comovements: trends and
macroeconomic fundamentals. Review of Finance, 19 (4), 1543-1585

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Source: “Global Equity Investing: The Benefits of Diversification and sizing your allocation”

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Rule 2c: Emerging and Frontier Market as Diversifiers?

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 What makes emerging frontier markets interesting?

 High expected growth? No! (it is likely already priced in)
 Additional diversification at moderate risk
Source: Blackrock Report, “The Final Frontier”
 Additional Risk Premiums (political risk; liquidity risk;…)

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 But: also correlations of frontier markets seems to be rapidly rising…
'Average' correlation with globlal equity market

0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Feb-01
Sep-01
Feb-08
Sep-08
Jan-97
Jan-04
Aug-97
Jul-00
Aug-04
Jul-07
Oct-98
Oct-05
Mar-98
Mar-05
Jun-03
Apr-02
Apr-09
Dec-99
Dec-06
May-99
May-06
Nov-02
Nov-09
-0.1
Frontier CEE Emerging CEE
Source: Baele, Bekaert, Schäfer (2015), “An Anatomy of CEE equity markets”

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 If diversifying is on your mind, then maybe diversifying across styles (e.g. small
versus large caps) has more potential:
Cross-Asset Correlations – 1999-2018
Source: https://www.klanewealthmanagement.com/blog/revisiting-the-benefits-of-international-diversification

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Rule 3: Diversify into other asset classes

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 The Endowment model:
“a theory and practice of investing…[that] is characterized by highly-diversified,

long-term portfolios that differ from a traditional stock/bond mix in that they
include allocations to less-traditional and less-liquid asset categories, such as
private equity and real estate as well as absolute return strategies.”

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 Most successful: the Yale Endowment Fund
• Huge out-performance
• Very high proportion of assets in alternative asset classes, such as hedge funds,
real estate, or private equity.
• Its manager, David F. Swensen, is considered a Star amongst investors

(https://en.wikipedia.org/wiki/David_F._Swensen)
• Returns have proven difficult to replicate, see

http://video.foxbusiness.com/v/1655227600001/the-yale-models-unmatched-
success/#sp=show-clips

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 Yale’s Asset allocation over time…

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Asset Allocations for U.S. College and University Endowments and Affiliated Foundations

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Hedge Funds

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Hedge Funds
• Economist August 2015: HF lost market share to ETF’s, and its performance is on a
downward trend

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Hedge Funds
• WSJ October 6, 2019: Hedge fund performance goes from bad to less bad…
https://www.wsj.com/articles/hedge-fund-performance-goes-from-bad-to-less-bad-11570413901

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Hedge Funds
• Hedge fund performance during crisis was very mixed

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Hedge Funds
• Hedge fund returns high correlation with 60/40 portfolio:

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Hedge Funds
• Hedge Fund performance during Flights-to-Safety
Source: Baele, Bekaert, Inghelbrecht, Wei (2018), Flights-to-Safety, Review of Financial Studies, 2019

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Hedge Funds
• Hedge Fund during Covid19 crisis (or at least first months)
Source: https://www.economist.com/finance-and-economics/2020/04/25/hedge-funds-hope-the-slump-will-make-them-relevant-again

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Private Equity
 Private equity:
 Equity of companies that is directly sold to investors (rather than on an organized
exchange).
 Illiquid investment with horizon of 5 to 10 years (or more).
 Private equity fund:

 Buys stakes in private equity, typically using 1/3 own equity and 2/3 debt financing.
 Like hedge funds, private equity (funds) are mostly held by sophisticated investors,
like pension funds or endowments, and are therefore less regulated.
 …the selling story…

 Investors earn an illiquidity premium (for locking their money for 5 to 10 years)
 Because PE firms tend to own substantial stakes and longer investment horizons,
they have the capacity to better control firms, and to turn “sluggish businesses into
world-beaters”.

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Private Equity
 Do PE firms live up to the high expectations in terms of returns?

 Difficult to assess, as with the absence of market prices (nonlisted firms, remember)
it is not straightforward to measure returns nor volatility.
 Estimates vary widely across studies. There seems to be some consensus however
that:
 PE outperforms standard public equity benchmarks, at least before costs…
 Also: PE’s performance has gone down over the last decade, to levels that bring
it at par with the S&P500.
 When PE performance is compared to more appropriate benchmarks (e.g. index
of small “value” firms), PE underperforms.
 Despite decreasing returns, a lot of money has flown into

PE funds lately.
 What could explain this?

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Private Equity
 Despite decreasing returns, a lot of money has flown into PE funds lately. What could
explain this?
1. Investors seek Leverage:

 You want to take on additional risk, but you are limited to do so (e.g.
because regulation or internal rules prevent you to do so)
 You can implicitly take on leverage by investing in PE rather than in the
S&P500. Remember that of every $ a PE invest 0.67$ is borrowed.
2. Investors appreciate that PE returns are artificially smooth

 As PE firms are not listed, and their valuation tends to rely on “self
appraisal”, PE returns do not move as much as public market returns.
 A portfolio that mixes public with private equity will “look” less risky, at
least in the short run (except when entering a prolonged bear market)
 The manager of such mixed fund is less likely to be forced to sell at rock-
bottom prices because of imposed risk constraints or solvency rules (which
tend to become binding when volatility goes up).
Read more: see https://www.economist.com/finance-and-economics/2019/02/21/why-private-equity-appeals;

https://www.aqr.com/Insights/Research/White-Papers/Demystifying-Illiquid-Assets-Expected-Returns-for-Private-Equity; and many papers by Ludovic
Phallippou.

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Commodities
 What are Commodities:
 Basic goods (of comparable quality, no matter who produces them)

that are used in commerce or manufacturing
 Four basic groups
1. Energy (crude oil, gas,…)
2. Metals (gold, platinum, copper, iron,…)
3. Livestock
4. Agriculture (wheat, rice, corn,…)
 Who is trading them?

 Before: trading mainly between producers and firms using
them as input in their production.
 More recently: investors take exposure by means of futures
contract (without physical delivery)

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Commodities
 Motivation to invest in commodities: Diversification power! Or not?

Low and High-Frequency Correlation between S&P GSCI Commodity Index and S&P500 Index returns
0.8
0.6
0.4
0.2
Start financialization of
commodity market
-0.2
-0.4
-0.6
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21
Source: own calculations based on GSCI data

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Commodities
Looking at subcategories important (as main index is dominated by energy)
Source: own calculations based on GSCI data

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What do you think about…

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Result from Class Poll
PS why don’t I see > 150 participants?????

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What about gold?

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Gold
Two prominent perceived qualities of Gold:
1. Gold is an inflation hedge
2. Gold provides a hedge against “bad times”

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Gold as an Inflation Hedge
If gold were a good inflation hedge, then its real value should be constant
over time (known as the “golden constant”)
Source: Erb, Harvey, Viskanta (2020), Gold, the Golden Constant, COVID-19, “Massive Passives” and Déjà Vu

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Gold as an Inflation Hedge

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Gold as a Hedge against Bad Times

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Gold
Even if those two stories were true, it would not

explain why gold price is so high:
1. Medium-term inflation expectations are very much

under control (about 1.5%)
2. The very good performance of the equity market

since March is not consistent with a flight-to-
quality.
What is going on: see next video (as of min 5.28)

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Gold as a Hedge against Bad Times
Link: https://www.youtube.com/watch?v=7dpdbhOmODI

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Crypto Currencies
 Extremely volatile, returns completely unpredictable, even ex-

post.
 Collection of opinions, mostly by famous people:

https://www.bloomberg.com/features/bitcoin-bulls-bears/

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What about Treasury Bonds?
 A more mundane suggestion: Bonds!

• Offer a premium over T-bills
• Have low correlation with stocks
• Go up in value in crises
 Caveats:
• Low return
• Attractive at current yields?

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Treasury Bonds as Diversifiers?

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Sharpe Ratios
0.8
0.7
0.6
0.5
0.4 Stocks
0.3
P
0.2
0.1
0
1926 -2010 1960 -2010 1970 -2010 1985-2010 2000 -2010
-0.1
P = 40-60 portfolio of equity and bonds

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Keynes versus Markowitz

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 Whether Treasury Bonds serve as a hedge against equities or not depends on

the cyclical nature of inflation
1. Inflation is countercyclical
Positive inflation shock signals bad news about the future economy
– Equities drop in value because of lower than expected growth prospects
– Bonds drop because higher than expected inflation raises yields
» Positive stock-bond correlation
Examples:
– oil shocks both pushed up inflation and depressed the economy
– Food price shocks increase inflation but depress consumption
2. Inflation is procyclical
Positive inflation shock signals good news about the future economy
– Equities surge because of better than expected growth prospects
– Bonds drop because higher than expected inflation raises yields
» Negative stock-bond correlation
Example: Higher than expected inflation signals the economy picking up / lower likelihood
of deflationary nightmare regime.

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HMC: Current Policy Portfolio
Minimum Policy Maximum Benchmark
1 Domestic Equity 22 32 42 80% S&P 500; 16% S&P Mid Cap;

4% Russell 2000
2 Foreign Equity 10 15 20 93% EAFEb; 7% Salomon Extended
Market Index (excluding US and EAFE overlap)
3 Emerging Markets 3 9 13 IFC Global Index and EMBI+ c
4 Private Equity 10 15 20 Cambridge Associates Weighted Composite
5 Absolute Return 0 4 8 LIBOR + 5%
6 High Yield 0 2 4 Salomon High Yield and Bankrupt
7 Commodities 2 5 8 60% GSCId; 40% NCREIFe Timber Index
8 Real Estate 4 7 10 NCREIF Property Index
9 Domestic Bonds 6 11 22 Lehman 5 + Year Treasury Index
10 Foreign Bonds 0 5 10 J.P. Morgan Non U.S.
11 Cash -10 -5 20 3-month LIBOR
Total 100
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Proposed Change
 Question: “Should HMC include inflation-protected

bonds (TIPS) as an additional asset class?”
 What are the characteristics that would make this an

interesting asset to invest in?
 Lets first try to understand the product
(useful background reading: https://www.pimco.be/en-be/resources/education/understanding-
inflation-linked-bonds/)
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Inflation-Protected Bonds
 Consider 10-year nominal bond with annual coupon of 3%

 Inflation increases to 5%
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 Consider 10-year inflation-linked bond with coupon of 3%

 inflation increases to 5% -> 5% increase in notional amount
 Fixed coupon rate on inflation-adjusted coupon
year nominal real

1 3.15 3 100  1  5%    3%
2 3.31 3
100  1  5%    3%
3 3.47 3
1  5% 
4 3.65 3
5 3.83 3
6 4.02 3
7 4.22 3
8 4.43 3
9 4.65 3
10 167.78 103 100  1  5% 10   1  3% 
 
100  1  5%    1  3% 
10
 
1  5% 
10
74

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75

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 What happens in case of deflation?

 Coupons will decrease with deflation
 Principal is protected against deflation (issuer guarantees
sovereign will never decrease below par).
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 Break-even inflation
 Inflation rate for which nominal and inflation-protected
bonds will do equally well.
Break-even inflation = T-bond yield to maturity – TIPS yield to maturity
 TIPS will outperform T-bonds if realized inflation is larger

than break-even inflation
 T-bonds will outperform TIPS in case realized inflation is
lower than break-even inflation.
Note: we assume a zero liquidity risk premium, which may be a heroic

assumption. 77

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See https://fred.stlouisfed.org/series/T10YIE for most up-to-date figure 78

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 Are inflation-protected bonds ‘risk free’?

 Issued by the government in own currency -> yes (but)
 Perfectly predictable, certain return -> no, horizon dependent
 Coupon reinvestment risk
 Principal reinvestment risk
 How does this compare to cash? Or to nominal bonds?
 Keeps purchasing power intact -> perhaps
 CPI may be ‘poor’ proxy for ‘your’ inflation risk
 Tax issues
 Deflation put
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 What criteria would you look at to determine whether TIPS should

be considered an additional asset class in Harvard’s policy
portfolio?
1. Relatively independent of other asset classes Maybe
2. Comprised of homogeneous investments Yes
3. Capitalization sufficient to absorb a meaningful fraction of

the investor’s portfolio. Yes
4. Does it raise utility? Maybe
We need to check (1) and (4) !

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Mean-Variance analysis of HCM
 Find portfolio with a target return of 6.5% that has minimum

variance.
 Capital market assumptions and constraints

EXPECTED STANDARD CONSTRAINTS
RETURN DEVIATION Lower Upper
Domestic Equity 0.0650 0.1600 0.2200 0.4200
Foreign Equity 0.0650 0.1700 0.0500 0.2500
Emerging Markets 0.0850 0.2000 -0.0100 0.1900
Private Equity 0.0950 0.2200 0.0500 0.2500
Absolute Return 0.0550 0.1200 -0.0600 0.1400
High Yield 0.0550 0.1200 -0.0800 0.1200
Commodities 0.0450 0.1200 -0.0500 0.1500
Real Estate 0.0550 0.1200 -0.0300 0.1700
Domestic Bonds 0.0430 0.0700 0.0100 0.2100
Foreign Bonds 0.0430 0.0800 -0.0500 0.1500
Cash 0.0350 0.0100 -0.1500 0.0500
TIPS 0.0400 0.0300 0.0000 1.0000
Correlations: see exhibit 4 After observing high return on TIPS, return on cash was raised from 2% to 3.5%
81

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Correlation Matrix
Large but << 1

Small put positive -> additional diversification benefits
Increase (decrease) in real rates is over what is offered by nominal bonds
bad (good) both for TIPS and equities (as
real cash flows are discounted at a higher real rate)
Positive correlation between assets that all

Negative correlation between cash and TIPS
are considered “inflation hedgers”
Increasing real rates are bad for TIPS but
good for cash returns (reinvestment risk)
82

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Un-constrained Constrained
Domestic Equity 0.05% 22.00%

Foreign Equity 5.03% 5.00%
Emerging Markets 17.06% 15.85%
Private Equity 18.80% 17.61%
Absolute Return -0.74% -6.00%
High Yield 3.40% -8.00%
Commodities 12.11% 15.00%
Real Estate 14.66% 12.63%
Domestic Bonds -17.75% 1.00%
Foreign Bonds 13.73% 3.53%
Cash -52.67% -15.00%
TIPS 86.33% 36.38%
Expected Return 6.50% 6.50%
Standard Deviation 7.78% 8.42%
83

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 Alternative set of constraints:

Domestic Equity 0.0650 0.1600 0.0000 1.0000
Foreign Equity 0.0650 0.1700 0.0000 1.0000
Emerging Markets 0.0850 0.2000 0.0000 1.0000
Private Equity 0.0950 0.2200 0.0000 1.0000
Absolute Return 0.0550 0.1200 0.0000 1.0000
High Yield 0.0550 0.1200 0.0000 1.0000
Commodities 0.0450 0.1200 0.0000 1.0000
Real Estate 0.0550 0.1200 0.0000 1.0000
Domestic Bonds 0.0430 0.0700 0.0000 1.0000
Foreign Bonds 0.0430 0.0800 0.0000 1.0000
TIPS 0.0400 0.0300 0.0000 1.0000
Cash 0.0350 0.0100 -0.5000 1.0000
84

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 Optimal weights under alternative constraints
Domestic Equity 0.04% 0.00%

Foreign Equity 5.03% 4.67%
Emerging Markets 17.06% 17.30%
Private Equity 18.80% 18.79%
Absolute Return -0.73% 0.00%
High Yield 3.41% 0.29%
Commodities 12.10% 14.76%
Real Estate 14.65% 14.24%
Domestic Bonds -17.75% 0.00%
Foreign Bonds 13.72% 9.70%
TIPS 86.34% 70.24%
Cash -52.67% -50.00%
85

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 Why are TIPS so attractive?

• High expected return and low risk relative to bonds!
• Low correlations with other assets
• Low volatility
 Does it make sense for TIPS to be 50% of the portfolio?

• No, TIPS market capitalization is very small.
• Would make portfolio unbalanced
86

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 Domestic Equities and Domestic Bonds are very

unattractive to the optimizer. Why?
 Examine optimization results using original

assumptions
Can you replicate the original policy portfolio?
87

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HCM Allocation: Original Assumptions

Domestic Equity 0.0650 0.1600 0.0000 1.0000
Foreign Equity 0.0650 0.1700 0.0000 1.0000
Private Equity 0.0950 0.2200 0.0000 1.0000
Absolute Return 0.0550 0.1200 0.0000 1.0000
High Yield 0.0550 0.1200 0.0000 1.0000
Commodities 0.0450 0.1200 0.0000 1.0000
Real Estate 0.0550 0.1200 0.0000 1.0000
Domestic Bonds 0.0430 0.0700 0.0000 1.0000
Foreign Bonds 0.0430 0.0800 0.0000 1.0000
Cash 0.0200 0.0100 0.0000 1.0000
Back to original assumption: cash yields 2%
88

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OPTIMAL PORTFOLIO
Original
Un-constrained Constrained Policy
Portfolio
Domestic Equity -5.46% 0.00% 32%
Foreign Equity -1.94% 1.31% 15%
Emerging Markets 11.33% 17.44% 9%
Private Equity 13.18% 20.95% 15%
Absolute Return 8.93% 2.23% 4%
High Yield 4.10% 5.61% 2%
Commodities 26.95% 19.46% 5%
Real Estate 17.89% 18.03% 7%
Domestic Bonds 31.05% 1.09% 11%
Foreign Bonds 27.73% 13.87% 5%
Cash -33.76% 0.00% -5%
89

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 Do you agree with the capital market assumptions in the case?
1. Return on cash from 2% to 3.5%

2. Expected return on equity = target return
3. Expected return on private equity
4. Correlation domestic bonds and equities

5. Correlation commodities and other asset classes
6. Correlation private equity and other asset classes
90

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 The introduction of TIPS made the ‘experts’ change the real return on
cash from 2% to 3.5%
 Implication I: this affects the implicit inflation/term premiums
Sources of Nominal Real Return Real Return

Risk/Return Cash on Cash Treasury Treasury TIPS
ST Real Rate
X X X X X
of Return
Expected
X X
Inflation
ST Inflation
X X
Risk Premium
Real Term
X X X
Premium
LT Inflation
X X
Risk Premium
91

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 Identify real and nominal components of expected

returns:
1. Real Return on Treasury – Real Return on Cash
≈ Term premium + Inflation Risk Premium
(Assume ST Inflation Risk premium = 0)
2. TIPS return – Real Return on Cash
≈ Real Term premium
3. Real return on Treasury – TIPS return
≈ Inflation Risk premium
92

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 HMC Assumptions:
Ang, Bekaert, Wei
(2008, JF)
Before TIPS After TIPS 1955-2005 data
ST Real Rate
of Return 2.00% 3.50% 1.24%
Real term 0.50%
premium ? (4.0%-3.5%) 0.08%
Inflation risk 0.30%
premium ? (4.3%-4%) 1.14%
Nominal Term 2.3% 0.80%

premium (4.3%-2%) (4.3%-3.5%) 1.22%
(= real term premium + Inflation risk premium)
Source: A. Ang, G. Bekaert, M. Wei (2008), "The Term Structure of Real Rates and Expected Inflation"
Journal of Finance, 63, 2, 797-849. 93

lOMoARcPSD|22802161
Implication 2: Implied Equity Premium de facto changed from 4.5% to 3%
Equity Premiums Around the World

Country Mean SD Country Mean SD
Australia 8.3 17.2 Netherlands 6.4 22.6
Belgium 4.4 23.1 South Africa 7.9 22.2
Canada 5.5 16.8 Spain 4.9 21.5
Denmark 3.8 19.6 Sweden 7.5 22.2
France 8.9 24.0 Switzerland 4.8 18.8
Germany 9.4 35.5 U.K. 5.9 20.1
Ireland 5.5 20.4 U.S.A. 7.2 19.8
Italy 10.3 32.5 Average 6.9 22.8
[1900-2002; arithmetic, over T-bills]
Source: E. Dimson, P Marsh and M Staunton (2003), Global evidence on the equity risk premium,
Journal of Applied Corporate Finance 2003, 15(4). 94

lOMoARcPSD|22802161
HCM Assumptions: An Experiment
 An experiment: Change expected returns
1. Cash: 2%
2. Real Term premium: 0.25% TIPS = 2.25%
3. Inflation premium: 0.95% Dom. Bonds = 3.20%
4. Equity premium: 5.5% Dom. equity returns: 7.5%
5. Emerging market returns: -1%

6. Private Equity: -1%
7. Adjust other categories to keep premium relative to
bonds constant (except for foreign bonds; commodities
and real estate)
95

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Domestic Equity 0.0750 0.1600 0.0000 1.0000
Foreign Equity 0.0750 0.1700 0.0000 1.0000
Private Equity 0.0850 0.2200 0.0000 1.0000
Absolute Return 0.0440 0.1200 0.0000 1.0000
High Yield 0.0440 0.1200 0.0000 1.0000
Commodities 0.0320 0.1200 0.0000 1.0000
Real Estate 0.0420 0.1200 0.0000 1.0000
Domestic Bonds 0.0320 0.0700 0.0000 1.0000
Foreign Bonds 0.0300 0.0800 0.0000 1.0000
TIPS 0.0225 0.0300 0.0000 1.0000
Cash 0.0200 0.0100 -0.5000 1.0000
96

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OPTIMAL PORTFOLIO
Un-
constrained Constrained Policy
Portfolio
Domestic Equity 26.72% 18.26% 22%
Foreign Equity 22.79% 19.02% 15%
Emerging Markets 12.42% 11.62% 9%
Private Equity 15.03% 15.71% 15%
Absolute Return -18.89% 0.00% 5%
High Yield -10.34% 0.00% 3%
Commodities 24.32% 24.26% 6%
Real Estate 13.79% 15.51% 7%
Domestic Bonds 10.88% 8.79% 7%
Foreign Bonds 3.08% 3.70% 4%
Cash -24.54% -22.97% 0%
Tips 24.74% 6.12% 7%

97

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HMC: Conclusions
 Would you suggest to include TIPS in the policy portfolio?

• Provide hedge against inflation that no other asset can do.
• Offers diversification benefits
• Offered unusually high returns
 What happened?
Proposal was accepted!
98

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HMC: Conclusions
Roll, Richard W., Empirical TIPS. Financial Analysts Journal, Vol. 60, No. 1, pp. 31-53, January/February 2004
99

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HMC: Conclusions
Volume in TIPS market Liquidity Risk Premium
100

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HMC: Conclusions
101

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HMC: Conclusions
102

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Strategic Asset Allocation - Harvard Endowment Fund Case -

Studocu is not sponsored or endorsed by any college or university

Harvard Management Company and

This document provides an outline of class presentations. It is

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Harvard Management Company

 Harvard Management Company manages the endowment fund of

 In 2000, the total assets under management was US$19 billion.

 68 percent is managed internally, 32 percent by outside asset

Check https://www.hmc.harvard.edu/ for recent numbers…

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Harvard Management Company

 Income from the endowment fund is important to the different

 Real return growth objective between 6% - 7%:

Target real return : 6% - 7%

 Their strategic asset allocation should help them accomplish this.

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Strategic Asset Allocation

 The Strategic Asset Allocation corresponds to the weights that the

 The Tactical Asset Allocation: active strategy to (temporarily)

 Example 1: Given the recent surge in US equities and the uncertainty

 Example 2: Within my equity portfolio, I underweight Tesla and

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Strategic Asset Allocation

 Why is strategic asset allocation important?

 Brinson et al. results (1986, 1996): Over 90% of the variability

 Update by Ibbotson and Kaplan (FAJ, 2000) confirms this:

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Strategic Asset Allocation

 Illustration for single mutual fund (from Ibbotson and Kaplan)

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Strategic Asset Allocation

 Across Mutual Fund Variation (from Ibbotson and Kaplan)

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HMC: Current Policy Portfolio

Minimum Policy Maximum Benchmark

1 Domestic Equity 22 32 42 80% S&P 500; 16% S&P Mid Cap;

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Strategic Asset Allocation

What is the role of the policy portfolio for HMC?

1. Long-run (or ‘strategic’) asset allocation of the endowment over

2. Benchmark for performance measurement

3. How is the policy portfolio determined?

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Strategic Asset Allocation

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Strategic Asset Allocation

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 Main question is this case:

 Before trying to answer that question, let us reflect on the

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Rule 1: Do not neglect Equities

 Equities have consistently outperformed T-bills and bonds

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Rule 1: Do not neglect Equities

Percentage of households in PSID (Panel Study of Income Dynamics)

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