More on Asset Allocation

Week 5
Minimum Variance and Efficient
Frontier
When we only have two risky assets, as in our KO + PEP example, it
is easy to construct this graph by simply calculating the portfolio
returns for all possible weights.
When we have more than 2 assets, it becomes more difficult to
represent all possible portfolios, and instead we will only graph only a
subset of portfolios. Here, we will choose only those portfolios that
have the minimum volatility for a given return. We will call this graph
the minimum variance frontier.
The upper half of the minimum variance frontier is called the efficient
frontier. The optimal portfolio is one of the portfolios on the efficient
frontier.
The next few slides describes how this frontier can be created.
Once the frontier is created, we can find the portfolio with the highest
Sharpe ratio by


Creating the minimum variance frontier
How to use a spreadsheet to calculate
the frontier when there are more than
2 assets
The Minimum Variance Frontier
With two assets, as we saw, we can construct the frontier
by brute force - by listing almost all possible portfolios.
When we have more than 2 assets, its gets difficult to
consider all possible portfolio combinations. Instead, we
will make the process simpler by considering only a subset
of portfolios: those portfolios that have the minimum
volatility for a given return.
When we plot the return and volatilities of these
portfolios, the resultant graph will be known as the
minimum variance (or volatility) frontier.
We will use Excels Solver for these calculations (look
under Tools. If it is not there, then add it into the menu
through Add-in).
The Steps
We will implement the procedure in three steps:
1. For each asset (and for the time period that you have
chosen), calculate the mean return, volatility and the
correlation matrix.
2. Set up the spreadsheet so that the Solver can be used.
See the sample spreadsheet. Your objective here is to
determine the weights of the portfolio that will allow you
to achieve a specified required rate of return with the
lowest possible volatility.
3. Repeat 2 for a range of returns, and plot the frontier
(return vs. volatility).
Step 1: Assembling the Data
A. Fix the time period for the analysis. You want a
sufficiently long period so that your estimates of the mean
return, volatility and correlation are accurate. But you also
dont want too long a period as very old data may not be
valid.
B. Estimate the mean return and volatility for each of your
assets. Next, calculate the correlation between each pair of
assets. If there are N assets, you will have to calculate
N(N-1)/2 correlations.
Step 2: Setting up the spreadsheet to use
the Solver (1/4)
The objective here is to set up the spreadsheet in a manner
that is easy to use with the solver.
The estimates of the return, volatility and the correlation
matrix are used to set up a matrix for covariances, which is
then used to calculate the portfolio volatility for a given set
of weights.
To create the frontier, you will ask the solver to find you
the weights that gives you the minimum volatility for a
required return.
Step 2: Using the Solver (2/4)
1.Target Cell: When you call the solver, it will ask you to
specify the objective or the target cell. Your objective is
to minimize the volatility - so in this case, you will specify
the cell that calculates the portfolio variance [$B$36]. As
you want to minimize the variance, you click the Min.
2. Constraints: You will have to specify the constraints
under which the optimization must work. There are two
constraints that hold, and a third which will usually also
apply.
Using the Solver: Constraints on the
Optimization (3/4)
1. First, the sum of the weights must add up to 1.
2. Second, you have to specify the required rate of return
for which you want the portfolio of least volatility. For
each level of return, you will solve for the weights that
give you the minimum volatility. To construct the frontier,
you will vary this required return over a range. Thus, you
will have to change this constraint every time you change
the required return.
Third, if you want to impose a short-selling constraint, you
can specify that each portfolio weight is positive.

Step 2: (4/4)
Finally, you specify the arguments that need to be
optimized. In this case, you are searching for the optimal
weights, so you will have to specify the range in the
spreadsheet where the portfolio weights used [A29 to
A34].
Step 3
The final step is to simply repeat step 2, until you
have a sufficiently large data set so that the
minimum variance frontier can be plotted.
.
The Optimal Allocation
We can now use the graph of the minimum variance
frontier to figure out the portfolio with the highest Sharpe
Ratio. This portfolio will be the portfolio such that the
CAL passing through it is tangent to the minimum variance
frontier.
The weights of this portfolio determines the optimal
allocation within the assets that make up the risky
portfolio. All investors should opt for this allocation.
The portfolio will always be on the upper portion of the
frontier, above the portfolio with the lowest volatility - this
portion is called the efficient frontier.

Example
The spreadsheet MinimumVarianceFrontier
provides an example of the computation of the
minimum variance frontier for a portfolio of 6
stocks KO, PEP, WMT, IBM, XOM, MSFT.
The optimal portfolio turns out to have the
following weights: 13% in WMT, 3.50% in IBM,
68% in XOM, and 15.50% in MSFT. This
portfolio had an average return of 23%, and a
volatility of 15.45%.
The return and volatility of S&P 500 are also
plotted on the graph for comparison.

Minimum Variance Frontier
Minimum Variance Frontier
0
0.1
0.2
0.3
0.4
0 0.1 0.2 0.3 0.4 0.5
Portfolio Volatility
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
S&P 500
The Sharpe Ratio for the Portfolios
Vol Return SharpeRf
0.19751 0.14 0.619 1.78%
0.1679 0.16 0.847
0.14897 0.18 1.089
0.14337 0.2 1.271
0.14446 0.21 1.331
0.14792 0.22 1.367
0.1545 0.23 1.373
0.16519 0.24 1.345
0.19604 0.26 1.235
0.23621 0.28 1.11
0.28311 0.3 0.997
0.33393 0.32 0.905
0.3883 0.34 0.83
28.24% 12.14% 0.367 SPX
The Optimal Portfolio vs. S&P 500
In our example, the optimal portfolio provides a
risk-return tradeoff far superior to investing in the
S&P 500.
For example, if we invest 48.8% in the optimal
portfolio and the remainder in the Treasury Bill, we
would expect to earn a return equal to that of the
S&P 500 (of 12.14%), but with a volatility of
7.50%, far lower than the S&P 500 volatility of
28%.
On the other hand, if we leverage up (borrowing at
the risk-free rate) to make the volatility of the
optimal portfolio equal to the volatility of S&P 500,
we would expect to earn a return of 38.25%, much
higher than the S&P 500 return of 12.14%.
In Summary (1/2)
1. The optimal allocation is determined in two steps. First, we decide
the allocation between the risky portfolio, and the riskless asset.
Second, we determine the allocation between the assets that comprise
the risky portfolio.
2. As every portfolio of the risky assets and the riskless asset has the
same Sharpe ratio, there is not one optimal portfolio for all investors.
Instead, the allocation will be determined by individual-specific factors
like risk aversion and the objectives of the investor, taking into account
factors like the investors horizon, wealth, etc.
3. When we are considering the allocation between different classes of
risky assets, it is possible to create a portfolio that has the highest
Sharpe Ratio. The weights of the risky assets in this portfolio will
determine the optimal allocation between various risky assets. This
portfolio can be determined graphically by drawing the capital
allocation line (CAL) such that it is tangent to the minimum variance
frontier. This portfolio will always lie on the upper part of the frontier
(or on the efficient part of the frontier).
In Summary (2/2)
4. The extent to which you can decrease the volatility of the portfolio
depends also on the correlation. The lower the average correlation of
the stocks in your portfolio, the lower you can decrease the volatility of
your portfolio.
5. The homework provides you with an exercise to determine the
optimal allocations.