Asset Allocation: Extension

Underlying economic factors? Cashflow

Effect vs. Discount Rate Effect
B ̴ CFB / rB
B (Bond), S ◦ CFB is fixed (except for TIPS which is adjusted
for inflation)
(Stock) and C ◦ rB is driven by monetary policy (r) and inflation
(Commodity)
Markets S ̴ CFS / rS
◦ CFS is positively related to g (economic growth)
A simplified and inflation
view ◦ rS is driven by r, inflation, and equity risk
premium

C is positively related to g and inflation

B, S and C
Markets
A simplified
view
Commodity market is
concurrent with business
cycle
Stock market is leading
indicator of business cycle
Bond market leads stock
market

BSC
 Market risk sentiment (Risk-on vs. Risk-off)
Nov. 2022

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Inflation

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Asset Mix
 Geopolitical
Risk

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Strategic
(long-term)
vs. Tactical
(short-term)
Asset
Allocation
(Nov. 2022)
Tactical
View (Nov.
2022)

Equity across
different
markets
 Lecture 4
Optimal Risky Portfolios
 Issues
Diversification benefit and risk measures
Optimal risky portfolio and efficient frontier
Asset allocation and portfolio selection
Separation property
Treynor-Black model

Read: Ch. 7 (excluding 7.5), Ch. 27.2 (Treynor-Black Model)

Exercise: P7.4 – 9; 7.11, 7.12, 7.16

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Motivating Questions
How to construct an optimal risky portfolio?
Is standard deviation a proper measure of risk if we have more
than one risky asset?
Is it necessary for portfolio managers to know investors’ risk
preference?

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 The Origin of Modern Portfolio Theory
14 Pages to Fame (JF, 1952)

Risk is central to the whole process of investing! Markowitz

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What if we have two risky
assets?
Last class, we examined asset allocation with one risky asset and a risk-
free asset.
We adopted standard deviation (volatility) as the measure of risk and
used the Sharpe ratio to describe the reward for risk.
Now, we have two risky assets and a risk-free rate of 5%
E(r) SD
1 12% 20%
2 20% 30%

How should we select risky assets?

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Optimal choice
Calculate Sharpe Ratio,

Sharpe Ratio
1 =(12%-5%)/20% = 0.35
2 =(20%-5%)/30%=0.50

If our choices are limited to either security 1 or 2, to maximize Sharpe

ratio, we should choose 2.

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Can we do better?
E(r)

SD

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The Investment Decision
Top-down process with 3 steps:
Capital allocation between the risky portfolio and
risk-free asset
Asset allocation across broad asset classes
Security selection of individual assets within each
asset class

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Portfolio Mathematics
Mean-Variance Framework
◦ Expected Return
◦ Standard Deviation

Two different levels of formulas

◦ Individual Asset
◦ Portfolio

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Portfolio
A portfolio is defined as follows,

r p = w 1 r 1 + w 2 r2

w1 = Proportion of funds in Security 1

w2 = Proportion of funds in Security 2
w1 + w2 = 100%

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Portfolio Expected Return
The expected return of a portfolio is a weighted average
of expected return of each asset comprising the portfolio,
with the portfolio proportions as weights.

E(rp) = w1E(r1)+ w2E(r2)

w1 = Proportion of funds in Security 1

w2 = Proportion of funds in Security 2
w1 + w2 = 1

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Example
Given E(r1)= 12%
E(r2)= 20%
w1 = 50%
w2 = 50%
w1 + w2 = 100%

E(rp) = w1E(r1)+ w2E(r2) = (.5)(12%)+(.5)(20%) = 16%

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Example: Long-Short Strategy
130-30 strategy:
◦ Short 30% (w=-30%) and invest the proceeds and initial capital (1-w =
130%) to buy securities.
◦ Maintain a 100% exposure to equity risk.

130-30 strategy outperforms the underlying market, by

taking advantage of overpriced securities.

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Portfolio Risk with Two Risky
Assets
When two risky assets with variances s12 and s22,
respectively, are combined into a portfolio with
portfolio weights w1 and w2, the portfolio variance is
given by

p2 = w12 12 + w22 22 + 2w1w2 1 2 (r1, r2)

(r1,r2) = Correlation coefficient for security1 and 2

Cov(r1,r2) = (r1,r2)12

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Portfolio Risk: Example
Given 1 = 20%
2 = 30%
(r1 r2) = 0.4
w1 = 50% and w2 = 50%

p2 = 0.52 0.22 + 0.52 0.32 + 2*0.5*0.5*0.2*0.3*0.4

= 0.0445

p = 21.1%

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Portfolio Risk
If standard deviation is a good measure of risk, portfolio risk should be
proportional to individual standard deviation.
w11+ w22 = (0.5)(0.2)+(0.5)(0.3) = 25%
However, 21.1% = p < 25%

Implications:
1. (Bad News!) Standard deviation is a questionable measure of risk,
especially for individual securities. ( cannot be additive.)
2. (Good News!) Forming a portfolio generates diversification benefit
Risk reduction = 25% - 21.1% = 3.9%

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Re-visit our question
If we choose a portfolio of the two risky assets, we can achieve even
greater Sharpe ratio

Sharpe = (16% - 5%)/21.1% = 0.52

So, we should not limit our choices to either asset 1 or 2.

Forming a portfolio can offer even better reward to risk ratio.

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Diversification leads to better
risky portfolios
E(r)

SD

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Correlation Coefficient
Correlation coefficient has a range: -1.0 <  < +1.0

As long as (r1r2) < +1

 p < w1  1 + w 2  2
There is a diversification benefit.

Risk reduction is (w1 1 + w2 2) - p .

The smaller the correlation, the greater the risk reduction potential

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Correlation: Examples
Bonds vs. Commodity

What do you think about their correlation?

◦ Likely to negatively correlated

What might be the driving force behind their relation?

◦ Inflation is the key driver behind the negative correlation
between bond price and commodity price.

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Correlation: Examples
Bonds vs. Stocks

What do you think about their correlation?

◦ Positively correlated most of time but ...
◦ Bond market leads stock market.

What might be the driving force behind their relation?

◦ Interest rate and inflation are key drivers.

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Special Cases
When (r1r2) = +1

 p = w 1  1 + w 2 2
There is no diversification benefit; i.e., no risk reduction.
But it is rare to have a perfectly positive correlation!

Example:
If r2 = 2*r1
(r1r2) = +1

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Special Cases
When 1 = 0 (risk-free asset)

p = w 2  2

The portfolio risk is proportional to the risk of the risky asset.

Having a risk-free asset results in a linear relationship (CAL).

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Special Cases
When (r1r2) = -1

p = w1 1 - w2 2
There is a hedging opportunity such that portfolio risk can be
hedged away.

Example:
Short index future vs. long index

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Hedging
If correlation coefficient is -1, we can determine w1 such
that the overall portfolio standard deviation is zero.
w1 + w2 =1

w1 1 = w2 2

w1 = 2 / (1 + 2 ) = 0.3/(0.2+0.3) = 0.6

w2 = 0.4

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Diversificatio
n Benefit as a
Function of
Correlation

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Risk Management
Three ways to manage risk:
1. Hedging
◦ If (r1r2) = -1
◦ Example: Short index futures
2. Insurance
3. Diversification
◦ If (r1r2) <1

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The Power of Diversification
n n
 P2    w w Cov ( r , r )
i j i j
i 1 j 1

If we define the average variance and average covariance of

the securities as:

21 n 2
   i 1/n
n i 1
1 n n
Cov  
n( n  1) j 1
 Cov(r , r )
i 1
i j

j i

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 Example: Three-Asset Portfolio

E ( r p )  w 1 E ( r1 )  w 2 E ( r2 )  w 3 E ( r3 )

2 2 2 2 2 2 2
 w  w  w 
p 1 1 2 2 3 3

 2 w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3

n=3
n variances
n*(n-1) covariances

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The Power of Diversification
We can then express portfolio variance as:

2 1 2 n 1
   
P C ov
n n

Implication:
As n increases, the influence from variance disappear while covariance
matters.
Risk is more about the co-movement of returns for different assets.
Example: Liquidity commonality leads to systematic risk.

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Portfolio Diversification

Standard deviation (total risk) can be partitioned into two components:

Firm-specific risk (diversifiable)
Systematic risk (undiversifiable)

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Systematic vs. Firm-Specific Risk

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Implication of Diversification for Risk
Measure
As the number of securities in a portfolio increases,
portfolio risk (standard deviation) declines to certain level.
Diversification can reduce firm-specific/unique risk, while
systematic/market risk remains.

If so, why do we need to compensate anyone for bearing

firm-specific risk?
Thus, a better risk measure is systematic risk (defined later).

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Markowitz Portfolio Selection
Determine the minimum-variance frontier of N
risky assets.
◦ Portfolio with the lowest standard deviation for a given
expected return.

Only consider choices on the efficient frontier.

◦ Portfolios which dominate any other portfolios with a
given standard deviation.

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Minimum-Variance Frontier of Risky Assets

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 Efficient
Frontier

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 Portfolio Selection and Risk Aversion
E(r) U’’’ U’’ U’

Efficient
frontier of
S risky assets
P
Less
Q risk-averse
investor
More
risk-averse Investors with different degree of risk aversion
investor would choose different risky portfolios

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Efficient Frontier after Adding Risk-free Asset

Determine an optimal risky portfolio on the efficient

frontier of risky assets
Then, allocate funds between the optimal risky portfolio
and risk-free asset.
The result is that the new efficient frontier is expanded.

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How to identify the optimal portfolio?
Maximize the slope of the CAL for any
possible portfolio, P.
The objective function is the slope:
E ( rP )  r f
SP 
P

The slope is also the Sharpe ratio.

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Capital Allocation Lines with Risky Portfolios

The optimal
portfolio P
maximizes
Sharpe Ratio

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Optimal Solution (Equation 7.13)

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Separation Property
Investors’ risk aversion does not matter in selecting
the optimal risky portfolio.

Two separate tasks:

◦ Selection of the optimal risky portfolio can be delegated
to fund managers.
◦ Investors’ choices differ only in their allocation between
risk-free and the optimal risky portfolio.

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 Separation
Property

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Application:
Asset Allocation with Stock, Bond and T-Bill
Step 1: Form an optimal portfolio of risky assets, i.e.,
stock and bond.
◦ Objective is to maximize the Sharpe Ratio, subject to
constraints on portfolio weights.
◦ This decision is independent of risk aversion of investors

Step 2: Allocate funds between the optimal risky

portfolio and risk-free asset
◦ Objective is to maximize the utility subject to the CAL.
◦ This is an individual decision
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Example: Stock, Bond and T-Bill
Expected Return Standard Correlation
Deviation
Stock 13% 20% 0.3
Bond 8% 12%
T-Bill 5% 0

Max. Sharpe Ratio

Subject to portfolio weights adding up to one

Optimal Risky Portfolio (Equation 7.13)

60% Stock
40% Bond

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 Optimal
Complete
Portfolio
Given that risk
aversion A =4,

The individual
investor can allocate
his funds between the
optimal risky portfolio
and T-bills

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In Practice
MPF DIS (Default Investment Strategy) in HK
Core Accumulation Funds
◦ 60% Global Equity Funds
◦ 40% Global Bond Funds

Age 65 Plus Funds

◦ 20% Global Equity Funds
◦ 80% Global Bond Funds

What would be the underlying factors for the MPF to come up with this
scheme?
◦ Correlation between equity and bond funds
◦ Risk aversion on average

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 Role of Risk-free Asset
Risk-free asset plays an important role of separating asset allocation
decision from the decision to select the optimal risky portfolio
With the presence of risk-free asset, portfolio decision is simplified to
identify a unique optimal risky portfolio.
All investors agree to the same optimal risky portfolio.
CML: Capital Market Line

The efficient frontier is also expanded, so everyone is better off.

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Efficient Frontier with Lending &
Borrowing
CAL
E(r)
B
Q
P

rf F


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Extensions
What if short-sales is restricted?
◦ Efficient frontier will be inferior.

What if lending and borrowing rates are different?

◦ The optimal risky portfolio is no longer unique; different optimal risky
portfolios for investors lending or borrowing.

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Focus Investing:
Theory and Mechanics
Golden Rules:
◦ Concentrate your investments in outstanding
companies run by strong management
◦ Limit to 10 stocks
◦ Think long term – 5 to 10 years
◦ Volatility happens. Carry on.

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Treynor-Black Model
Even if you are good at selecting undervalued stock, should
you focus on the stock you picked by betting all your money?
Or you still need to diversify?
Treynor-Black Model allows you to achieve both abnormal
return from mispriced security and diversification.

Assuming that market is nearly efficient.

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Treynor-Black Model
Treynor-Black Model is used to combine actively
managed stocks with a passively managed portfolio.
Using the Sharpe Ratio, the optimal combination of
active and passive portfolios can be determined.

Suppose market portfolio (M) is the optimal risky

portfolio for (almost) everyone, but you have
identified an undervalued stock A.

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 Treynor-Black Model
CAL CML
E(r)
A
P

A’
M

rf


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Treynor-Black Model
Sharpe measure will increase with added ability to pick
mispriced stocks
Slope of CAL>CML
(rp-rf)/p > (rm-rf)/m

P is the portfolio that combines the passively managed

portfolio with the actively managed portfolio
The combined efficient frontier has a higher return for
the same level of risk

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Example
Here we simplify the Treynor-Black Model as asset allocation with two
risky assets M and A, plus a risk-free asset rf = 5%. Correlation coefficient
is 0.4
E(r ) SD
M 12% 20%
A 20% 30%

Identify the optimal portfolio P (Using Equation 7.13)

wM = 38.46%
wA = 61.54%

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Can you achieve a better result than
putting all your money into A?
Optimal portfolio:
◦ E(rp) = 16.92%
◦ p = 22.66%

Find another portfolio on the CAL such that standard

deviation is the same as A
◦ y*22.66% = 30%
◦ y = 1.323

E(r)= 1.323*16.92% +(1-1.323)*5% = 20.77% > 20%

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