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William F. Sharpe
Stanco 25 Professor of Finance, Emeritus Graduate School of Business Stanford University Chairman Financial Engines Incorporated

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Macro-Investment Analysis

Macro-Investment Analysis Contents


Before starting, you may wish to read an Overview of the work. In the table of contents, any entry shown as a link (usually underlined) is available. The other material (usually shown in red) is presently planned but unavailable.

Introduction Matrices and Programming Prices Probabilities Risk and Return Optimization Factor Models Style Analysis Equilibrium Performance Measurement International Investment

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Macro-Investment Analysis
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Dynamic Strategies Monte Carlo Simulation Retirement Planning

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Macro-Investment Analysis: Overview

Macro-Investment Analysis: An Overview of the Work

This is an Electronic Work-in-Progress, a form of communication that is both new for and poorly understood by its author. It is very much in progress. This means that it will grow over time and that the material will undergo substantial revisions. Some material may even presume that the reader has knowledge scheduled to be included in other, as-yet-unwritten sections. The reader's (browser's?) indulgence is requested as the overall edifice is constructed.

The Subject
It is not an easy matter to describe the subject of a Work of this sort. This is especially true in the early stages, when it is still under construction. However, a few paragraphs from an early section may prove useful. Some may regard the Work as a sort of electronic Investments text, but the focus is more specific. This is reflected in the title, which is, at the writing, unique. All three components of the title are relevant. The focus is on techniques of analysis that can lead to sensible top-level (macro-) investment decisions. It is helpful to personalize some of the roles that concern us. An Investor must ultimately select positions in various types of investment vehicles. In doing so, he or she can be assisted by an Analyst. Importantly, many of the investment vehicles used by investors are themselves packages of more fundamental positions -- packages provided by Investment Firms. In essence, we concentrate on a multi-level approach to investing, with the Investor at the top level, assisted by the Analyst, a set of Investment Firms at a second level, and the securities of corporations and government agencies at yet lower levels. Such a multi-level approach to investing is found both among individual and institutional investors. Individuals utilize shares of publicly-available investment funds which in turn hold securities of individual corporations. Large institutional investors such as pension funds use commingled funds or separately managed accounts which serve much the same purpose. Both can also make use of many types of derivative securities, the values of which reflect the performance of major sectors of various capital markets.

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Macro-Investment Analysis: Overview

Traditionally, investments textbooks have been directed to investors who plan to build portfolios of the securities of corporations and public agencies. However, in the real world such investors are becoming fewer and fewer. Increasingly, the construction of portfolios from individual securities is an activity undertaken by Investment Firms, whose goal is to provide components that may usefully be employed by investors. The ultimate investor then focuses on finding an appropriate combination of such components, not on building an overall portfolio security by security. This work is designed to provide the analytic skills needed to aid such investors. It is thus explicitly directed to the Analyst. However, knowledge of its contents should help Investors utilize and evaluate the services offered by Analysts. In addition, Investment Firms familiar with its contents should be able to design products that will better meet the needs of Investors. If you want to help an investor build and manage a portfolio of mutual funds or similar vehicles in sophisticated ways, this Work is for you. If not, it still may have much to offer. Take what you will.

Organization
The Work is divided into three sets of material:
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Principles and Techniques Empirical Analyses Computer Material

Principles and Techniques


This first body of material will eventually resemble an on-line textbook. Indeed, some or all of it might eventually appear in a traditional printed form. Except for issues of organization and exposition, the material should be subject to relatively few changes. To oversimplify: good theory is timeless. This material is intended to stand on its own and (eventually) to be read in the sequence shown.

Empirical Analyses
The second body of material will include estimates of parameter values, tests of hypotheses, etc.. As in most empirical research, results are subject to change as more people process more data in more ways. Each of the analyses will be described in sufficient detail so that the reader can at least get the sense of the methods used and the key results. Those who desire a deeper understanding should read the discussions provided under Principles and Techniques .

Computer Material

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Macro-Investment Analysis: Overview

This material includes programs, procedures, functions and spreadsheets designed to illustrate and implement key principles and techniques. Some of the material has also been used in the Empirical Analyses. Coverage is partial, at best, and there is no guarantee that the routines are efficient, elegant or always correct. The reader is invited to use them at his or her peril.

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Macro-Investment Analysis

Introduction
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Investment Approaches Financial Economics Models and Paradigms

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Investment Approaches

Investment Approaches

Contents:
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The Focus of this Work Other Investment Approaches

The Focus of this Work


This work has some attributes of an investments text, but it is by no means a traditional one in either form or substance. The difference in the former is obvious. The difference in the latter is reflected in the title, which is, at this writing, unique. All three components of the title are relevant. The focus is on techniques of analysis that can lead to sensible top-level (macro-) investment decisions. It is helpful to personalize some of the roles that will be of concern throughout this work. An Investor must ultimately select positions in various types of investment vehicles. In doing so, he or she can be assisted by an Analyst. Importantly, many of the investment vehicles used by investors are themselves packages of more fundamental positions -- packages provided by Investment Firms. In practice of course, these three roles are rarely divided neatly among individuals and organizations. Some Investors provide at least part of the analysis required for appropriate decisions. Many investment decisions are made by intermediaries, such as pension funds, endowment funds and the like, charged with acting in the interests of those who will ultimately be the beneficiaries of the investments undertaken. The staffs of such organizations often provide much of the analysis needed for appropriate decisions. Some Investment Firms provide analytic services for investors. And so on. Nonetheless, it is useful to consider as distinct the functions of Investor, Analyst, and Investment Firm. In essence, we concentrate on a multi-level approach to investing, with the Investor at the top level, assisted by the Analyst, a set of Investment Firms at a second level, and the securities of corporations at yet lower levels, as portrayed in the figure below.

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Investment Approaches

Such a multi-level approach to investing is found both among individual and institutional investors. Individuals utilize shares of publicly-available investment funds (such as those called mutual funds in the United States, unit trusts in the United Kingdom, investment companies in Japan, etc.) which in turn hold securities of individual corporations. Large institutional investors such as pension funds use commingled funds or separately managed accounts (provided by banks, investment management firms, insurance companies and the like) which serve much the same purpose. Both can also make use of many types of derivative securities (provided by banks, exchanges, investment banking firms, etc.), the values of which reflect the performance of major sectors of various capital markets. Macro-Investment Analyses are performed for individual investors by financial advisors, who either charge explicitly for such services ("for-fee Advisors") or are compensated implicitly via commissions received from Investment Firms for the sale of the latters' products. Investment brokers often serve the same function, either for a fee based on the assets managed (using so-called "wrap accounts") or for commissions based on the investments undertaken. Similar services are provided by insurance agents, private bankers, and others. Macro Investment Analyses are performed for institutional investors by investment consulting firms. Those who work primarily with pension funds are often called pension consultants. Most such firms charge fees that are independent of the particular investments undertaken. Not surprisingly, many of the techniques described in this work were initially developed by consulting firms for institutional investors with sufficiently large investments to justify the costs associated with sophisticated analytic methods and extensive data collection and analysis. However, the accumulation of substantial databases, advances in knowledge and decreases in computational and communications costs are making such procedures accessible economically to a much larger set of investors. At this writing, there is a world-wide trend to give individuals more control over the investment of funds designed to cover retirement expenses. This makes it imperative that ways be found to provide the advice that will make it possible for such investment decisions to be taken rationally. One way or another, the skills of the Analyst must be applied widely. Traditionally, investments texts have been directed to investors who plan to build portfolios of the securities of traditional corporations. However, in the real world such investors are becoming fewer and fewer. Increasingly, the construction of portfolios from corporate securities is an activity undertaken by Investment Firms whose goal
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Investment Approaches

is to provide components that may usefully be employed by Investors. The ultimate investor then focuses on finding an appropriate combination of such components, not on building an overall portfolio security by security. This work is designed to provide the analytic skills needed to aid such Investors. It is thus explicitly directed to the Analyst. However, knowledge of its contents should help Investors utilize and evaluate the services offered by Analysts. In addition, Investment Firms familiar with its contents should be able to design products that will better meet the needs of Investors. For emphasis, we will often capitalize Investor, Analyst and Investment Firm when used in the senses described above. This follows the legal tradition of using such notation to refer to previously "defined terms".

Other Investment Approaches


It is useful to contrast the multi-level approach to investments emphasized in this work with some alternatives. We present them roughly in the order in which they were introduced historically. In simple societies, there is little distinction between savings and investment. One saves by reducing present consumption. One invests in the hope of increasing future consumption. Thus the woodsman who spares a tree for another year reduces consumption in the present (a long warm night by the fire) in the hope of increasing it in the future (warmer and longer nights by the fire next year). The tree is a productive investment -- barring floods, lightning strikes, etc., there will be more wood next year than there is this year. In most societies, intermediary steps connect individuals' savings with productive investments. Such investments are usually undertaken by firms, using resources generated by the savings of individuals. In many cases governmental agencies perform roles similar to those of business firms. In our terminology, the individual who saves (defers consumption) is an Investor. To avoid confusion with Investment Firms, we will use the term Business to refer to a firm or governmental agency engaged in productive investment. Certainly the simplest (and no doubt earliest) form of investment is that in which each business is funded by one investor (or perhaps one family of investors). The figure below illustrates this, with I representing an Investor and B a Business.

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Investment Approaches

Note that our woodsman conforms to this structure, although the Business (tree) is not separately identified as such . While this simple form of investment provides the maximum possible incentive for the Investor to insure that the Business is run efficiently, it "puts all the Investor's eggs In one basket." It did not take long for Investors to realize that that some sort of risk-sharing could benefit all concerned. For example, at one time, each ship sent from London to bring back spices from the Orient was financed by one merchant. If the ship happened to sink, the investor lost everything. But if several merchants pooled their resources, with each taking partial interests in several ships, risk could be greatly reduced, with no diminution in overall expected return. Such pooling could be accomplished in a number of ways. One of the simpler procedures involved the issuance of "ownership shares" (not surprisingly), with each investor holding a diversified portfolio of shares in several ships. Considering each such ship a business, this is diagrammed below.

Note that such an arrangement has its drawbacks. Greater separation of ownership and control is required, and monitoring of the managers of the Businesses by owners (Investors) is more complex. Under such conditions it may be more difficult or costly to insure that management will act in ways that will best serve the interests of owners. In other words: a conflict may arise between efficient corporate governance and risk-sharing via diversification. In modern versions of such an arrangement, Businesses are often structured as limited liability corporations, with
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Investment Approaches

ownership claims represented by shares of corporate stock. While direct ownership of portfolios of shares of corporate stock can provide the benefits of diversification, it is not the only way to accomplish this. One alternative utilizes an intermediary Investment Firm. For example, such a firm can hold claims on Businesses, with Investors holding shares in the Investment Firm. The traditional role of banks -- gathering deposits and lending money to business -- conforms to this model, at least in part. A less complex example is provided by a mutual fund that buys shares of stocks in corporations and issues shares representing proportional ownership of the resulting portfolio. Diagramatically:

In this case the problems associated with corporate governance are mitigated, since the Investment Firm is in a position to serve as the exclusive monitor of each of the Businesses. On the other hand, the division of ownership of the Investment Firm among many Investors may lessen incentives for the management of the Investment Firm to act solely in the interests of the Investors. Perhaps most important, the use of a financial intermediary can greatly reduce the required number of contractual arrangements. For example, if there were N investors and M businesses, direct investment with sufficient diversification might require N*M such arrangements. However, if one financial intermediary could provide all the needed diversification, only N+M contracts would be required. Schema involving financial intermediaries lie behind traditional taxonomies for classifying Businesses, Investment Firms, and Investors. Such entities differ primarily in their use of securities. The next figure shows this in terms of representative balance sheets, with assets on the left and claims on assets on the right.

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Investment Approaches

Many cases are, of course, far more complex, involving other assets, liabilities, cross-holdings, etc.. In the traditional finance curriculum, corporate finance courses dealt with the problems and actions of businesses, financial institutions courses with those of financial institutions, and investments courses with those of Investors. However, in many economies, the lines are sufficiently blurred to call into question the desirability of such compartmentalization. Nonetheless, the taxonomy can serve to help differentiate functions, even though a given entity may provide more than one such function. The approach portrayed earlier, in which the Investment Firm serves as an intermediary, allows Investors to achieve the benefits of diversification, but does not allow them to fully adapt their investments to suit differing preferences for risk vis-- vis return, or differing attitudes towards the desirability of receiving return in different circumstances. Such goals can be accomplished in a number of ways. Most importantly, Businesses can issue claims with different priorities on underlying earnings. For example, a Business might borrow from (issue debt to) an Investment Firm and obtain the rest of its funds from holders of common stock, promising to give the latter whatever might be left over after making required debt payments. Investors could then allocate their money (to taste) between shares issued by the Investment Firm and shares (stock) issued by Businesses, as shown below.
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Investment Approaches

This approach allows investors to more efficiently attempt to maximize utility by choosing appropriate combinations of risk and return and the conditions under which returns are obtained. From a societal view, this allows for the allocation of risk among investors in the most efficient manner -- a task that can be greatly assisted by a well-developed set of financial instruments and institutions. In practice, of course, the situation is infinitely more complex than this. In advanced economies there are many different types of Investment Firms, and a given firm may offer more than one Investment Product. A typical product is likely to involve specialization in a particular domain of investments, with diversification across the investments within that domain. This makes it possible for many Investors to limit their holdings to such Investment Products. In effect, the Investor holds securities of operating businesses indirectly rather than directly, as shown here:

This is the model in which the Investor needs the tools of Macro-Investment Analysis. In such a world the investor must (1) select desirable Investment Products and (2) allocate funds among them. This can be portrayed in traditional accounting terms as follows:
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Investment Approaches

This type of Investor serves as the focal point for the analytic techniques described in this book. While generality can be obtained by simply defining securities issued by individual operating corporations as Investment Products, the key idea of the approach followed here is to change the focus from the selection of securities issued by Businesses to the selection of Investment Products (such as bank deposits, mutual fund shares, annuities, etc.) issued by Investment Firms (banks, mutual fund companies, insurance companies, and the like). As will be seen, analyzing the characteristics of a complex Investment Product requires specialized techniques not needed when investors follow the approach assumed in the typical investments textbook.

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Financial Economics

Financial Economics

Macro Investment Analysis is part of the field generally known as Financial Economics, which is, in turn, a specialty within the broader field of Economics. To provide a context for what will follow, it is useful to consider (if only briefly) the domain of the financial economist. One of the fundamental aspects of economic activity is a trade in which one party provides another party something, in return for which the second party provides the first something else. In many such trades, or transactions, one or both parties are human beings. If Mr. A gives Ms. B an orange and Ms. B gives Mr. A two apples, it is a trade between two people. In other cases, only one is a human being. If a fisherman throws a fish back in the water to get more fish a year hence, it is a trade between a person and nature. Often the first type of trade is called an exchange, while the second is called production. Economists generally (but not always) concern themselves with exchanges in which one of the items traded is money. To facilitate trade, most societies establish a convention in which a particular item serves as numeraire. Thus if dollars serve as money, one typically trades oranges for apples by (1) trading oranges for dollars ("selling oranges"), then (2) trading dollars for apples ("buying apples"). The terms of the first trade (e.g. $1 for 1 orange) determine the price of an orange (e.g. $1); the terms of the second trade (e.g. $0.50 for one apple) determine the price of an apple (e.g. $0.50). Together, these prices determine the terms of trade for an exchange of oranges for apples (e.g. 1 orange for 2 apples). The use of money greatly simplifies trading, thus lowering transactions costs. If a society produces 100 different goods, there are 4,950 different possible "good-for-good" trades ([100x100-100]/2). With money, only 100 prices are needed to establish all possible trading ratios. Traditional economics focuses on exchanges in which money is one, but only one, of the items traded. Financial economics concentrates on exchanges in which money of one type or another is likely to appear on both sides of a trade. In a single society with only one form of money, there would be no role for financial economics were it not for time and uncertainty. In fact, however, both of these aspects are crucial elements in the lives of individuals and economies. Many decisions involve trading money now for money in the future. Such trades, be they between people or with nature, fall in the domain of financial economics. In many such cases, the amount of money to be transferred in the future is uncertain. Financial
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Financial Economics

economists thus deal with both time and uncertainty. Often the latter is called risk. In many situations, agreements allow one party to make decisions at later times that can affect subsequent transfers of money. Thus financial economists deal with contracts involving options. Often, information can reduce or possibly eliminate the uncertainty associated with future outcomes. Thus financial economists study the impact of information on trades involving money. In sum, the financial economist can be distinguished from more traditional economists by his or her concentration on monetary activities in which time, uncertainty, options and/or information play roles. Not surprisingly, Macro Investment Analysis requires careful attention to all four of these key elements.

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Models and Paradigms

Models and Paradigms

Contents:
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Models Paradigms Plan of the Work

Models
In this work, we develop models designed to enable the Analyst to better counsel an Investor. Before embarking on this task, it is useful to consider the role of theory in practical affairs. This work is concerned with theory. To understand a complex financial economy, one must begin with a simple one. All economic theory uses abstraction. Key elements of a process are investigated in the hope that resulting implications will help illuminate the issues being addressed. In effect, the financial economist builds a simplified model to help answer one or more questions. Not surprisingly, different questions may be addressed most effectively with different models. Financial economics is concerned with the terms under which financial trades take place. Determining such terms is often called valuation. Financial economics is concerned with both the trades that people do make and those that they should make. Valuation and analysis of trades that are made fall in the domain of positive financial economics (analysis of what is). Analysis of trades that people should make falls in the domain of normative financial economics (analysis of what should be). The ultimate test of a positive model is the consistency with reality of its implications concerning the questions asked. The ultimate test of a normative model is its ability to provide better outcomes in the areas for which it is intended. Often financial economists assume that people make trades optimally, given certain assumed objectives. The implications of such behavior are then examined. In such cases, normative financial economics provides a base for positive financial economics. It is useful to analyze situations in which (1) trades can be made without any cost and (2) a specific body
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Models and Paradigms

of information is known to all members of a society. In such a world, there are no transactions costs and anyone can swap X for Y on the same terms as he or she can swap Y for X. In the real world, this is rarely the case. Consider foreign exchange. One might be able to buy 1 franc for $0.21 but sell 1 franc for only $0.19. A currency dealer covers costs by bidding only $0.19 for a franc but asking $0.21. The bid-ask spread represents the cost of transacting. The average of the bid and ask prices (e.g. $0.20) approximates the price that might prevail in an idealized (transactions cost-free) world. Financial institutions provide transactions services, broadly construed. To do business, such an institution must find a way to arrange a set of trades more efficiently than can those with whom it does business. To compete effectively, an institution must also do this at least as efficiently as other institutions. Were there no transactions costs, there would be no financial institutions. Advances in communications, computation, and financial economics have greatly increased the competition among such institutions and provided accompanying decreases in transactions costs.

Paradigms
It would be convenient if every investment problem could best be analyzed with a model derived from a single overarching paradigm (pattern). For some issues, one paradigm will prove more practical; for other issues, another. One useful classification of paradigms used in financial economics identifies major types, based on the treatment of time and outcomes. For each of these elements, one may consider discrete alternatives or a continuum of possibilities. The most straightforward approach treats time and outcomes as discrete. For example, one identifies time period 0 (today), time period 1 (e.g. next year), time period 2 (two years hence), etc.. Each time period is associated with a limited number of possible outcomes. For example, good weather and bad weather; stocks rise 10%, rise 5%, fall 5%, fall 10%, etc.. The discrete time, discrete outcome approach is often termed the time-state paradigm or the Arrow- Debreu paradigm, after the two Nobel prize-winning authors who developed its basic characteristics. A second approach retains the notion of discrete time, but treats outcomes as continuous. For example, at time 1 the stock market might be assumed to return any amount between -50% and +100%, with any intermediate value (such as 10.34123%) possible. To make such an approach feasible, Analysts generally characterize prospective outcomes using probability distributions. Thus the stock market might be assumed to offer a return characterized by a normal (bell-shaped) distribution with an expected value (mean) of 11% and a likely range (standard deviation) of 15%. Related to the standard deviation measure of risk is its square, the variance. The discrete time, continuous outcome approach is often termed the mean-variance paradigm or the Markowitz paradigm after the Nobel prize-winning author who proposed

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it and showed how it could be used in the investment process. A combination involving continuous time and discrete outcomes makes little sense and hence is not utilized. However, considerable work in financial economics has utilized models in which both time and outcomes are assumed to be continuous. This is generally known as the continuous time paradigm. In practice, the mean-variance approach is widely used in applications involving investment portfolios, and the continuous time approach in applications involving derivative contracts. Procedures deriving from the time-state approach are also widely used for the analyses of derivatives. Continuous-time models are of substantial importance in financial economics, and especially so in theoretical work. However, the mathematical sophistication required for a full understanding of this approach is substantial. Fortunately, most of the key economic aspects of issues relevant to Investors can be understood as well or better using one or both of the alternative paradigms. From the viewpoint of the Analyst, the continuous time formulas of practical relevance can generally be regarded as limiting cases of related time-state formulations in which the number of time periods becomes very large and the length of each period very small; we generally present them as such, without detailed discussion of the limiting process. The time-state paradigm provides considerable generality, yet its understanding requires little in the way of mathematical sophistication. We rely on it heavily when establishing principles concerning the key economic relationships that should be fully understood by the Analyst. The mean-variance paradigm is more limited in scope, but is well-suited for applications in which numeric values must be estimated in order for investment decisions to be made appropriately. Accordingly, we will devote a great deal of attention to it as well. Philosophically, one may consider mean-variance approaches as special cases of time-state approaches in which the number of possible states of the world is very large and can only be practically dealt with using summary measures based on probabilities. Given this view, it is important to begin with time-state formulations, then move to mean-variance approaches.

Plan of the Work


Skillful Macro Investment Analysis requires an understanding of many aspects of Financial Economics and an ability to apply a wide range of techniques. Organization of the requisite body of material is not a simple task. We have chosen an arrangement built on major themes, with an understanding that the reader who fails to proceed in sequence does so at his or her peril. The title of each section is deceptively short -- an alternative that seems preferable to the usual long list
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of subjects separated by the usual sets of colons and semicolons. Be forewarned, however, that subjects often appear in unexpected places and that some issues are treated in increasing detail in two or more places.

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Macro-Investment Analysis

Matrices and Programming


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Matrices Matrix Operations MATLAB Excel Asset Allocation with Investment Funds

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Matrices

Matrices

Contents:
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Matrix Algebra Vectors Matrices

Matrix Algebra
Finance lends itself well to calculations that use matrix algebra To oversimplify, this term refers to computations that involve vectors (rows or columns of numbers) and matrices (tables of numbers), as wells as scalars (single numbers). In a great many cases, the simplest way to describe a set of relationships uses matrix algebra. Moreover, key calculations that the Analyst should perform routinely are best made with matrix operations. For this exposition of matrix operations, we rely to a considerable extent on the specifications of MATLAB -- a computer program designed to efficiently perform matrix calculations. This has the very large added advantage that the computations can in fact be performed directly by anyone with access to the MATLAB system. Since MATLAB provides such an ideal environment for our purposes, we describe it in a later section in considerable detail. For those who wish to use a more familiar spreadsheet environment for computations, we also describe ways in which matrix operations can be performed in Microsoft Excel, although in considerably less detail.

Vectors
A vector is either a row or a column of numbers. In either case, its dimension is described by giving the number of rows first, followed by the number of columns. For example, consider p, a row vector with the prices of two assets (say a bond and a stock): p = 54 21

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Matrices

Vector p is {1*2} (pronounced "1 by 2"), since it has one row and two columns. If prices are stated in dollars, the vector's current values indicate that one bond costs $54 and one stock costs $21. Vector p can be said to be a "two-element row vector". Similarly, consider n, a column vector with the number of shares of each of the securities: n = 1 2 Vector n is {2*1}. It indicates that the investor's portfolio contains one bond and two stocks. It can be said to be a "two-element column vector".

Matrices
A matrix is a table of numbers. Within text passages, it is conventional to denote them with bold letters. For example, consider D, a matrix of the prices of the securities on three days of the week : D = 54 55 56 21 18 27

Matrix D is {3*2}. As before, the number of rows is given first, followed by the number of columns. D shows that on the first day, the bond was worth $54 and the stock was worth $21. On the second day the bond was worth $55 and the stock $18. On the third day the bond was worth $56 and the stock $27. In many ways, the use of the term vector is redundant. One may view a row vector as simply a {1*c} matrix, where c is the number of columns, and a column vector as simply an {r*1} matrix, where r is the number of rows. A very special case is that of a {1*1} matrix -- i.e. a single number. This is often termed a scalar. In general, we will use the term matrix in its most general form, to include full matrices, vectors and scalars. Matrix operations are generally defined to include cases in which some or all matrices are vectors or even scalars. The terms vector and scalar are useful primarily for communicating information about the dimensionality of certain matrices. While matrices are generally composed solely of numeric values, it is often desirable to think of them as the "insides" of tables which include identifying information in the borders. Thus, matrix D might comprise the values from the following table:
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Matrices

Mon Tue Wed

Bond Stock 54 21 55 18 56 27

Occasionally we will use the term "Table X" to refer to matrix X with identifying information appended on the left and top borders. From time to time, we will use notation such as {days*assets} to identify not only the size of the matrix (number of days by number of assets) but also the nature of the information. Thus each element of D contains a price for the day given by its row and the asset given by its column. This "curly bracket" notation is decidedly non-standard, but its use can serve as an aid to understanding. In many cases it can also help avoid serious errors. In some cases we will append the description to the matrix name, as in: D{days*assets} Note, however, that programming systems such as MATLAB or Excel would either be confused or complain if asked to process such a description. The added information is strictly for human use. Mathematicians generally use single letters to represent matrices, vectors and scalars. Moreover, they often follow a convention that uses lower-case regular fonts for scalars, lower-case bold fonts for vectors, and upper-case bold fonts for full matrices, as we have done in the text above and will sometimes do in subsequent text passages. In other cases we will use descriptive names for matrices. In program segments, only a regular (computer-like) font will be used, since programming languages do not distinguish among fonts.

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Matrix Operations

Matrix Operations

Contents:
q q q q q q q q

Matrix Multiplication Matrix Addition Matrix Subtraction Other Element-by-element Operations Matrix Inverstion Solving Simultaneous Linear Equations The Transpose of a Matrix Multiple Operations

Matrix Multiplication
A key matrix operation is that of multiplication.

The product of two vectors


Consider the task of portfolio valuation. This requires the multiplication of the number of shares of each security by the corresponding price per share, then the summation of the results. A simple matrix operation can accomplish this easily. Suppose that: price {1*assets} = 54 21 quantity {assets*1} = 1 2 Let value be the product of price and quantity: value = price*quantity

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In this case:

value = 96 To compute the value, one multiplies matrix (here, vector) price by matrix (here, vector) quantity. To understand this process, it is useful to represent each number by a symbol: price = p1 quantity = n1 n2 value = p1*n1 + p2*n2 The first number in price is multiplied by the first number in quantity, then the second number in price is multiplied by the second number in quantity. The process continues until the end is reached, at which time all the products are summed. Rather clearly, this cannot be done unless the number of columns in the first matrix equals the number of rows in the second. Put somewhat differently, the inner dimensions of the two matrices must be the same. This is always required in matrix multiplication and should be checked in advance. Here: price {1*assets} *quantity {assets*1} ===> value {1*1} Note that the information in the curly brackets verifies that the multiplication can take place, since the inner dimensions are the same (assets). Such information also indicates the dimensions of the answer, which is given by the outer dimensions (here: 1 by 1). In general, the product obtained by multiplying two matrices will have the same number of rows as the first matrix, and the same number of columns as the second. For example: {2*3} times {3*5} ==> {2*5} {3*2} times {2*4} ==> {3*4} {1*2} times {2*1} ==> {1*1} The last case is the one in the example. More generally, multiplying a row vector times a column vector always produces a scalar.
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p2

Matrix Operations

To repeat, it is good practice (and often necessary) to think about the dimension of an answer before performing any matrix multiplication. When doing so, one can also check to make certain that the inner dimensions are the same, as is required. The general scheme is: {a*b} times {b*c} will produce {a*c}

The product of a matrix and a vector


When one or more of the matrices to be multiplied is a table, the process is simply one of repeated vector multiplications. Consider, for example, the determination of the value of a portfolio on three different days (Monday, Tuesday, Wednesday): Here, there are three sets of prices. The Price Table is: Bond Mon 54 Tue 55 Wed 56 Stock 21 18 27

while the Price Matrix is: 54 55 56 21 18 27

The dimensions of Price are {days*assets} -- in this case, {3*2}. Now, consider multiplication of Price times quantity, to obtain value: Price {days*assets} *quantity {assets*1} ===> value {days*1} Given the quantity vector q: Bond Stock 1 2

The result is the column vector: 96 91


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110 The first number in the result value is obtained by multiplying the vector in the top row of matrix Price by the column vector quantity, giving the same result as before. The second number in the result is obtained by multiplying the vector in the second row of matrix Price by the column vector quantity, and so on. Using symbols: Price = p11 p21 p31 quantity = n1 n2 value = p11*n1 + p12*n2 p21*n1 + p22*n2 p31*n1 + p32*n2 Recall that value is {days*1}. Hence, the associated table is: Mon Tue Wed 96 91 110 p12 p22 p32

The value of the portfolio was $96 on Monday, $91 on Tuesday, and $110 on Wednesday.

The product of two matrices


When two tables are multiplied, the process is simply expanded, with each column of the result obtained by using the corresponding column of the second matrix. For example, consider the task of finding the values of two portfolios on each of three days. In this case, Quantity is itself a matrix. In table form: PortA PortB Bond 1 5 Stock 2 2 In matrix form:

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1 2

5 2

The product is a matrix showing the value of each portfolio on each of the three days: Price {days*assets} *quantity {assets*portfolios} ===> Value {days*portfolios} In table form: PortA Mon 96 Tue 91 Wed 110 PortB 312 311 334

Matrix Addition
The sum of two matrices
If two matrices have the same dimensions, they may be added together. The result is a new matrix with the same dimensions in which each element is the sum of the corresponding elements of the previous matrices. For example, consider the following tables: portA: Bond Stock portB: Bond Stock 5 2 1 2

To find the total amounts held in the two portfolios, simply add the corresponding matrices: portAll = portA + portB In table form: portAll: Bond Stock

6 4

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The sum of a matrix and a scalar


It is also possible to add a constant to every element in a matrix. For example: portPlus = portAll + 5 Gives:

portPlus: Bond Stock

11 9

Matrix Subtraction
Matrix subtraction is like addition. Each element of one matrix is subtracted from the corresponding element of the other. If a scalar is subtracted from a matrix, the former is subtracted from every element of the latter. For example: portA: Bond Stock portB: Bond Stock 5 2 1 2

portB - portA: Bond 4 Stock 0 portB - 1: Bond Stock

4 1

Other Element-by-element Operations


Addition and subtraction of matrices operate on an element-by-element basis. In some cases it is desirable to perform multiplication, division or exponentiation in the same manner. We follow the MATLAB conventions, preceding the relevant operator with a dot (period) to indicate that such an element-by-element operation is desired.
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Element-by-element operations with matrices


Here are examples involving vectors: portA: Bond Stock portB: Bond Stock

1 2

5 2

portA .* portB: Bond 5 Stock 4 portA ./ portB: Bond 0.2 Stock 1.0 portB .^ portA: Bond 5 Stock 4

Element-by-element operations with a matrix and a scalar


Element-by-element operations can also be performed with a matrix and a scalar. For example: portA .* 5: Bond Stock portA ./ 5: Bond Stock portA .^ 3: Bond Stock

5 10

0.2 0.4

1 8

Matrix Inversion
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Thus far, we have not discussed matrix division; only array division. There is a matrix construct similar to that of division, and it is central to much of the work of the Analyst. The key ingredient is the use of the inverse of a matrix, to which we now turn. First, a few preliminaries. A square matrix has the same number of rows and columns. An identity matrix is a square matrix with ones on the diagonal from upper left to lower right and zeros elsewhere. For example: I = 1 0 0 0 1 0 0 0 1 Such a matrix is often denoted I. The product of an identity matrix (of the right size) and a column vector is the column vector, as can be seen by applying the rules for matrix multiplication. Thus, if: v = 3 4 5 I*v ==> v (read: I times v gives v). More generally, the product of any matrix M and an identity matrix with the same number of columns as M will be the original matrix: I*M ==> M as can be seen by working through the operations involved in matrix multiplication. The inverse of a square matrix is a matrix of the same size that, when multiplied by the matrix, gives an identity matrix of the same size. The inverse of a matrix is sometimes written with a "-1" superscript. We use instead the more computer-friendly MATLAB form: inv(M)

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where M is a square matrix. By definition: inv(M)*M = I Note that only square matrices can have inverses (although not all do). To see why matrix inversion is similar to division, consider a {1*1} matrix -- i.e. a scalar -- with a value of 5. The identity matrix of the same size will also be a scalar, in this case the single value 1. From this it follows that the inverse of the original matrix (scalar) will be the reciprocal of its value. Thus: (1/5)*5 = 1 Multiplication by the inverse of a matrix is like dividing by the matrix, except this is strictly true only if the matrix is {1*1}.

Solving Simultaneous Linear Equations


Matrix inversion is often used to solve a set of simultaneous linear equations. Consider a situation in which there are two states of the world ("weather is good", "weather is bad") and two securities (Bond, Stock). Matrix Payoff {states*assets} shows the payments made by each security in each state of the world. Vector quantity {assets*1} shows the composition of a portfolio. Vector result {states*1} shows the payments that will be received from the portfolio in each possible state of the world. Below, we show all three in table form: Payoff: good bad quantity: Bond Stock 1 2 Bond Stock 60 40 60 10

result = Payoff*quantity: good 140 bad 80 Thus the portfolio will provide $140 if the weather is good. If the weather is bad it will only provide $80.

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Now, assume that an investor would like to receive $240 if the weather is good and $150 if the weather is bad. The problem is to determine the portfolio (quantity) that will produce the desired payment vector. Consider the equation for the computation: Payoff*quantity = result Note that Payoff is square, so it is possible to compute its inverse, barring complications to be discussed later. We multiply both sides of the equation by this inverse (a "legal" matrix operation): inv(Payoff)*Payoff*quantity = inv(Payoff)*result But the product of the inverse and the original matrix is the identity matrix, so: I*quantity = inv(Payoff)*result But the product of an identity matrix and a vector is the vector. Thus: quantity = inv(Payoff)*result This is precisely what we want -- an equation for a portfolio (quantity) that will provide the desired set of cash flows (result)! The three components are shown below, with the resulting values shown in bold: result: good bad

240 150

inv(Payoff): -0.0056 0.0333 quantity: Bond Stock

0.0222 -0.0333

2 3

Thus the desired result can be achieved with a portfolio of 2 bonds and 3 stocks. Any set of simultaneous linear equations for which there is a solution can be solved in this manner. It may seem that the requirement that the matrix of coefficients be square is overly restrictive. However, to solve a set of such equations requires precisely as many equations as there are unknowns, so the matrix
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of "left-hand sides" (here, Payoff) must have as many rows (equations) as it does columns (variables). Unfortunately, sometimes this won't work. It is impossible to take the inverse of some matrices, even though they are square. In such cases the matrix in question is said to be singular. In typical investment applications this will occur when a strategy is not truly independent and can be provided with some combination of other included strategies. When this occurs, the programming system being used is likely to complain that it cannot take the needed inverse because the matrix in question is singular (or very nearly so). This is a signal that the economics of the original problem formulation need to be reexamined.

The Transpose of a Matrix


It is not unusual to find that a matrix is the "wrong way around" for a needed calculation. More precisely, its rows should be columns and its columns should be rows. Happily, there is a standard operation that "turns around" a matrix (or vector). The transpose of a matrix is, in effect, the matrix rotated in this manner. For example, if M is: 1 2 3 4 5 6 then M' (read: M-prime or M-transpose) is: 1 4 2 5 3 6 This is sometimes denoted by appending a "T" as a superscript after M , but we will use the MATLAB version M'.

Multiple Operations
To facilitate exposition, we have generally restricted our examples to one matrix or array operation. Sometimes we have put the result on the left; and sometimes on the right. Moreover, we have used an arrow when it appeared useful and an equality sign at other times. When writing commands to be executed by a programming system, of course, rather strict rules of syntax must be followed. Generally, the result must be written first, followed by an equality sign, followed by an expression indicating the desired computations. Such expressions can include multiple matrix and/or array operations, if desired. For example:

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D = inv(A)*(b*c) This would be perfectly legal if the dimensions of A, b and c were appropriate. The sense of the equality sign is that of assignment. Thus the statement really says: "D should be assigned the result obtained by multiplying the inverse of A times the product of b and c." Statements such as this, which are designed to be operated on by a programming system, are generally written without bold fonts, since such subtleties would be lost on the processor, even if they could be presented to it.

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MATLAB

MATLAB

Contents:
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Introduction MATLAB Versions Matrices as Fundamental Objects Matrix Operations Assignment Statements Case Sensitivity Immediate and Deferred Execution Showing Values Initializing Matrices Making Matrices from Matrices Using Portions of Matrices Text Strings Matrix and Array Operations Using Functions Logical and Relational Operations on Matrices Sorting Matrices Controlling Execution Flow Writing Functions Comments and Help Data Input and Output MATLAB Function Library

Introduction
MATLAB stands for Matrix Laboratory. According to The Mathworks, its producer, it is a "technical computing environment". We will take the more mundane view that it is a programming language. This section covers much of the language, but by no means all. We aspire to at the least to promote a

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reasonable proficiency in reading procedures that we will write in the language but choose to address this material to those who wish to use our procedures and write their own programs.

MATLAB Versions
Versions of MATLAB are available for almost all major computing platforms. Our material was produced and tested on the version designed for the Microsoft Windows environment. The vast majority of it should work with other versions, but no guarantees can be offered. Of particular interest are the Student Versions of MATLAB. Prices are generally below $100. These systems include most of the features of the language, but no matrix can have more than 8,192 elements, with either the number of rows or columns limited to 32. For many applications this proves to be of no consequence. At the very least, one can use a student version to experiment with the language. The Student Editions are sold as books with disks enclosed. They are published by Prentice-Hall and can be ordered through bookstores. In addition to the MATLAB system itself, Mathworks offers sets of Toolboxes, containing MATLAB functions for solving a number of important types of problems. Of particular interest to us is the optimization toolbox, which will be discussed in a later section.

Matrices as Fundamental Objects


MATLAB is one of a few languages in which each variable is a matrix (broadly construed) and "knows" how big it is. Moreover, the fundamental operators (e.g. addition, multiplication) are programmed to deal with matrices when required. And the MATLAB environment handles much of the bothersome housekeeping that makes all this possible. Since so many of the procedures required for MacroInvestment Analysis involve matrices, MATLAB proves to be an extremely efficient language for both communication and implementation.

Matrix Operations
Consider the following MATLAB expression: C = A + B If both A and B are scalars (1 by 1 matrices), C will be a scalar equal to their sum. If A and B are row vectors of identical length, C will be a row vector of the same length, with each element equal to the sum of the corresponding elements of A and B. Finally, if A and B are, say, {3*4} matrices, so will C, with each element equal to the sum of the corresponding elements of A and B.
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In short the symbol "+" means "perform a matrix addition". But what if A and B are of incompatible sizes? Not surprisingly, MATLAB will complain with a statement such as: ??? Error using ==> + Matrix dimensions must agree. So the symbol "+" means "perform a matrix addition if you can and let me know if you can't".

Assignment Statements
MATLAB uses a pattern common in many programming languages for assigning the value of an expression to a variable. The variable name is placed on the left of an equal sign and the expression on the right. The expression is evaluated and the result assigned to the variable name. In MATLAB, there is no need to declare a variable before assigning a value to it. If a variable has previously been assigned a value, the new value overrides the predecessor. This may sound obvious, but consider that the term "value" now includes information concerning the size of matrix as well as its contents. Thus if A and B are of size {20*30} the statement: C = A + B Creates a variable named C that is also {20*30} and fills it with the appropriate values. If C already existed and was, say {20*15} it would be replaced with the required {20*30} matrix. In MATLAB, unlike some languages, there is no need to "pre-dimension" or "re-dimension" variables. It all happens without any explicit action on the part of the user.

Case Sensitivity
MATLAB variable names are normally case-sensitive. Thus variable C is different from variable c. A variable name can have up to 19 characters, including letters, numbers and underscores. While it is tempting to use names such as FundReturns it is safer to choose instead fund_returns or to use the convention from the C language of capitalizing only second and subsequent words, as in fundReturns. In any event, a\Adopt a simple set of naming conventions so that you won't write one version of a name in one place and another later. If you do so, you may get lucky (e.g. the system will complain that you have asked for the value of an undefined variable) or you may not (e.g. you will assign the new value to a newly-created variable instead of the old one desired). In programming languages there are always tradeoffs. You don't have to declare variables in advance in MATLAB. This avoids a great deal of effort, but it allows nasty, difficult-to-detect errors to creep into your programs.

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Immediate and Deferred Execution


When MATLAB is invoked, the user is presented with an interactive environment. Enter a statement, press the carriage return ("ENTER") and the statement is immediately executed. Given the power that can be packed into one MATLAB statement, this is no small accomplishment. However, for many purposes it is desirable to store a set of MATLAB statements for use when needed. The simplest form of this approach is the creation of a script file: a set of commands in a file with a name ending in .m (e.g. do_it.m). Once such a file exists and is stored on disk in a directory that MATLAB knows about (i.e. one on the "MATLAB path"), the user can simply type: do_it at the prompt in interactive mode. The statements will then be executed. Even more powerful is the function file; this is also a file with an .m extension, but one that stores a function. For example, assume that the file val_port.m, stored in an appropriate directory, contains a function to produce the value of a portfolio, given a vector of holdings and a vector of prices. In interactive mode, one can then simply type: v = val_port(holdings, prices); MATLAB will realize that it doesn't have a built-in function named val_port and search the relevant directories for a file named val_port.m, then use the function contained in it. Whenever possible, you should try to create "m-files" to do your work, since they can easily be re-used.

Showing Values
If at any time you wish to see the contents of a variable, just type its name. MATLAB will do its best, although the result may take some space if the variable is a large matrix. MATLAB likes to do this and will tell you what it has produced after an assignment statement unless you request otherwise. Thus if you type: C = A + B MATLAB will show you the value of C. This may be a bit daunting if C is, say, a 20 by 30 matrix. To
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surpress this, put a semicolon at the end of any assignment statement. For example: C = A + B;

Initializing Matrices
If a matrix is small enough, one can provide initial values by simply typing them in. For example: a b c d = = = = 3; [ 1 2 3]; [ 4 ; 5 ; 6]; [ 1 2 3 ; 4 5 6];

Here, a is a scalar, b is a {1*3} row vector, c a {3*1} column vector, and d is a {2*3} matrix. Thus, typing "d" produces: d = 1 4 2 5 3 6

The system for indicating matrix contents is very simple. Values separated by spaces are to be on the same row; those separated by semicolons are on to be on separate rows. All values are enclosed in square brackets.

Making Matrices from Matrices


The general scheme for initializing matrices can be extended to include matrices as components. For example: a = [1 2 3]; b = [4 5 6]; c = [a b]; gives: c = 1 While: 2 3 4 5 6

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d = [a ; b] gives: d = 1 4 2 5 3 6

Matrices can easily be "pasted" together in this manner -- a process that is both simple and easily understood by anyone reading a procedure (including its author). Of course, the sizes of the matrices must be compatible. If they are not, MATLAB will tell you.

Using Portions of Matrices


Frequently one wishes to reference only a portion of a matrix. MATLAB provides simple and powerful ways to do so. To reference a part of a matrix, give the matrix name followed by parentheses with expressions indicating the portion desired. The simplest case arises when only one element is wanted. For example, using d in the previous section: d(1,2) equals 2 d(2,1) equals 4 In every case the first parenthesized expression indicates the row (or rows), while the second expression indicates the column (or columns). If a matrix is, in fact, a vector, a single expression may be given to indicate the desired element, but it is often wise to give both row and column information explicitly, even in such cases. MATLAB's real power comes into play when more than a single element of a matrix is wanted. To indicate "all the rows" use a colon for the first expression. To indicate "all the columns", use a colon for the second expression. Thus, with: d = 1 4 2 5 3 6

d(1,:) equals 1 2 d(:,2) equals

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2 5 In fact, you may use any expression in this manner as long as it evaluates to a vector of valid row or column numbers. For example: d(2,[2 3]) equals 5 6 d(2, [3 2]) equals 6 5 Variables may also be used as "subscripts". Thus: if z = [2 3] then d(2,z) equals 5 6 Particularly useful in this context (and others) is the construct that uses a colon to produce a string of consecutive integers. For example: the statement: x = 3:5 produces x = 3 Thus: d(1, 1:2) equals 1 2

Text Strings
MATLAB is wonderful with numbers. It deals with text but you can tell that its heart isn't in it. A variable in MATLAB is one of two types: numeric or string. A string matrix is like any other, except the elements in it are interpreted asASCII numbers. Thus the number 32 represents a space, the number 65 a capital A, etc.. To create a string variable, enclose a string of characters in "single" quotation marks (actually, apostrophes), thus:
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stg = 'This is a string'; Since a string variable is in fact a row vector of numbers, it is possible to create a list of strings by creating a matrix in which each row is a separate string. As with all standard matrices, the rows must be of the same length. Thus: the statement x = ['ab' ; 'cd'] produces: x = ab cd while x = ['ab' 'cd'] produces: x = abcd as always.

Matrix and Array Operations


The Mathworks uses the term matrix operation to refer to standard procedures such as matrix multiplication. The term array operation is reserved for element-by-element computations.

Matrix Operations
Matrix transposition is as easy as adding a prime (apostrophe) to the name of the matrix. Thus: if: x = 1 2 3 then: x' = 1 2 3 To add two matrices of the same size, use the plus (+) sign. To subtract one matrix from another of the same size, use a minus (-) sign. If a matrix needs to be "turned around" to conform, use its transpose.

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Thus, if A is {3*4} and B is {4*3}, the statement: C = A + B will get you the message: ??? Error using ==> + Matrix dimensions must agree. while: C = A + B' will get you a new matrix. There is one case in which addition or subtraction works when the components are of different sizes. If one is a scalar, it is added to or subtracted from all the elements in the other. Matrix multiplication is indicated by an asterisk (*), commonly regarded in programming languages as a "times sign". With one exception the usual rules apply: the inner dimensions of the two operands must be the same. If they are not, you will be told so. The one allowed exception covers the case in which one of the components is a scalar. In this instance, the scalar value is multiplied by every element in the matrix, resulting in a new matrix of the same size. MATLAB provides two notations for "matrix division" that provide rapid solutions to simultaneous equation or linear regression problems. They are better discussed in the context of such problems.

Array Operations
To indicate an array (element-by-element) operation, precede a standard operator with a period (dot). Thus: if x = 1 and y = 4 5 6 then: x.*y = 4 10 18 the "dot product" of x and y. 2 3

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You may divide all the elements in one matrix by the corresponding elements in another, producing a matrix of the same size, as in: C = A ./ B In each case, one of the operands may be a scalar. This proves handy when you wish to raise all the elements in a matrix to a power. For example: if x = 1 then: x.^2 = 1 2 3

MATLAB array operations include multiplication (.*), division (./) and exponentiation (.^). Array addition and subtraction are not needed (and in fact are not allowed), since they would simply duplicate the operations of matrix addition and subtraction.

Using Functions
MATLAB has a number of built-in functions -- many of which are very powerful. Some provide one (matrix) answer; others provide two or more. You may use any function in an expression. If it returns one answer, that answer will be used. The sum function provides an example: if x = 1 2 3 the statement: =sum(x) + 10 produce: = 16

then y will y

Some functions, such as max provide more than one answer. If such a function is included in an expression, only the first answer will be used. For example:

if x =
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1 4 3 the statement: z = 10 + max(x) will produce: z = 14 To get all the answers from a function that provides more than one, use a multiple assignment statement in which the variables that are to receive the answers are listed to the left of the equal sign, enclosed in square brackets, and the function is on the right. For example:

if x = 1 4 3 the statement: [y n] = max(x) will produce: y = 4 n = 2 In this case, y is the maximum value in x, and n indicates the position in which it was found. Many of MATLAB's built-in functions, such as sum, min, max, and mean have natural interpretations when applied to a vector. If a matrix is given as an argument to such a function, its procedure is applied separately to each column, and a row vector of results returned. Thus: if x = 1 4 then : sum(x) = 5 2 5 3 6

Some functions provide no answers per se. For example, to plot a vector y against a vector x, simply use the statement: plot(x,y) which will produce the desired cross-plot.

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Note that in this case, two arguments (the items in the parentheses after the function name) were provided as inputs to the function. Each function needs a specific number of inputs. However, some have been programmed to react appropriately when fewer are given. For example, to plot y against (1,2,3...), you can use the statement: plot(y) There are many built-in functions in MATLAB. Among them, the following are particularly useful for Macro-Investment Analysis:
q

ones ones matrix zeros zeros matrix size size of a matrix diag diagonal elements of a matrix inv matrix inverse rand uniformly distributed random numbers randn normally distributed random numbers cumprod cumulative product of elements cumsum cumulative sum of elements max largest component min smallest component sum sum of elements mean average or mean value median median value std standard deviation sort sort in ascending order find

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find indices of nonzero entries corrcoef correlation coefficients cov covariance matrix

Not listed, but of great use, are the many functions that provide plots of data in either two or three dimensions, as well as a number of more specialized functions. However, this list should serve to whet the Analyst's appetite. The full list of functions and information on each one can be obtained via MATLAB's on-line help system.

Logical and Relational Operations on Matrices


MATLAB offers six relational operators:
q q q q q q

< : less than <= : less than or equal to > : greater than >= : greater than or equal to == : equal ~= : not equal

Note carefully the difference between the double equality and the single equality. Thus A==B should be read "A is equal to B", while A=B should be read "A should be assigned the value of B". The former is a logical relation, the latter an assignment statement. Whenever MATLAB encounters a relational operator, it produces a one if the expression is true and a zero if the expression is false. Thus: the statement: x = 1 < 3 produces: x=1, while x = 1 > 3 produces: x=0 Relational operators can be used on matrices, as long as they are of the same size. Operations are performed element-by-element, resulting a matrix with ones in positions for which the relation was true and zeros in positions for which the relation was false. Thus: if A = 1 3 and B = 2 4

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3 1 2 2 the statement: C = A > B produces: C = 0 1 1 1 One or both of the operands connected by a relational operator can be a scalar. Thus: if A = 1 2 3 4 the statement: C = A > 2 produces: C = 0 0 1 1 One may also use logical operators of which there are three:
q q q

& : and | : or ~ : not

Each works with matrices on an element-by-element basis and conforms to the ordinary rules of logic, treating any non-zero element as true and any zero element as false. Relational and logical operators are used frequently with If statements (described below) and scalar variables, as in more mundane programming languages. But the ability to use them with matrices offers major advantages in some Investment applications.

Sorting Matrices
To sort a matrix in ascending order, use the sort function. If the argument is a vector, the result will be a new vector with the items in the desired order. If it is a matrix, the result will be a new matrix in which each column will contain the contents of the corresponding column from the old matrix, in ascending order. Note that in the latter case, each column is, in effect, sorted separately. Thus:

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if x = 1 5 3 2 2 8 the statement: y=sort(x) will produce: y = 1 2 2 5 3 8 To obtain a record of the rows from which each of the sorted elements came, use a multiple assignment to get the second output of the function. For the case above: the statement: [y r] = sort(x) would produce y as before and r = 1 2 3 1 2 3 Thus the second item in the sorted list in column 1 came from row 3, etc..

Controlling Execution Flow


It is possible to do a great deal in MATLAB by simply executing statements involving matrix expressions, one after the other, However, there are cases in which one simply must substitute some nonsequential order. To facilitate this, MATLAB provides three relatively standard methods for controlling program flow: For Loops, While Loops, and If statements

For Loops
The most common use of a For Loop arises when a set of statements is to be repeated a fixed number of times, as in: for j= 1:n ....... end

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There are fancier ways to use For Loops, but for our purposes, the standard one suffices.

While Loops
A While Loop contains statements to be executed as long as a stated condition remains true, as in: while x > 0.5 ....... end It is, of course, crucial that at some point a statement will be executed that will cause the condition in the While statement to be false. If this is not the case, you have created an infinite loop -- one that will go merrily on until you pull the plug. For readability, it is sometimes useful to create variables for TRUE and FALSE, then use them in a While Loop. For example: true = 1==1; false = 1==0; ..... done = false; while not done ........ end Of course, somewhere in the While loop there should be a statement that will at some point set done equal to true.

If Statements
A If Statement provides a method for executing certain statements if a condition is true and other statements (or none) if the condition is false. For example: If x > 0.5 ........ else ....... end In this case, if x is greater than 0.5 the first set of statements will be executed; if not, the second set will be executed.
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A simpler version omits the "else section", as in: If x > 0.5 ........ end Here, the statements will be executed if (but only if) x exceeds 0.5.

Nesting
All three of these structures allow nesting, in which one type of structure lies within another. For example: for j = 1:n for k = 1:n if x(j,k) > 0.5 x(j,k) = 1.5; end end end The indentation is for the reader's benefit, but highly recommended in this and other situations. MATLAB will pair up end statements with preceding for, while, or if statements in a last-come-firstserved manner. It is up to the programmer to ensure that this will give the desired results. Indenting can help, but hardly guarantees success on every occasion. While it is tempting for those with experience in traditional programming languages to take the easy way out, using For and While loops for mathematical operations, this temptation should be resisted strenuously. For example, instead of: port_val = 0; for j = 1:n port_val = port_val + ( holdings(j) * prices(j)); end write: port_val = holdings*prices; The latter is more succinct, far clearer, and will run much faster. MATLAB performs matrix operations at blinding speed, but can be downright glacial at times when loops are to be executed a great many
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MATLAB

times, since it must do a certain amount of translation of each statement every time it is encountered.

Writing Functions
The power of MATLAB really comes into play when you add your own functions to enhance the language. Once a function m-file is written, debugged, and placed in an appropriate directory, it is for all practical purposes part of your version of MATLAB. A function file starts with a line declaring the function, its arguments and its outputs. There follow the statements required to produce the outputs from the inputs (arguments). That's it. Here is a simple example: function y = port_val(holdings,prices) y = holdings*prices; Of course, this will only work if the holdings and prices vectors or matrices are compatible for matrix multiplication. A more complex version could examine the sizes of these two matrices, then use transposes, etc. as required. It is important to note that the argument and output names used in a function file are strictly local variables that exist only within the function itself. Thus in a program, one could write the statement: v = port_val(h,p);

The first matrix in the argument list in this calling statement (here, h) would be assigned to the first argument in the function (here, holdings) while the second matrix in the calling statement (p) would be assigned to the second matrix in the function (prices). There is no need for the names to be the same in any respect. Moreover, the function cannot change the original arguments in any way. It can only return information via its output. This function returns only one output, called y internally. However, the resultant matrix will be substituted for the entire argument "call" in any expression. If a function is to return two or more arguments, simply assign them names in the declaration line, as in: function [total_val, avg_val] = port_val(holdings,prices) total_val = holdings*prices; avg_val = total_val/size(holdings,2); This can still be used as in the earlier case if only the total value is desired. To get both the total value
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and the average value per position, a program could use a statement such as: [tval aval] = port_val( h,p); Note that as with inputs, the correspondence between outputs in the calling statement and the function itself is strictly by order. When the function has finished its work, its output values are assigned to the variables in the calling statement. Variables other than inputs and arguments may be included in functions, as needed. They are strictly local to the function and have no existence outside it. Indeed, a variable in a function may have the same name as one in another place; the two will coexist with neither bothering the other. While MATLAB provides for the use of "global variables", their use is widely discouraged and will not be treated here.

Comments and Help


It is an excellent idea to include comments throughout any m-file. To do so, use the percent (%) sign. Everything after it up to the end of the line will be ignored by MATLAB. The first several lines after each function header should provide a brief description of the function and its use. Once the function has been placed in an appropriate directory, a user need only type help followed by the function name to be shown all the initial comment lines (up to the first non-comment or totally blank line). Thus if there is a function named port_val, the user can get this information by typing: help port_val To provide even more assistance, create a script file with nothing but comment lines, each giving the name and a brief description of all your functions and scripts. If this were named mia_fun, the user could simply type: help mia_fun to get a list of your functions, then type help function name to get more details on any specific function.

Data Input and Output


There are many ways to get information into and out of the MATLAB environment. We will cover only the simpler ones here.

Data Input
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The most straightforward way to get information into MATLAB is to type it in "command mode". For example: prices = [ 12.50 37.875 12.25]; assets = ['cash ';'bonds ' ; 'stocks']; MATLAB even makes it easy to enter matrices in a more normal form by treating carriage returns as semicolons within brackets. Thus: holdings = [ 100 200 300 400 500 600 ] will create a {3*2} matrix, as desired. A second way to get data into MATLAB is to create a script file with the required statements, such as the one above. This can be done with any text processor. Large matrices of data can even be "cut out" of databases, spreadsheets, etc. then edited to include the desired variable names, square brackets and the like. Once the file or files are saved with .m names they only have to be invoked to bring the data into MATLAB. Next up the chain of complexity is the use of a flat file which stores data for a matrix. Such a file should have numeric ascii text characters, with each element in a row separated from its neighbor with a space and each row on a separate line. Say, for example, that you have stored the elements of a matrix in a file named test.txt in a directory on the MATLAB path. Then the statement: load test.txt will create a matrix named test containing the data.

Data Output
A simple way to output data is to display a matrix. This can be accomplished by either giving its name (without a semicolon) in interactive mode. Alternatively you can use the disp function, which shows values without the variable name, as in: disp(test); For prettier output, MATLAB has various functions for creating strings from numbers, formatting data, etc.. Function pmat can produce small tables with string identifiers on the borders.

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If you want to save almost everything that appears on your screen, issue the command: diary filename where filename represents the name of a new file that will receive the subsequent output. When you are through, issue the command: diary off Later, at your leisure, you may use a text editor to extract data, commands, etc. to data files, script or function files, and so on. There are, of course, other alternatives. If you are in an environment (such as a Windows system) that allows material to be copied from one program and pasted into another, this may suffice. To create a flat file containing the data from a matrix use the -ascii version of the save command. For example: save newdata.txt test -ascii will save the matrix named test in the file named newdata.txt. Finally, you may save all or part of the material from a MATLAB session in MATLAB's own mat file format. To save all the variables in a file named temp.mat, issue the command: save temp At some later session you may load all this information by simply issuing the command: load temp To save only one or more matrices in this manner, list their names after the file name. Thus: save temp prices holdings portval

would save only these three matrices in file temp.mat. Subsequent use of the command: load temp would restore the three named matrices, with their values intact.

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There are more sophisticated ways to move information into and out of MATLAB, but they can be left to others.

MATLAB Function Library


We provide a number of MATLAB functions that may prove of value to the Macro-Investment Analyst and, possibly, others. The user is advised to proceed with caution when using any of them.

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Excel

Excel

Contents:
q q q

Introduction Named Ranges Matrix Operations in Excel

Introduction
Microsoft's Excel spreadsheet program provides an alternative environment for many of the computations required for Macro-Investment Analysis. Its ubiquity and ease of use are among its more attractive features. However, spreadsheets are notoriously dangerous, since the underlying logic of a set of calculations is usually contained in formulas scattered around a sheet (or sheets). Worse yet, the formulas are usually hidden from sight, behind the numbers representing the results of their calculations. These disadvantages loom especially large when an environment is to be chosen primarily as a means of communication. For our purposes, languages such as MATLAB are superior to a spreadsheet environment -- Excel or any other. The situation is not, however, as bleak as it once was. Since the introduction of version 5.0, Excel has included a full programming language that allows for structured, documented, and readable sets of commands. Formally, it is a version of Microsoft's Visual Basic for Applications, but we will use the simpler form: Visual Basic or to be even more succinct: VB. In Excel, VB procedures are called Macros , but this is far too humble a term for perfectly respectable programs and we will resist its use except when absolutely necessary. Will will not cover Visual Basic, since it is a complex programming language that requires an extensive treatise. Suffice it to say that it provides an alternative to MATLAB and other languages for preparing investment application programs. Here we concentrate on a a discussion of matrix operations in the standard Excel spreadsheet environment. The treatment will be cursory, at best since Excel is far too complex to cover in any detail in this exposition. Our goal is only to suggest ways in which it can be used by the Analyst for matrix
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operations.

Named Ranges
Many Excel formulas require the specification of one or more ranges of cells as arguments. In many cases the easiest way to indicate such a range is to select it using keystrokes and/or a mouse as the formula is typed. For clarity, we adopt an alternative approach, using only named ranges in our formulas and statements. Since names remain with the formulas and statements, it is easy to change the physical range of cells to which a name applies whenever results are desired for a different range of inputs. Perhaps more important, the use of appropriate range names can greatly improve the readability of a set of formulas or statements. The safest way to assign a name to a range of cells is to first select it, then choose Insert Name Define from the menu, followed by the desired name. Be certain to avoid names that look like cell locations or combinations of them (e.g. A22). In Excel, range names are not case sensitive. Thus Prices, prices and PRICES are considered the same name. To select a named range, choose Edit Go to (or the equivalent key), followed by the range name. Alternatively, use the drop-down list of names located just above and to the left of the spreadsheet. When a named range is selected, the name will appear in the window for this list. (In fact, you can name ranges by selecting them, then typing the name in this box; however, this sometimes allows conflicts to creep in and should be avoided). Once you have named a range, you may use it in any formula that allows for a range as an argument. As indicated earlier, we will always choose this alternative.

Matrix Operations in Excel


Unbeknownst to many users, Excel can do matrix operations very efficiently, either directly, or through the use of matrix functions. Microsoft prefers to use the term "Array" to "Matrix", so most references in their manuals and help system can be found under the former term. Key to understanding the use of matrix operations in Excel is the concept of the Matrix (Array) formula. Such a formula uses matrix operations and returns a result that can be a matrix, a vector, or a scalar, depending on the computations involved. Whatever the result may be, an area on the spreadsheet of precisely the correct size must be selected before the formula is typed in (otherwise you will either lose some of the answer or get added and possibly confusing information). After typing such a formula, you "enter" it with three keys pressed at once: CTRL, SHIFT and ENTER. This indicates that a matrix (array) result really is desired. It also designates the entire selected range as the desired location for the answer. To modify or delete the formula, select the entire region beforehand.
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When matrix computations are performed in this way, the "result areas" will be updated immediately whenever any of the numbers in the "input areas" change (unless automatic recomputation has been turned off). This can be a great help when one wishes to evaluate the effects of changes in assumptions, initial conditions, etc.. This feature, coupled with the ability to see matrices, complete with identification of the rows and columns (i.e. in the form that we have termed tables), will often make the spreadsheet environment the preferred choice for computation, if not for communication. In Excel, some matrix operations are performed automatically, using standard operators (as in MATLAB). Others require the use of matrix functions. We treat each below.

Matrix Addition
Assume that Holdings_1 and Holdings_2 are two ranges of the same size (say, {20*1}) containing the holdings of mutual funds in two accounts. To create a vector with the total holdings of both accounts, select an empty {20*1} range on the sheet, type in the formula: = Holdings_1 + Holdings_2 then press CTRL-SHIFT-ENTER. As a matter of good practice, you might wish to name the resultant range (e.g. Tot_Holdings) for future reference. Any two matrices of the same size can be added in this manner, with the result placed in a range of the same size.

Matrix Subtraction
Not surprisingly, a matrix can be subtracted from one of the same size in a manner analogous to that of addition. For example to find the holdings of account 2, you could use the formula: = Tot_Holdings Holdings_1

Using Matrices with Scalars


To add a constant to every element of a matrix, simply include it in a formula, as in: = Tot_Holdings + 100 You can also subtract a constant from every element or multiply or divide every element by a constant. For example:
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= Prices * 1.10

Matrix Multiplication
To multiply two matrices, use the MMULT function. Thus, if prices and holdings are compatible for multiplication, you could compute the value of a portfolio with the formula: = MMULT(prices,holdings)

Transposition
If a matrix is not turned in the right direction, simply use the TRANSPOSE function. Thus if prices is a {20*1} vector and holdings is also, you could use the formula: = MMULT(TRANSPOSE(prices),holdings) to produce the value of the portfolio. As is often the case, there is another way to do the same thing in Excel. The (non-matrix) function SUMPRODUCT produces the sum of the products of the elements in two vectors of equal dimensions. Thus if prices and holdings are both {20*1}, you could compute the value of the portfolio with the formula: = SUMPRODUCT(prices,holdings) Note that to enter this formula, only the ENTER key need be pressed. The provision of alternative methods for accomplishing a given type of calculation endears Excel to many users, especially those who grew up with prior versions. But it tends to frustrate those who yearn, perhaps quixotically, for a simple, yet powerful computing environment.

Matrix Inversion
To produce the inverse of a matrix, use the MINVERSE function, as in: = MINVERSE(lhs) Of course the matrix in the named range must be square and invertable.

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Combining Matrix Operations


In Excel, as in MATLAB, you may combine matrix operations in a single formula. Remember, however, that everything must conform, that the output range should be the correct size for the final result, and that you must press CTRL-SHIFT-ENTER to enter the formula in the output range. As in more mundane formulas, it never hurts to include sufficient parentheses to remove any possible ambiguity concerning your desires.

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Asset Allocation with Investment Funds

An Example: Asset Allocation with Investment Funds

Contents:
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Assets and Funds The Current Portfolio The Current Allocation Obtaining a Desired Allocation Finding Alternative Allocations Finding Pure Asset Plays

Assets and Funds


To see the power of matrix operations, we consider an important example -- the choice of a portfolio of investment funds designed to achieve a desired asset allocation. Assume that an Analyst has identified three major asset classes: DomBds: DomStx: ForStx: Domestic Bonds Domestic Stocks Foreign Stocks

Three Funds are available for investment: FundA FundB FundC After considerable work, the Analyst has estimated the exposures of each fund to each of the three asset classes. For present purposes, think of these as the funds' allocations of money among the asset classes. The results of the analysis are summarized in matrix A:

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Asset Allocation with Investment Funds

DomBds DomStx ForStx

FundA 0.60 0.40 0.00

FundB 0.20 0.50 0.30

FundC 0.00 0.30 0.70

Thus FundA has 60% of its money in Domestic Bonds and 40% in Domestic Stocks; Fund B has 20% in Domestic Bonds, 50% in Domestic Stocks, and 30% in Foreign Stocks, etc..

The Current Portfolio


At the moment, the Investor has 20% of her money invested in FundA, 30% in FundB and 50% in FundC. This is shown in vector x: FundA FundB FundC 0.20 0.30 0.50

The Current Allocation


What is the Investor's current allocation among the three major asset classes? The answer can be found by simply multiplying matrix A by vector x. The required MATLAB statement is: b = A*x This provides the result: DomBds DomStx ForStx 0.18 0.38 0.44

Thus her portfolio has 18% in Domestic Bonds, 38% in Domestic Stocks and 44% in Foreign Stocks. Note the dimensions associated with this calculation: A {assets*funds) * x (funds*1) ===> b {assets*1} The inner dimensions are the same, as they must be. And the dimensions of the result are, as usual, the outer dimensions of the two operands.

Obtaining a Desired Allocation


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Asset Allocation with Investment Funds

What if the Analyst, after conferring with the Investor, decided that it would be better to allocate the assets differently, with 15% in Domestic Bonds, 35% in Domestic Stocks and 50% in Foreign Stocks? How should money be divided among the investment funds to achieve this goal? To begin, create vector bb {assets*1}, with the desired allocation: DomBds DomStx ForStx 0.15 0.35 0.50

We seek a new vector of fund investments that will provide this allocation. Let the former be xx {funds*1}. We want the following to hold: A*xx = bb To solve this set of equations requires only the MATLAB statement: xx = inv(A)*bb or the equivalent operation in Excel (or another system). The required investments are given in xx. In table form: FundA FundB FundC 0.20 0.15 0.65

The Investor should put 20% of her assets in FundA, 15% in FundB and 65% in FundC.

Finding Alternative Allocations


What if the Analyst wished to present two different allocations among asset classes to the Investor? The procedure described above could be repeated with different values in vector bb. But there is an even simpler approach. First, include all allocations of interest in a matrix, with one column per desired mix. In this case, BBB {assets*mixes} is: Mix1 0.15 Mix2 0.15

DomBds

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Asset Allocation with Investment Funds

DomStx ForStx

0.35 0.50

0.40 0.45

It is tempting to simply substitute this matrix for the vector bb used in the previous case. In fact, this is a temptation to which one can and should succumb, for it will provide the desired answers. The MATLAB statement: XXX = inv(A)*BBB will produce the following, in table form: Mix1 0.20 0.15 0.65 Mix2 0.10 0.45 0.45

FundA FundB FundC

Why does this work? Recall that matrix multiplication can be regarded as a series of multiplications of the first matrix (here, inv(A)) by the adjoining column vectors in the second matrix (here, BBB). Not surprisingly, each column in the result (XXX) is the solution to a simpler problem in which only the corresponding column of BBB is utilized. What about the dimensions? To answer this question we need to know the dimensions of inv(A). Recall that A is {assets*funds}. It follows that its inverse is {funds*assets} (it is, after all, inverted). Thus: inv(A) {funds*assets} * BBB {assets*mixes} ===> as characterized above. XXX {funds*mixes}

Finding Pure Asset Plays


In this example the only vehicles available for direct investment are the three investment funds. If one wishes to invest in asset classes, it must be done via such funds. We have shown how to find the set of fund allocations required to achieve any desired asset allocation. One particularly interesting set of the latter includes the three possible pure asset plays. Consider the following set of mixes, contained in matrix BBBB: Mix1 1.00 0.00 Mix2 0.00 1.00 Mix3 0.00 0.00

DomBds DomStx

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Asset Allocation with Investment Funds

ForStx

0.00

0.00

1.00

Mix1 represents allocation of all one's assets to Domestic Bonds, Mix2 to Domestic Stocks, and Mix3 to Foreign Stocks. Each is a "pure asset play". For example, an Investor with Mix1 will be totally unaffected by the performance of Domestic Stocks and Foreign Stocks -- only the returns from Domestic Bonds will matter. To find the allocations among investment funds required to achieve each of these mixes, we simply repeat the procedure used in the previous case. Letting matrix XXXX represent the desired results: XXXX = inv(A)*BBBB which gives: DomBds 2.60 -2.80 1.20 DomStx -1.40 4.20 -1.80 ForStx 0.60 -1.80 2.20

FundA FundB FundC

Thus one wishing to create a pure Domestic Bond play would place an amount equal to 260% of her money in FundA and 120% in FundC. To help finance these investments, she would take a negative position in Fund B with an amount equal to 280% of her money. Could this be done in practice? Possibly, if the investment funds' shares were traded and could be "sold short". Some closed-end fund shares might be used in this manner, but in all likelihood such an extreme strategy would be infeasible or at least costly. To deal with such real-world aspects requires more complex problem formulations and solution procedures, which will be discussed in due course.. However simplistic, this example does illustrate an important point. Look again at matrix BBBB. It is, in fact, a {3*3} identity matrix (which can be created in MATLAB with the expression eye(3)).. Thus XXXX is the product of the inverse of A times an identity matrix. But this must be the inverse of A! Hence, each column in the inverse of A shows the allocation of money among funds that will provide a pure asset play. As will be seen, this relationship can be applied in both normative and positive applications.

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Macro-Investment Analysis

Prices
q q q q q

Time-state Claims Valuation Multiple Commodities, States and Times Interest Rates and Bond Yields Forward Prices

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Time-state Claims

Time-state Claims

Contents:
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The Arrow-Debreu Paradigm An Apple Tree Time-state Claims Prices of Atomic Time-state Claims The Sufficiency of Atomic Security Prices Arbitrage Zero-investment Strategies

The Arrow-Debreu Paradigm


An important subfield of physics -- nuclear physics -- deals with the smallest particles of which matter is composed. Constructs developed by Kenneth Arrow [Arrow 1964] and Gerard Debreu [Debreu 1959] provided a similar foundation for financial economics. The resulting approach is often called the Arrow-Debreu Paradigm. It characterizes promised future payments in terms of both the times at which payments are to be made and the states of the world that must obtain for payments to be made. Hence the often-used name: the time-state paradigm. Since the approach represents securities and other types of financial instruments in terms of their most elemental components, one could as well title it: Nuclear Financial Economics.

An Apple Tree
We start with the simplest possible example that involves both time and uncertainty. There are two time periods: 0: today 1: a year from now There are also two possible future states of the world: G: the weather over the next year will be good B: the weather over the next year will be bad

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Time-state Claims

The states of the world are mutually exclusive (if one occurs, the other cannot) and exhaustive (one of them must occur). The economy is very simple indeed. The only commodity is the apple and there is no money per se. In effect, the apple is the unit of currency. The only type of productive investment in this economy is, not surprisingly, an apple tree. We focus initially on a tree that will produce: 63 apples if the weather is good 48 apples if the weather is bad This is shown in the figure below. Time proceeds from left to right. The box on the left refers to present value. The boxes on the right represent alternative states of the world. One but only one of the states of the world in a vertical position will take place at the time in question. The names of the states are indicated at the tops of the boxes. The numbers inside the boxes indicate the payoffs.

Time-state Claims
In our economy there are three elemental time-state claims: One apple at time 0 (today) One apple at time 1 if the weather is good One apple at time 1 if the weather is bad In keeping with our interpretation of the Arrow-Debreu approach as Nuclear Financial Economics, we will call these atomic time-state claims. Note that the latter two descriptions include the item (apple), the number of units (one), the time at which delivery is to be made (0 or 1), and the state of the world that must obtain for delivery to be made (good or bad weather). In the case of the first description, no state is given, since present values are not conditional on future states of the world. To simplify the exposition, we will refer to these claims as:

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Time-state Claims

One "present apple" One "good weather apple" One "bad weather apple"

(PA) (GA) (BA)

with the understanding that these are simply shorthand descriptions. In principle, any investment vehicle can be considered to be composed of such atomic claims. Thus the output of our apple tree is equivalent to a 63 GAs and 48 BAs.

Prices of Atomic Time-state Claims


Many of the fundamental concepts of Financial Economics are based on the assumption that markets exist in which claims can be traded efficiently (at low cost). We begin with the assumption that dealers stand ready to trade atomic claims and to do so without cost. As will be seen, these dealers are a bit of an artifice. Later we consider more realistic assumptions about the world. Assume that Dealer G "makes a market" in good weather apples. In particular, she is willing to trade (swap): 0.285 present apples for 1.000 good weather apples or 1.000 good weather apples for 0.285 present apples or any multiple thereof (dividing apples into pieces, as required). This can better be understood in standard financial terms. Assume that an owner of an apple tree has issued a certificate of the following form: I, __________ promise to deliver to the bearer of this certificate one apple at the end of year ____ if (but only if) the weather during the year has been good. In standard parlance, this piece of paper (or its electronic equivalent) would be termed a security. Assume that a credit-rating agency has examined the property of the apple grower (the apple tree) and has established that no more than 63 of these securities have been issued and that there are no other claims on the grower's assets in the event of good weather. As a result, the securities are rated AAA ("triple-A") and can be considered default-free. Under these conditions, the security in question represents a property right in an atomic time-state claim. In a sense, it is thus an atomic security or, given the origin of the concept, an Arrow-Debreu security. The price of this security is 0.285 present apples, since the dealer stands ready to trade this number of present apples for the security. More generally, the price of any security is the amount of the relevant numeraire paid immediately for which the security can be traded. Note that the ability to make a trade is central to the definition of a price.

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In the real world, of course, dealers charge more to sell a security than they are willing to pay to buy it. The spread between the ask (selling) and bid (buying) price provides compensation for the market-making function. In our examples we assume (unrealistically) that there is no such spread and hence that there is but one price. In practice, the average of the bid and ask prices is often used as a surrogate for "the price". For detailed computations, of course, the specifics of a proposed transaction may need to be taken into account and the relevant price (bid or ask) used. This diversion completed, we return to our world of non-profit dealers. In addition to Dealer G, we assume that another, Dealer B, is willing to trade (swap): 0.665 present apples for 1.000 bad weather apples or 1.000 bad weather apples for 0.665 present apples or any multiple thereof (again, dividing apples into pieces, as required). The trading environment is shown in the figure below.

The Sufficiency of Atomic Security Prices


Thus far we have a world with three types of time-state claims (PA, GA and BA). Explicit markets exist for trading (1) PA and GA and (2) PA and BA. Note that each such trade has the characteristic of an investment -today's goods are traded for the prospect of goods in the future. Thus one purchasing a GA atomic security can be said to have invested 0.285 (present) apples to obtain 1.000 apples in the future if the weather is good. But what of the other possible type of trade in this world? What would it mean to trade good weather apples for bad weather apples? How might one accomplish this? And what would be the terms of trade? To answer these questions, consider the following agreement:

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Time-state Claims

Party A promises to pay party B: 6 apples if the weather is good Party B promises to pay party A: 3 apples if the weather is bad Neither party pays the other anything today (on signing) Such an agreement is called a swap in financial parlance. It represents the third possible type of trade in our simple world: GA for BA. Is this a fair deal? If one desires an answer based on ethical considerations, other disciplines will have to be invoked. Financial Economics can only indicate whether or not one of the parties could get a better deal elsewhere. Assume that Party A comes to you with the proposal that you sign the agreement as Party B. You are willing to give up 3 apples if the weather is bad in order to increase your consumption if the weather is good. But is 6 apples the best that you can do? To answer the question, consider the following alternative trades: Go to dealer B, trade 3 BA for 3*0.665 = 1.995 PA Go to dealer G, trade 1.995 PA for 1.995/0.285 = 7 GA The net result is, of course, to trade 3 BA for 7 GA -- a better deal than offered by canny Party A, who will have to search elsewhere for a counterparty foolish enough to take the deal. Note that although explicit markets are being made in only future atomic time-state claims, it is possible to "create" trades involving any present and future claims. This is a perfectly general result. If one can trade each possible future atomic time-state claim for present units of a numeraire, any desired trade can be accomplished. Thus a set of atomic security prices is sufficient for accomplishing any desired trade.

Arbitrage
Consider two people sharing a pizza. To insure an even division, it is wise to agree that one party should cut it, and the other should choose his or her piece. Similarly, it is useful to require someone offering a bet on a sporting event to be willing to take either side on the offered terms. With this in mind, we return to Party A and Party B. Assume that a securities firm is willing to serve as either Party A or Party B in the previously-described swap (6 GAs for 3 BAs). Clearly, you have no interest in being Party B. But what about serving as Party A? Consider the following set of trades: Sign the Agreement as party A (pay 6 GA, get 3 BA) Go to dealer B, trade 3 BA for 3*0.665 = 1.995 PA Go to dealer G, trade 6*0.285 = 1.710 PA for 6 GA It is useful to put all this information in a payment matrix with each row representing a time-state combination and each column a transaction. Conventionally, we represent outflows with negative numbers, inflows with
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Time-state Claims

positive numbers, and neither with zeros. Agreement 0 - 6.0 + 3.0 Dealer B + 1.995 0 - 3.0 Dealer G - 1.710 + 6.0 0

Present Good weather Bad weather

Of particular interest is the sum of the payments in each row, shown in the final column below: Agreement 0 - 6.0 + 3.0 Dealer B + 1.995 0 - 3.0 Dealer G - 1.710 + 6.0 0 Net + 0.285 0 0

Present Good weather Bad weather

Note what this set of transactions accomplishes -- getting something for nothing! Moreover, there is no reason to settle for such a small gain. Double the sizes of all the transactions and the net gain is doubled. Quadruple them and the gain is quadrupled. Well and good, but what if one really wanted apples next year if the weather is good. Not to worry. Add a final trade in which 0.285 present apples are traded for 1.000 good weather apples. Want bad weather apples? Add a trade to convert the gains into the appropriate payment. No matter what a person's preferences may be, it is desirable to exploit the foolishness of the firm offering this swap. Too good to be true? Probably. This example constitutes an arbitrage -- every trader's dream. To formalize: An arbitrage provides a positive net payoff in at least one time and state and no negative net payoff in any time and state. An arbitrage is thus a money machine (or, as in this case, an apple machine). When an opportunity of this type arises, traders will rush to exploit it, causing others to adjust their terms of trade until swap terms involve no arbitrage. A set of swap terms that does not permit arbitrage is arbitrage-free.

Zero-investment Strategies
In an important sense, every security transaction can be considered a swap. The purchase of an atomic security is a swap of present goods for conditional future goods. The sale of such a security is a swap of conditional future goods for present goods. Such cases, when one "side" of the swap involves present goods or services, are typically termed investments. Thus one invests present apples in the hope of obtaining more apples in the future. But note that the swap of good weather apples for bad weather apples is no different in kind, even though no goods or services are exchanged at the time of the agreement. To be explicit, we refer to swaps of this latter kind as zero-investment strategies. As with other transactions, they

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are represented by cash flow vectors with positive and negative numbers, but with zeros in the first (present) row.

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Valuation

Valuation

Contents:
q q q q q q q q q q q q q q

Present Value Net Present Value Asymetric Information Productive Investment Riskless Securities The Law of One Price Financing Methods The Principle of Value Additivity Risky Debt Re-allocating Value Among Groups of Claimants Inferring Atomic Security Prices Financial Engineering Opportunity Sets Consumption and Investment Decisions

Present Value
How much is an apple tree "worth" in our economy? Such a question is best interpreted as "how many present units of the numeraire should be traded for the apple tree?". The answer is found by calculating the cost of obtaining the same set of payoffs in another way. The result is the present value of the apple tree. The process of determining the present value of a security or productive investment is termed valuation. In principle, the process is very simple. Recall that the tree will provide 63 apples if the weather is good and 48 if it is bad. Dealer G will provide the former for 0.285*63=17.955 present apples. Dealer B will provide the latter for 0.665*48=31.920 present apples. The total cost of obtaining the same results in this other manner will thus be 17.955+31.920=49.875 present apples. This is the present value of the apple tree, as shown in the figure below.

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There is nothing metaphysical about this concept of value. It is based entirely on the cost of obtaining a fully equivalent set of payments. If an apple tree is selling for less than this, one can obtain an arbitrage by buying the tree and selling its production through the dealers. If a tree is selling for more, one can offer the same outputs, sell them and use the proceeds to buy securities from the dealers to guarantee delivery. In each case, there will be something left over for the arbitrageur. In real markets, such opportunities are few and fleeting. In an arbitrage-free market, they are totally absent -there is one set of atomic security prices and every security will sell for a price equal to its present value, computed using these atomic security prices. In such a market the present value of any set of claims is computed by multiplying the quantity of each claim by its price, then summing.

Net Present Value


A distinction is often made between the present value and the net present value of a set of claims. The former is generally based on all future payments and thus determines the present value of those payments. The latter is generally based on all payments, including any required payment in the present ("up front"). Thus:

net present value = present value - present payment In matrix terms, either concept can be represented as equal to p*q where p is a {1*states} vector of elemental security prices and q is a {states*1} vector of payments. In this case, if: p: good weather 0.285 and q: good weather 63 bad weather 0.665

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Valuation

bad weather then pv = 49.875.

48

If the tree could be purchased for 49.875 apples: p: present 1.000 and q: present good weather bad weather and npv = 0.0. The net present value of an investment that is valued correctly ("fairly priced") is zero, as in this case. The goal of an arbitrageur is to find a strategy with a positive net present value. As indicated earlier, arbitrages are hard to find in well-developed capital markets. -49.875 63 48 good weather 0.285 bad weather 0.665

Productive Investment
How can an entrepreneur evaluate a "trade with nature" (productive investment)? If the commodities produced by such activity will not significantly alter either commodity prices or time-state-claim prices, the rule is simple: engage in any such investment with positive net present value. Assume that a scientist discovers how to plant 60 apples in a way that will produce 100 apples if the weather is good and 50 apples if the weather is bad. Is this desirable? To find out, compute the net present value: p: present 1.000 q: present good weather bad weather -60 100 50 good weather 0.285 bad weather 0.665

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Valuation

and npv = 1.75. The NPV is positive, so the technology should be implemented. The entrepreneur might sell stock in this apple firm. Its value would be 61.75 apples, which is the present value of the possible future payments. Thus the scientist's investment of 60 apples could be turned into 61.75 apples today. She could (1) use the profit of 1.75 apples today, (2) swap it for apples next year if the weather is good, (3) swap it for apples next year if the weather is bad, or (4) select some combination of the three alternatives.

Asymetric Information
In practice, of course, it is not always easy for an insider to cash in on the future prospects of his or her enterprise. Our example assumes that outside investors are able to confirm that the scientist's tree will in fact produce 100 apples if the weather is good and 50 if the weather is bad. Security analysts, who study publicly-traded securities, attempt to make the best possible forecasts of firm's future prospects and the associated payments to the holders of their securities. Banks and other credit-granting agencies expend substantial resources to assess the firms to which they may lend money. And, of course, the managements of companies provide information about their progress and prospects. However, there is the ever-present possibility that insiders may provide forecasts that are overly optimistic, either through excessive enthusiasm or in an attempt to drive up the prices of securities that they may wish to sell. The underlying problem is the fact that the parties to a proposed trade may have different sets of information. The possibly negative effects of the resulting asymetry can be mitigated in a number of ways. Insiders may retain substantial positions in a firm to show their good faith. They may pledge their personal assets to cover certain types of shortfalls. And so on. At the very least, however, additional resources will be almost certainly have to be expended to verify predictions, audit records, etc.. In our quest to establish first principles in a simple setting, we leave until later an extended discussion of issues associated with differential information, the costs associated with attempts to improve participants' information sets, etc.. For now we assume that people agree on the payment vectors associated with various investments and that the only source of uncertainty concerns the state of the world that will actually obtain.

Riskless Securities
A riskless security pays the same amount at a given time, no matter what state of the world obtains. Equivalently, it is a bundle of equal amounts of atomic claims for a time period. In our case, a riskless security pays a fixed amount (say X apples) at time period 1, whether the weather has been good or bad. Equivalently, it is a bundle of X good weather apples and X bad weather apples. To value such a security one follows the general rule: multiply price times quantity. For example, assume that a AAA-rated security promises to pay 20 apples at time period 1. Then: p: good weather 0.285 bad weather 0.665

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Valuation

q: good weather bad weather and pv = 19.00. Note that this computation involves multiplying a fixed amount (20) by each of the atomic security prices for claims for the associated date, then summing the results. One could as well have summed the prices, then multiplied the result by the fixed payment. In this case: (0.285 * 20) + (0.665 * 20) = (0.285 + 0.665) * 20 = 0.95 * 20 20 20

The sum of the appropriate atomic security prices is termed the discount factor for the date in question. It represents the present value of a payment of one unit to be made with certainty at the specified future date. The process of computing a present value in this manner is called discounting. Thus one discounts the (certain) future value to obtain the present value of a riskless security. Note that this calculation, like any other valuation analysis, rests on the ability to obtain the same set of payments in a different way. An apple a year from now has a present value of 0.95 apples because one can obtain the same thing using other types of transactions. Absent functioning markets that provide alternatives, the processes of valuation (in general) and discounting (in particular) lack a rigorous basis.

The Law of One Price


In an arbitrage-free economy with no transactions costs, any given time-state claim will sell for the same price, no matter how obtained. This will also be true for any "package" of time-state claims. This property is known as the law of one price. It is easy to see why the law must hold in an economy of the sort we have posited. Assume that a given set of time-state claims can be traded for cash today at either of two prices -- X or Y. Then an arbitrageur could buy the set of claims for the lower of the two prices and sell it for the higher, pocketing the difference. No matter what occurred in the future, he or she would receive from one counterparty exactly the cash required to meet the promises made to the other. In the real world where transactions costs are relevant, the lack of arbitrage opportunities only insures that prices for a given set of time-state claims will fall within a band narrow enough to preclude transactions that can provide something for nothing net of transactions costs. Moreover, since different traders face different transactions costs, it may be possible for some to make money from discrepancies in prices, while others cannot. Traders, financial institutions, and those who create new financial instruments attempt to exploit discrepancies in
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Valuation

prices that arise from transactions costs, broadly construed. In so doing, they may make money for themselves. But they also tend to decrease the transactions costs that will be borne by others. Thus the actions of arbitrageurs and other traders tend to bring markets for key time-state claims and combinations of such claims closer and closer to the ideal of zero transactions costs and true conformity with the law of one price.

Financing Methods
We return now to our "standard" apple tree, which will produce 63 apples if the weather is good and 48 if the weather is bad. Consider an entrepreneur who wishes to set up a firm that will buy one such tree. As we have shown, the present value of the tree is 49.875 (present) apples. To buy the tree, our entrepreneur thus needs 49.875 apples. How can he get them? One alternative is to simply take it out of his bank account, borrow money on his house, etc.. In such a case, he will serve as both owner and manager. To keep things simple, we assume that the firm has no costs. Hence its revenues will equal its profits (revenues minus costs). Since our world ends at the end of the year, the firm can be also be expected to distribute these profits. If the entrepreneur provides all the financing, the firm can provide him with a security that provides the holder with the property right to receive all the earnings that it distributes. Such an instrument would be termed an equity security or, more commonly, a common stock. In this case, the firm can be said to have employed an all-equity financing strategy. In practice, the firm might issue 100 stock certificates, each representing the right to receive 1/100'th of the firm's distributions. Each certificate would be called a share of the firm's stock. The holder of one share would receive 0.63 apples if the weather is good and 0.48 apples if the weather is bad. Not surprisingly, one share would be worth 0.49875 present apples -- 1/100'th of the value of the set of all outstanding shares. But there are other ways to finance a firm. In fact, the possibilities are almost endless. We consider first a simple example involving two classes of securities. Assume that the firm issues a bond of the following form: The Apple Tree Firm promises to pay the holder 20 apples at the end of the year, no matter what the weather has been and a stock of the form: The Apple Tree Firm promises to pay the holder all the apples left over after the bondholder has been paid.

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Valuation

The stock is a residual claim, while the bond is a prior claim -- it is senior in the firm's capital structure. What is the bond worth? What is the stock worth? First, the payment vectors. qfirm: good weather bad weather qbond: 63 48

good weather bad weather qstock = qfirm - qbond: good weather bad weather

20 20

43 28

It is straightforward to compute the values: p*qfirm p*qbond p*qstock = = = 49.875 19.000 30.875

The Principle of Value Additivity


In the previous example the sum of the values of the securities equaled the value of the firm. This is not too surprising. The payments made by the firm are simply divided among the claimants: qbond + qstock = qfirm But thus it must be the case that: p*(qbond + qstock) and: p*qbond + p*qstock Spelled out:
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= p*qfirm

= p*qfirm

Valuation

value of bond + value of stock = value of firm The result is perfectly general. No matter how the payments are divided among claimants, the sum of the values will be the same. This is known as the principle of value additivity. While it is entirely possible to help one set of claimants and hurt others by rearranging the allocation of cash flows among them, the sum of the values should be unaffected by any such allocation. More simply put, financial decisions that only redistribute claims should not affect total value. Some characterize this as the principle of the conservation of value. It is, of course, important to include all the claimants in such calculations. In the real world, governments impose taxes on firms and/or those who receive income from firms. As a result, the government must be included when considering claimants to a firm's cash flows. Moreover, lawyers, accountants, investment bankers and others are likely to absorb more of a firm's proceeds under some financial arrangements than under others. Thus while total value may be conserved, some financial legerdemain may divert substantial amounts of value from prior claimants towards those who aid in a transformation. The principle of value additivity assumes that prices of time-state claims are unaffected by any changes in the financing of the firm. If a proposed change is large relative to the underlying set of associated time-state claims in an economy, it may be necessary to take into account alterations of time-state claim prices and any resulting increases or decreases in value. If financial arrangements actually affect a firm's operations and hence its revenues and/or costs, value may in fact be increased (or reduced) as well as re-distributed. Some have argued that greater ownership by managers and/or greater debt burdens may increase managerial incentives to maximize profit and hence increase overall firm value. The possibility of such effects is generally accounted for outside the domains of standard valuation theory.

Risky Debt
A bond represents debt in which a borrower promises to pay a lender specified amounts in the future. More precisely, the borrower promises to pay if he or she can. If the borrower is a corporation with limited liability, the payment will be made in full and on time only if the borrower's cash inflows and cash outflows associated with claims with greater priority permit. Otherwise, some or all of the promised payment will be in default (i.e. not paid). Consider an owner of one of our apple trees who issues a bond that promises to pay 60 Apples in period 1 (if possible). If the weather turns out to be good, the payment will be made in full. If it turns out to be bad, only 48 Apples will in fact be paid. The valuation of such a bond is shown below. Present Value 17.10

State good

Payment 60

Price 0.285

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Valuation

bad

48

0.665

31.92 -------49.02

Note that the bond will not sell for as much as a similar bond that is riskless. The latter would sell for 60*0.95, or 57 present apples. Comparing the promised payment with the present value (price of the bond) will favor the risky bond (60/49.02) over the riskless one (60/57). It is not surprising that risky bonds offer higher promised yields than riskless ones. A more difficult question concerns their expected yields, taking the possibility of default into account. We deal with these issues subsequently. The presence of risky debt does nothing to affect the principle of value additivity. Consider the prospects of the residual claimants (stockholders) in this case: Present Value 0.855 0 -------0.855

State good bad

Payment 3 0

Price 0.285 0.665

The sum of the values of the bond and stock claims will be 49.02 + 0.855, or 49.875, which equals the value of the underlying assets (the apple tree).

Re-allocating Value Among Groups of Claimants


One of the problems associated with financing via two or more classes of claims is that of avoiding decisions that may increase a firm's value but actually decrease the value of one or more set of claims. A simple example can illustrate the point. Consider the apple tree firm that has bonds outstanding with promised payments of 60 apples. As shown earlier, the value of the firm is 49.875, divided between the value of the bonds (49.02) and that of the stocks (0.855). Now, assume that management has an opportunity to trade its present apple tree for one that will produce 61 apples if the weather is good and 49 apples if the weather is bad. The value of this new tree is shown below: Present Value 17.385 32.585 -------49.970

State good bad

Payment 61 49

Price 0.285 0.665

Clearly the proposed trade is desirable, since it will increase value from 49.875 to 49.970. But this new value will be distributed differently: Before After

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Bond Stock

49.020 0.855 -------49.875

49.685 0.285 -----49.970

While the value of the firm has increased, the value of the stock has actually decreased! The increase in the bond's value due its greater security has swallowed more than the entire increase in the value of the firm. While those holding bonds (or even proportional amounts of bonds and stocks) would endorse the change, those holding only stock would be violently opposed. In principle, stockholders and bondholders in such a situation could work out a re-arrangement of terms to their mutual advantage so that such an opportunity could be exploited. However, this may require time, bargaining, legal costs, etc., making the cost greater than the benefit. In this case a change in the firm's business to one of lower risk advantaged holders of (formerly) risky debt and disadvantaged holders of junior claims (here, stock). In the converse situation, an increase in the risk of a firm's operations may lower the value of bonds and increase the value of stock. Such a change may not enhance the firm's total value, but may still prove desirable for stockholders. To minimize temptations on the part of management to engage in such tactics, bondholders typically require covenants placing at least some restrictions on management prerogatives. The danger, of course, is that profitable (value-enhancing) undertakings that may increase risk will be foregone as a result.

Inferring Atomic Security Prices


Thus far we have assumed that dealers stand ready to buy and sell atomic securities that pay off in one and only one time and state of the world. This is not totally fanciful, for financial instruments with similar characteristics do exist. For example, a term life insurance policy will provide payment only if the state of the world is "insured is dead". Conversely, an annuity policy will provide payments only if the state of the world is "insured is alive". Indeed, one could (at great expense) provide a riskless security by purchasing both a life insurance policy and an annuity. Nonetheless, it is true that the typical traded security is better characterized as a bundle of different types of time-state claims. Does this obviate our approach? In principle, no. Imagine a world in which only two securities are traded on a regular basis. One is the common stock of the Apple Tree Firm described above. The other is its bond. It is convenient to represent their payments in matrix form. Let Q be: Bond 20 20 Stock 43 28

Good Weather Bad Weather

Assume that the bond sells for 19 Present Apples and that the stock sells for 30.875 present apples. The vector of security prices is thus:

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ps: Bond 19 Stock 30.875

Consider now the payoffs obtained from a given combination of securities, for example, a portfolio that includes 1 bond and 2 stocks. We represent this is a vector of the number of each type of security. Here, n: Bond Stock 1 2

To determine the number of apples provided by this portfolio in each state of the world we multiply Q by n to obtain c, a vector of payments. (We utilize c to indicate cash flows, even though a might be more appropriate here, given the fact that apples are involved). As always, it is useful to check to see that the dimensions are appropriate. Here: Q {states*securities} * n {securities*1} ----> c {states*1}

This operation can be performed regardless of the number of securities. In this case we have as many securities as states; however portfolios with fewer securities than states or with more securities than states can be used in the calculations as long as the requisite information is contained in both Q and n. In this case, the resulting set of state-contingent payments is: c: Good Weather Bad Weather 106 76

Note that in these calculations we started with a portfolio, n, then computed the resulting contingent cash flows (payments), c. We turn now to the reverse question. Assume that one wishes to obtain a set of state-contingent payments c. What portfolio n will provide them? As before, the requisite equation is: Q*n = c If Q is square, it may be possible to take its inverse. If so: n = inv(Q)*c

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and this relationship can be used to determine the portfolio n that will provide a desired set of state-contingent payments c. For example, assume that one wishes to have 845 apples if the weather is good and 620 if the weather is bad, i.e. c: good weather bad weather then: inv(Q)*c = Bonds Stocks 10 15 845 620

How much will this portfolio cost? To find out, we "price it out" by multiplying the vector of security prices times the portfolio positions: ps*n = 653.125

It will cost 653.125 present apples to provide the desired contingent payments (845 apples if the weather is good and 620 if the weather is bad). One way to do this is to purchase 10 Apple Firm bonds and 15 Apple Firm Stocks. Note that in the above calculations: ps*n = ps*inv(Q)*c = [ps*inv(Q)]*c The bracketed expression is of particular interest. In this case it is: ps*inv(Q) = 0.285 0.665

This should look familiar. It is, in fact, the vector of atomic state prices with which we started. This is not surprising, since the cost of any vector of state-contingent payments can be found by multiplying this vector times the desired payment vector. In the special case in which c has a one in the first row and zero in the second, the answer will be 0.285. But this is the cost of an atomic claim in state 1 (good weather). Similarly, if c has a zero in the first row and a one in the second, the answer will be 0.665 -- the cost of an atomic claim in state 2 (bad weather). The result is quite general: p = ps*inv(Q) Even in a market in which atomic securities are not traded explicitly, it is possible to create them synthetically by combining positions in existing securities. Moreover, any desired set of payments can be replicated with a suitably-chosen portfolio of existing securities. The cost of obtaining that set of payments can be determined by computing the cost of the replicating portfolio. Equivalently, it can be determined by pricing the contingent
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payments using the atomic security prices implicit in the prices of existing securities. Note that this bit of apparent legerdemain requires the inversion of Q -- the matrix that maps securities to payments in states of the world. For this to even be possible, Q must be square -- there must be precisely as many securities as states of the world. In addition, the securities must be sufficiently "different" that an inverse can be computed. If both conditions are met, the securities represented in the matrix can be said to span the space of time-state payments. What if there are more securities in the world than there are states? Simple. If there are M states, select M (different) securities for inclusion in matrix Q, then compute the implied atomic security prices. Next, for each remaining security: compute the present value using the derived set of atomic prices and compare the result with its traded price. If there are no discrepancies, the market is arbitrage-free and the computed atomic prices can be used for all further calculations. If you find a discrepancy, it is possible to get something for nothing via arbitrage with a set of trades involving the securities in Q and the security for which the associated value differs from price. Stop everything and take advantage of this information. Then, when you have helped bring markets back to an arbitrage-free status (and reaped your reward for undertaking this socially valuable activity), proceed with the analysis as above.

Financial Engineering
Imagine an investor who tells an investment banker that he would very much like to receive 100 apples next year if the weather is good, and 130 if it is bad. His question: how much will the investment banker charge to guarantee that her firm will provide such payments? To find the answer, we set c: good weather bad weather then compute: n = inv(Q)*c: Bonds Stocks and: ps*n = 114.95 9.30 -2.00 100 130

If the client will pay at least $114.95, the investment banker can provide the commitment and make a guaranteed profit. Perhaps she will quote $120.00. If the client accepts, the banker can purchase 9.30 apple firm Bonds and short 2.00 of its Stocks. This will cost $114.95, leaving $5.05 in profit. However, the investment banker is perfectly hedged. No matter what the future state of the world may be, her payments to the client will be exactly

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offset by the net receipts from the portfolio. Specialists who make such computations are termed financial engineers. Their task is to determine ways to provide desired sets of payments under various contingencies with existing securities and/or new arrangements that can partially or fully offset other commitments.

Opportunity Sets
Given an initial wealth and a set of market opportunities, an investor can attain a number of alternative combinations of time-state claims. The set of all such opportunities is termed (rather unimaginatively), the investor's opportunity set. To separate the influence of wealth from that of market opportunities, one can consider the set of opportunities available with a wealth of one unit of present value. A particular investor's opportunity set will have the same form, scaled up as needed to account for his or her wealth. In the present instance we can plot such a set as a three-dimensional diagram since there are only three needed dimensions -- present apples, good weather apples and bad weather apples. We do so in a later section. For now we consider an even simpler case that focuses on the opportunities for future apples per present apple invested. We plot four investment strategies. The first represents purchase of a pure "bad weather apple" security, the second one of the Apple Tree Firm's bonds, the third one of the firm's stocks, and the last a pure "good weather apple" security. The associated payment matrix is: Q: Good Bond Stock Bad 1 20 43 0 0 20 28 1

Good weather Bad weather

and the associated security price vector, ps is: Good 0.285 Bond 19.000 Stock 30.875 Bad 0.665

We wish to determine the future apples per present apple invested for each of these securities. To do so we divide each future value in Q by the corresponding price in ps: q ./ [ps;ps] = Good Weather Bad Weather Good 3.5088 0 Bond 1.0526 1.0526 Stock 1.3927 0.9069 Bad 0 1.5038

The ratio of an ending value to the initial value is termed a value relative. Thus if the weather is good, the value
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relative for a stock will be 1.3927. Subtracting 1.0 gives the return. If the weather is good, the stock will return 0.3927, or 39.27 percent. Note that an atomic security will return -100% in all states and times but the one for which it is designed. All the returns are plotted in the figure below and connected with a straight line:

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The point representing the bond lies on a line sloping upward at 45 degrees from the origin, since it provides the same payment in each state of the world. The point representing the stock lies above it and to the left. One can attain any combination lying on the straight line connecting these two points by holding a portfolio of both securities, with the sum of the values of the two holdings equal to one present apple. The larger the amount invested in the stock, the closer the point will be to the point representing an all-stock portfolio. The larger the amount invested in the bond, the closer the point will be to the point representing an all-bond portfolio. Let rb be the vector of value relatives for the bond (column 2 in the matrix above) and rs the vector of value relatives for the stock (column 3 in the matrix above). Then the vector of value relatives for a portfolio with proportion xs invested in the stock and (1-xs) invested in the bond will be: rp = xs*rs + (1-xs)*rb For example, with xs = 0.6: rp = 1.2567 0.9652 If only the bond and the stock can be traded, how can one attain points on the line outside the range encompassed by these two securities? Simple. Apply the same formula, but with a negative value of xs or (1-xs). Thus if xs = 0.5 and (1-xs) = 1.5: rp= 0.8826 1.1255 Since the equation is one of a straight line, any point on the extension of the line through the points representing the two traded securities is available by combining a long (positive) position in one with a short (negative) position in the other. Our two atomic securities are, of course, extreme cases of this general principle. This example shows graphically why any two securities can be used to "span a space" with two states of the world. It also shows why any security not priced in accordance with the atomic prices implied by two traded securities will present an opportunity for arbitrage. Assume that a third security (Z) exists that plots above the line in the figure. Imagine a line drawn from it to the origin. Label as ZZ the point at which this constructed line crosses the line in the figure. The portfolio of bonds and stocks that will provide ZZ offers a smaller payoff in each state of the world than does Z. Thus one could take a short position in portfolio ZZ and use the proceeds (one present apple) to purchase security Z. In each future state of the world, security Z would provide more than enough apples to pay the counterparty or counterparties to the short position in portfolio ZZ. Voila: something for nothing. Once arbitrage opportunities of this sort have disappeared all possible strategies will on a linear opportunity set. In a two-dimensional case such as this, the set will plot as a line. In a three-dimensional case it will plot as a plane. In higher dimensional cases the task of plotting would be arduous indeed, but mathematicians would say that the points "plot" on a hyperplane.

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If one wishes to be precise, both the linear frontier and all points under it should be considered members of the opportunity set, since one can always throw apples away. The points on the frontier can be said to constitute the set of efficient opportunities, since only individuals who could be satiated (get too much of a good thing) might wish to consider interior points. Note that all of this discussion depends on the assumption that one can take a negative position in a security when and if desired. This can be done by simply signing a document of the form: I promise to pay the holder whatever the Apple Tree Firm pays its stockholders Alternatively, one can engage in a short sale. This is implemented as follows. Assume that A wishes to sell stock X short (equivalently, take a short position). He or she can borrow shares from B, who does own them, then sell them to C (who can remain oblivious to the fact that the shares were never actually owned by A). Upon the sale of the shares, A will receive an amount equal to the price of the shares -- exactly the reverse of the situation that would obtain if he or she had purchased them (in which case A would have paid this amount). However, A will have promised to "make B whole", by paying to B anything that B would have received had he or she retained the shares. In addition, B can usually demand that A return the shares on demand. One way or another, A will pay the amounts that someone who had purchased the shares would have received. Here, too, the situation is reversed. In such circumstances, a short sale will in fact be equivalent to a negative purchase. In practice, things are not always this simple. B may worry that A will be unable to make some or all of the required payments and/or fail to purchase the stock if and when B calls for its return. Hence B may demand that A earmark some "good faith money" that can be acquired in the event of any such default. Worse yet, B may require that A forego some or all the interest earned on such money, with such gains going to B. Under such circumstances, a short sale is not precisely equivalent to a negative purchase. Increasingly, institutional arrangements allow investors to take short positions that are very similar, if not identical, to negative holdings. Any costs or impediments associated with such approaches can be considered transactions costs. As usual, we will generally ignore them to avoid even more complexity.

Consumption and Investment Decisions


Consider the opportunities available to an individual with W apples to spend. He or she could spend the entire W apples immediately, obtaining thereby W units of consumption today. In this rather extreme case, he or she could look forward to no consumption in the future. An alternative (and equally extreme) strategy would involve purchase of the maximum number of claims for future consumption if the weather is good. Since the price of each such claim is 0.285 apples, he or she can exchange W apples today for 3.5088*W apples in the future if the weather is good. Of course, such a choice involves zero consumption today and zero consumption in the future if the weather is bad. The third possible extreme strategy involves the exchange of apples today for the maximum possible amount of consumption in the future if the weather is bad. Since each such claim costs 0.665, a total of 1.5038*W apples can be consumed under these conditions, but only by sacrificing both consumption today and in the future in the
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event that the weather is good. These choices are extreme or pure consumption-investment strategies. One and only one type of time-state claim is chosen, with all others rejected. Clearly, few would choose such strategies. The figure below shows the opportunity set in this case. It is a plane, the borders of which are shown by the three red lines connecting the extreme strategies.

The most interesting alternatives lie on the portion of the plane away from the corners. Such points represent efficient combinations of present and contingent future consumption. Any point on the plane can be obtained by an individual with a wealth (present value) of W apples by a judicious allocation of that wealth among the three "pure" strategies and/or any other securities that are priced appropriately. Our use of the term wealth in this example is not gratuitous. The wealth of an individual may be defined as the
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maximum amount of present consumption that could be obtained if all his or her property were sold (traded for present units of the numeraire). Thus an individual who owned an apple tree might currently be located at a point near the middle a plane such as that shown in the figure, but his or her wealth would still be measured by the intercept on the consumption axis of the plane through that point. Given market prices, individual opportunity sets will differ only in scale. If individual D is twice as wealthy as individual C, her opportunity set will be parallel to that of C but twice as far from the origin. An individual's opportunity set will thus be determined by his or her wealth and security characteristics and prices. In an economic sense, anyone who chooses a point on the opportunity set other than the one at the allconsumption corner is an investor who sacrifices potential present consumption to obtain at least the possibility of future consumption. The goal of the Analyst is to help the Investor understand the possible trade-offs and then move efficiently from the point representing current opportunities to the point on the frontier of the opportunity set that is most desirable for the Investor. It is convenient to decompose a set of choices of this sort into a consumption/investment decision and an investment decision. In a three-dimensional diagram, the former would concern the position chosen on the Consumption Now axis, while the latter would concern the relative positions chosen on the Good and Bad axes. While this dichotomy is useful, it is important to remember that investment opportunities may influence one's consumption decision and that consumption opportunities may influence one's investment decision.

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Multiple Commodities, States and Times

Contents:
q q q q q q q q q q q q q

Expanding the World Money Real and Nominal Interest Rates Multiple Commodities Multiple States Incomplete Markets Hedging at Minimum Cost Completing a Market Multiple Times Dynamic Strategies Model Risk Options Derivatives

Expanding the World


The Apple economy has served us well, but it is time to consider more complex worlds. We begin with situations in which there are other commodities and, most importantly, money. We then consider circumstances in which more than two states of the world can occur in a single period. Finally, we expand the analysis to cover situations in which there are more than two time periods.

Money
Standard definitions assign the term "money" to instruments that are legal tender within a political jurisdiction. In principle, one must accept such instruments in the settlement of transactions. Currency and deposits against which checks can be written are usually considered money. Assets that can quickly, easily and cheaply be turned into money are often termed "near-money". For our purposes, money can be thought of as a medium of exchange. We will generally use dollars as our standard monetary unit in examples. One may think of these as U.S. Dollars, Australian Dollars, Hong Kong Dollars, or any other such currency. For notation, we follow the standard practice of preceding an amount with the identifying symbol. Thus $1.50 represents 1.50 dollars. For symmetry, we will do the same for apples: hence, A2.50 represents 2.50 apples.
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In most economies, conditions of trade are stated in monetary units. Moreover, most trades involve a swap in which at least one side involves money per se. Thus we trade money for apples (buy apples), trade money today for money a year from now (e.g. buy a one-year Treasury bill), trade money today for apples next year, etc.. If one wishes to trade today's apples for next year's oranges, it may be most efficient to sell the apples today (trade today's apples for today's money), invest the proceeds (trade today's money for next year's money), and use the proceeds to purchase oranges next year (trade next year's money for next year's oranges). The number of dollars for which a commodity can be traded at any given time is generally termed its price. In some contexts it is desirable to use a more precise term: the spot price of a commodity is an amount determined and paid contemporaneously with the delivery of that commodity. The spot price of a commodity will depend on both the amount of the commodity and the amount of money available at the time. Other things equal, the greater the amount of money relative to the amount of a commodity, the higher will be its price. Inflation (rising prices) is often attributed to "too much money chasing too few goods". Central banks attempt to control national money supplies to avoid excessive inflation (and deflation). However, other objectives and outside influences may compromise such good intentions. In practice, there is by no means a simple one-to-one relationship between the money supply and prices. As economies become more intertwined it becomes more and more difficult for a government or central bank to manage any element of a national economy, including its prices. And, of course, even if the general level of prices in an economy remains constant, there will be changes in relative prices, as dictated by changing demand and supply conditions. To illustrate the behavior of a monetary economy, we begin with a world with only apples and money. As before, there are two periods and two future states of the world (good and bad weather). Initially, we assume that the monetary authorities are able to adjust the money supply so that there is more money when there are more apples and less when there are fewer and that this adjustment will succeed in keeping the price of an apple constant at $0.50. As in the earlier examples, we assume that the price of 1 good weather apple is 0.285 present apples and that the price of 1 bad weather apple is 0.665 apples. Consider first all the possible trades between the present and time 1 if the weather is good: Time 0 Time 1 (good)

A0.285 ---------------- A1 | | | A1 = $0.50 | A1 = $0.50 | | $0.1425 $0.50 If apples can be traded as shown in the top portion of the diagram, then it is possible to trade $0.1425 today for $0.50 next year if the weather is good. This follows from the fact that knowledge of the state of the world resolves all uncertainty at any specific time. Thus at time zero we know that if the weather turns out to be good, the price of an apple will be $0.50 at time 1. Hence $0.1425 can be converted to 0.285 apples today, those apples can be used to purchase a claim for 1 apple next year if the weather is good, and we know in advance that that apple can be converted to $0.50 if that state of the world obtains.

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In practice, the economy is more likely to look like this: Time 0 Time 1 (good)

A0.285 A1 | | | A1 = $0.50 | A1 = $0.50 | | $0.1425 -------------- $0.50 Explicit markets will exist for buying and selling commodities at each time period, with transactions involving time and/or uncertainty conducted in monetary units. Thus if one wants to swap today's apples for next year's apples if the weather is good, one might sell A0.285 apples, obtain $0.1425, use this amount to purchase a claim for $0.50 if the weather is good, and plan to use that amount to purchase 1 apple when and if the state of the world obtains. Well and good, but what if the price of a commodity in a future time and state is expected to differ from that of today? Assume that if the weather is good, the price of an apple is expected to rise to $0.60 due to an increase in the money supply, the velocity at which money circulates, or both. In this case we would have: Time 0 Time 1 (good)

A0.285 A1 | | | A1 = $0.50 | A1 = $0.60 | | $0.1425 -------------- $0.60 Note that the current apple price of one good weather apple remains at A0.285. However, the current dollar price of one good weather dollar is $0.1425/$0.60, or $0.2375. We term the former a real (apple) exchange rate and the latter a nominal one. When future commodity prices differ from current prices, there will be disparities of this sort. However, arbitrage will insure that there is a close relationship among commodity prices, real exchange rates and nominal exchange rates. To complete this latter example, assume that if the weather is bad the price of apples will remain at $0.50. Thus: Time 0 Time 1 (bad)

A0.665 A1 | | | A1 = $0.50 | A1 = $0.50 | | $0.3325 --------------- $0.50 The dollar price of one dollar if the weather is bad is $0.3325/$0.50, or $0.665; in this case the apple and dollar exchange rates are the same.
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Real and Nominal Interest Rates


In the current example, there are two discount factors: Real 1 good weather apple = 0.285 present apples 1 bad weather apple = 0.665 present apples -------------------------------------1 future apple = 0.950 present apples Nominal 1 good weather dollar = 0.2375 present dollars 1 bad weather dollar = 0.665 present dollars -------------------------------------1 future apple = 0.9025 present apples Thus the real discount factor is 0.950, while the nominal discount factor is 0.9025. Closely related to the concept of a discount factor is that of the default-free interest rate. For a case involving only the present and a future period, the rate may be expressed on a per-period basis and calculated simply. If the discount factor is d, then one unit will "grow to" 1/d in one period. Thus, given a real discount factor of 0.95, one apple will grow to 1/0.95, or 1.0526 (approximately) apples in one year. We say that the associated interest rate is 0.0526, or 5.26 percent per year. Thus: 1+i or: i = (1/d) - 1 = 1/d

equivalently: d = 1/(1+i)

In our example, the real interest rate is 5.26%, while the nominal interest rate is approximately 10.80%: (1/0.9025)-1. In a potentially inflationary environment, nominal interest rates will be higher than real interest rates, with the difference larger, the greater the likely degree of inflation.

Multiple Commodities
In the real world there are, of course, many different types of commodities (there are also different types of currencies, but we leave this complication for a later discussion). Formally, the time-state approach assumes that once the state of the world is known, all uncertainty is resolved concerning contemporaneous commodity prices. Thus markets need only (!) exist for each commodity and money at a given time and for claims for money across

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time and possible states of the world. With multiple commodities, the simple notion of a real exchange rate breaks down, and with it the notions of real discount factors and real interest rates. For example, the real interest rate expressed in oranges may differ from that expressed in apples, kumquats or whatever. Economists attempt to get around this problem by using the price of a pre-defined basket of goods and services to compute a price index. They then convert nominal exchange rates to real rates using the price of such a basket of goods. Such undertakings are fraught with hazard. A basket is unlikely to be fully representative of the purchasing habits of a given individual or institution. If the basket's composition is held fixed, the change in cost will likely overstate the cost of obtaining a constant degree of satisfaction, since adaptation to a new set of relative prices is not taken into account. Finally, it is difficult to fully take into account changes in quality when attempting to determine a change in the "cost of living" (or producing) at a given level of happiness (or efficiency). Despite these problems, price indices are important for financial analysis. Accordingly, governmental agencies compute and publish various versions designed to represent the costs faced by representative consumers and producers. Most countries have established consumer price indices as well as producer price indices. More general measures are those used for computing overall national statistics, in particular gross domestic product deflators, employed to estimate changes in the real levels of domestic production of economies. Any price index can be used to estimate a real counterpart for a nominal value. In practice, Analysts usually employ a consumer price index (CPI) designed to represent (as best possible) the buying habits of a typical member of an economy.

Multiple States
Thus far we have assumed that from one period to the next there are only two possible states of the world (specifically, good weather and bad weather). For many applications this stretches credulity. Over a year there can be good weather, fair weather, bad weather, plagues, pestilence, and so on. If an entire economy is to be modeled, one may need to consider a multiplicity of possible outcomes. Imagine a world in which there are two periods (now and a year from now) and three possible states of the world (Good Weather, Fair Weather and Bad Weather). As before, there is a Bond and a Stock. All values are stated in dollars. The payment matrix is given by Q: Bond 20 20 20 Stock 43 35 28

Good Weather Fair Weather Bad Weather

and the security prices by ps: Bond 19 Stock 30.875

What are the atomic prices?


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Our general rule is, of course p = ps*inv(Q) But it is impossible to take the inverse of Q, since it is not square. The number of rows is equal to the number of possible states of the world. To be able to invert the matrix we need as many columns (securities) as there are rows (states of the world). In this case we need one more security. Assume some research turns up a convertible bond. Such an instrument is a bond with promised payments that can, on the holder's demand, be converted to a common stock with equity interest. Since one should only undertake such a conversion when the equity is worth more than the bond, we can write the cash flows associated with the various states of the world assuming optimal exercise of the option to convert. Assume that doing so gives the payment matrix Q: : Bond 20 20 20 Stock 43 35 28 Convertible 35 25 25

Good Weather Fair Weather Bad Weather

If the convertible is selling for $24, we have the security price vector ps: Bond 19 Stock 30.875 Convertible 24

We can now compute the atomic prices p = ps*inv(Q). To four decimal places they are::

Good Weather 0.0250

Fair Weather 0.5571

Bad Weather 0.3679

The discount factor is, as always, sum(p). In this case: sum(p) = 0.95 which is not surprising, given the presence of the same riskless bond as used in the earlier examples. With three states of the world, three securities are needed to "span the space". However, to do so, the securities must be sufficiently different. Consider, for example, the following payment matrix Q: Bond 20 20 20 Stock 43 35 28 Security X 21.5 17.5 14.0

Good Weather Fair Weather Bad Weather

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If you were to try to take the inverse of this matrix, the results would be (at the very least) a warning message. MATLAB would say something like: Warning: Matrix is close to singular or badly scaled. Results may be inaccurate. RCOND = 4.648137e-019 The problem is not difficult to discern -- every payoff from Security X is precisely half that from the Stock. It is thus not different enough to complement the other two securities and allow construction of portfolios that can replicate any desired set of payments across the three states. The securities are not "different enough" -- they do not span the state space. To see what the latter expression means, consider again our earliest example of the Apple Tree Bond and Stock. The diagram showing the opportunity set for contingent payments per dollar invested is repeated below, with two arrows added.

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The point shown for the Stock depends on three values -- its payments in each of the two states of the world and its current price. Given the payment vector, the price will determine the actual location of the point, but it will lie on the vector shown by the arrow through the current point, no matter what the price may be. Similarly, the Bond will plot at some point along the vector shown by the arrow through its current point. As long as the arrows are distinct ("different"), the securities will plot at two different points and support an opportunity set with a boundary such as that shown by the line in the diagram. Imagine the consequences if the securities fell on the same vector (arrow). If they were priced to plot at the same point, it would clearly be impossible to use them to obtain any other combination of payments. If they plotted at different points, one could take a short position in one and a long position in the other and make a potentially infinite amount of money with no risk and no investment! The latter case is of course implausible, and both fail our test.. In general, if there are S states of the world in a given time period, S securities that plot on different "arrows" in the state space are required. Since the locations of the arrows depend only on the payment vectors, it is the set of such vectors (our matrix Q) that must meet this condition. The test is simple: if Q can be inverted, the securities are sufficiently different. If it cannot, they are not. If an available set of securities spans a state space, we say that the markets are complete.

Incomplete Markets
If states of the world are defined very narrowly, the number of possible states of the world is very large. The number of securities (broadly construed) is also large, but almost certainly smaller than the number of possible states. Thus markets are incomplete in a global sense. On the other hand, for many applications it is sufficient to define states broadly. For example, assume that an Analyst wishes to value and/or hedge an investment product that has payments tied to the level of a stock index. For such an analysis, there is no need to differentiate between the state "Stock Index level = $500 and sailing conditions are good" and the state "Stock Index level = $500 and sailing conditions are bad". The broader state "Stock Index level = $500" suffices, for it resolves all the uncertainty that is relevant for the issue at hand. While securities may not span a detailed space, they may do so very well for a more aggregated one. Consider the following payment matrix Q: Bond 20 20 20 Stock 43 28 28

Good Weather Fair Weather Bad Weather and price vector ps: Bond 19

Stock 35

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Each security provides the same payment in the state Fair Weather as in the state Bad Weather. If one is interested only in payment patterns that also have this characteristic, the problem may be reduced to one involving two states. Thus, we have Q: Bond 20 20 Stock 43 28

Good Weather Fair or Bad Weather

and can compute the atomic prices p = ps*inv(Q). They are::

Good Weather 0.56

Fair or Bad Weather 0.39

The latter price is, in effect, the sum of two prices: the price of $1 if the weather is fair and the price of $1 if the weather is bad. We are able to measure the sum but have no way to know what the value of each of the components might be. The markets are sufficiently complete to price or replicate any payment pattern in which the same amount is to be paid in the two states (Fair and Bad Weather). However, if someone asks for a payment pattern in which a different amount is to be received in Fair Weather than in Bad Weather, it will be impossible to find a replicating strategy involving the Bond and the Stock in question. This example is of considerable practical importance. Payment patterns that can be replicated with existing securities can be priced with considerable accuracy. Moreover, an Investment Firm can offer products with such patterns by taking an offsetting position in the appropriate replicating strategy. When this is done, the product is said to be fully hedged and there is in principle no risk associated with it other than uncertainty about the future state of the world. More interesting but more problematic are investment products that offer payment patterns not available with combinations of existing securities. Such products cannot be fully hedged by the provider, nor can their prices be established definitively using the prices of other securities. Consider an Investor who asks an Investment Firm to create an investment product with the following payments: Good Weather Fair Weather Bad Weather 40 30 20

What should the Investment Firm charge? And how might it hedge as much of the associated risk as possible? The problem is, of course, the fact that no matter what combination of the Bond and the Stock is chosen, the net payments will be the same in Fair Weather and Bad Weather. To be absolutely certain that no net outlay might be required, the firm would have to select a combination of securities that would pay 40 in Good Weather and 30 in Fair or Bad Weather. In this case: ps =
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Bond 19 Q = Good Weather Fair or Bad Weather c = Good Weather Fair or Bad Weather n = inv(Q)*c: Bond Stock price = ps*n: 34.10 Bond 20 20

Stock 35

Stock 43 28

40 30

0.5667 0.6667

Thus it would cost $34.10 (price) to purchase a portfolio (n) that would cover all outflows. Note, however, that in the event that the weather is Bad, the portfolio will provide $30 while the firm would be obligated to pay out only $20, leaving $10 as profit. Thus the Investment Firm would be delighted to sell the product for a price of $34.10. Moreover, if it did so and undertook the hedge (n), the Investor would be assured of receiving the promised payments under all circumstances.

Hedging at Minimum Cost


The approach used in the previous example may be generalized by formulating the problem in a manner that allows for the number of securities to be less than, equal to or greater than the number of states of the world. The goal is to minimize the cost of meeting or exceeding the required payment in each state of the world. Using our previous notation: select: to minimize: subject to: n ps*n Q*n >= c

In this formulation, n {securities*1} is the vector of decision variables, ps {1*securities} contains the coefficients of the linear objective function, or minimand, Q {states*securities} contains the coefficients of the left-hand side of the constraint set, and c {states*1} contains the coefficients of the right-hand side of the constraint set. The matrix representation of the constraint set is straightforward, The left-hand side Q*n is a {states*1} vector,

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as is the right-hand side c. The matrix inequality indicates that each element of the left-hand vector (amount available to be paid) must be greater than or equal to the corresponding element of the right-hand vector (amount required to be paid). Since this problem involves a linear objective function and linear inequality constraints, it is a member of the class of linear programming problems and can be solved using any of a number of algorithms (procedures) designed for such tasks. MATLAB's optimization toolbox includes a function named lp for this purpose. The simplest use is described in MATLAB as follows:

x = lp(f,A,b) solves the linear programming problem: min f'x subject to: Ax <= b x

This is almost precisely what we need. However, the inequality is reversed. This is easily overcome, for: Q*n >= c is the same as: -Q*n <= c (for example: 3>=2 and -3 <=-2) Thus the problem can be solved with the following MATLAB expressions: n = lp(ps,-Q,-c); price = ps*n; While our current interest is in the use of the linear programming formulation in an incomplete market setting, it can also be used in a complete market. In such a case, the procedure can produce a portfolio that will achieve the required set of payments exactly. If more securities are included than there are states, there will typically be multiple ways of meeting the goals; however, if the markets are arbitrage-free, all such portfolios will have the same cost. Linear programming algorithms can provide a set of Lagranian multipliers, each of which indicates the change in the objective function (here, cost) per unit change in one of the right-hand side coefficients. In this instance, each such multiplier for constraints that are binding is the atomic price for a state -- how much it would cost to have one more dollar paid in that state. Here is the MATLAB description of the procedure used to obtain these multipliers: [x,LAMBDA]=lp(f,A,b) returns the set of Lagrangian multipliers, LAMBDA, at the solution. To obtain the set of atomic prices and the hedge portfolio, one could use the MATLAB expression:

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[n p] = lp(ps,-Q,-c);

Completing a Market
We return now to the problem faced by the Investment Firm. A potential client wants a product that will pay c: Good Weather 40 Fair Weather 30 Bad Weather 20 But the only existing securities are a Bond and a Stock with payments Q: Bond 20 20 20 Stock 43 28 28

Good Weather Fair Weather Bad Weather and prices ps: Bond 19

Stock 35

The firm has run its linear programming algorithm and found that for $34.10 it can meet its obligation in every state of the world, but with $10 left over if the weather is Bad. Surely, it figures, this is worth something (but at most 0.39*10 = $ 3.90, according to our previous calculations). Assume that after some thought, it offers the product for $32.00. Moreover, it is willing to "make a market" and "take either side", that is, buy or sell the product at that price. We now have three securities, with payment matrix, Q: Bond 20 20 20 Stock 43 28 28 Product 40 30 20

Good Weather Fair Weather Bad Weather and price vector ps: Bond 19

Stock 35

Product 32

The market is now complete, with atomic prices p = ps*inv(Q): Good Weather Fair Weather Bad Weather

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0.56

0.18

0.21

In effect, the Investment Firm has priced the Fair Weather and Bad Weather claims at $0.18 and $0.21, respectively, resolving the indeterminacy of the split of the prior known value of $0.39 between the two claims. In the real world, as in this example, an Investment Firm, by offering a new product with sufficient guarantees of payment in all circumstances, can provide an important service by making the capital markets more complete. In this case the availability of such a product fully completed the market, since the Bond, the Stock and the new Product completely span the space of relevant states of the world. Any desired set of payments across the three states can be replicated with some combination of these three instruments. Even if motivated only by greed and cupidity, Investment Firms can provide significant social services and move markets closer and closer to the idealized ones described in works such as this.

Multiple Times
Practical applications of the time-state approach often dispense with the convenient fiction that the world ends after one period. It is time for us to do so as well. Following practice, we focus on cases in which a variable of interest can move in one of two directions in each time period. To keep things as simple as possible, we allow for two future time periods (times 1 and 2), in addition to the present (time 0). The tree of possible states of the world now has seven nodes:

Instead of numbering the nodes sequentially we use letters for all but time zero. The number of letters indicates the time period (thus state gg is at time period 2, since there are two letters). The sequence of letters indicates the path taken to reach the node (thus gb indicates a good branch followed by a bad one). A diagram such as this is sometimes termed a lattice. Since only two branches emanate from each node, the underlying relationship is often termed a binomial process.

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A security or Investment Product is represented with a set of values or cash flows in such a tree. We start with a two-period zero-coupon Bond that grows in value by 5% per period. Its initial value is $1.00. The values of a Bond at the nodes are shown below:

Our second security is a Stock that pays no dividends. Its price increases 26% in good times but falls to 96% of its prior value in bad times. Its initial value is also $1.00. The values at the nodes are shown below:

In this case S, the number of future states of the world equals six. Our previous discussion indicated that six different securities would be required to span this space and hence allow replication and valuation of Investment Products. This remains true if the term "security" is expanded to include a planned acquisition of a security in the future. Taking this view, six distinct elemental combinations of payments can be provided using the two traded instruments. The associated purchases and sales are as follows:
q q q q q

B0: Buy a bond today; sell it at the end of period 1 S0: Buy a stock today; sell it at the end of period 1 Bg: At period 1, if the state is g, buy a bond; sell it at the end of period 2 Sg: At period 1, if the state is g, buy a stock; sell it at the end of period 2 Bb: At period 1, if the state is b, buy a bond; sell it at the end of period 2

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q

Sb: At period 1, if the state is b, buy a stock; sell it at the end of period 2

Only the first two strategies involve an outlay at the present. The latter involve outlays (negative cash flows) at future times under some circumstances, but none today. The associated payment matrix Q is: B0 1.05 1.05 0 0 0 0 S0 1.26 0.96 0 0 0 0 Bg -1.00 0 1.05 1.05 0 0 Sg -1.00 0 1.26 0.96 0 0 Bb 0 -1.00 0 0 1.05 1.05 Sb 0 -1.00 0 0 1.26 0.96

g b gg gb bg bb

The price vector ps is: B0 1.00 S0 1.00 Bg 0 Sg 0 Bb 0 Sb 0

To find the atomic prices, we proceed as always to find p = ps*inv(Q): g 0.2857 b 0.6667 gg 0.0816 gb 0.1905 bg 0.1905 bb 0.4444

Dynamic Strategies
To see how a multiple-time approach can be used in a practical situation, consider the following Investment Product: At time 2, Investment Firm will pay the holder an amount equal to: $1.50 if the Stock is worth more than $1.50 $1.00 if the Stock is worth less than $1.00 The value of the Stock otherwise What is this collar around the price of the Stock worth? Is there some other way that an Investor could obtain the same results? To answer these questions, construct a vector (c) with the cash flows associated with the product: g b gg gb 0 0 1.50 1.2096

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bg bb

1.2096 1.00 = p*c:

Next, compute the value 1.0277

and the replicating portfolio n = inv(Q)*c: B0 S0 Bg Sg Bb Sb 0.2853 0.7423 0.2670 0.9680 0.3136 0.6987

While we may term this a portfolio, it would usually be considered a dynamic strategy. It calls for an initial purchase of $0.2853 of Bonds and $0.7423 of Stocks (for a total cost of $1.0277). If the weather turns out to have be good at the end of the first period, the Bonds will have grown to 1.05*$0.2853, or $0.2996, while the Stocks will have grown to 1.26*0.7423, or $0.9354, giving a total portfolio value of $1.2350. The strategy calls for this portfolio to be sold and a portfolio with $0.2670 of Bonds and $0.9680 of Stocks purchased. The cost will be precisely equal to the proceeds obtained from the sale of the initial positions, as shown below: Initial 0.2996 0.9354 ------1.2350 Revised 0.2670 0.9680 -------1.2350 Difference -0.0326 0.0326 -------0.0000

Bond Stock

In fact, of course, it would only be necessary to sell $0.0326 of Bonds and purchase $0.0326 of Stocks to implement the needed change. If the weather turns out to have been bad, the stock position at the end of the year will only be worth 0.96*$0.7423, or $0.7127. The situation would then be the following: Initial 0.2996 0.7127 ------1.0123 Revised 0.3136 0.6987 -------1.0123 Difference 0.0140 -0.0140 -------0.0000

Bond Stock

In this case, $0.0140 of Stocks would be sold and the proceeds used to purchase $0.0140 of Bonds.

Model Risk
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In principle, any set of time and state-contingent cash flows can be replicated with any set of securities that spans the relevant space of time-state claims. Moreover, if there are only two possible branches at each node in the tree representing the underlying process, planned acquisition and sale of two different securities at each intermediate future time period will suffice to span the entire space. What can go wrong? Two things. First, a counterparty can default, in whole or in part, on an obligated payment. Second, the model may be wrong. The possibility of the latter is known as model risk. Two examples will illustrate the type of dangers lurking behind such arrangements. Assume that the tree drawn in the previous example is in error in one respect. If Stocks do poorly in the first year, they are likely to do somewhat poorer than initially projected in the second year. Specifically, the true payment matrix is. QQ: B0 1.05 1.05 0 0 0 0 S0 1.26 0.96 0 0 0 0 Bg -1.00 0 1.05 1.05 0 0 Sg -1.00 0 1.26 0.96 0 0 Bb 0 -1.00 0 0 1.05 1.05 Sb 0 -1.00 0 0 1.20 0.90

g b gg gb bg bb

The correct strategy would have been nn = inv(QQ)*c: B0 S0 Bg Sg Bb Sb 0.4450 0.6093 0.2670 0.9680 0.3535 0.6987

which would have cost $1.0543. The strategy adopted, using the wrong model, cost less ($1.0277), but would in fact provide a different set of payments (QQ*n) from that desired: g b gg gb bg bb 0.0000 0.0000 1.5000 1.2096 1.1677 0.9581

If the first year turns out to be Bad, problems lie ahead. The Investment Firm will think that it is fully hedged but wake up to find that it either owes $1.2096 with only $1.1677 of assets (state bg) or that it owes $1.0000 with
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only $0.9581 of assets (state bb). The second example is different in kind but similar in outcome. Assume that the tree and payment matrix are completely accurate, but that the market "moves too fast" to make any trades at the end of the first period. Instead, the positions established at the outset must be held until the end of the second period. This is not unlike the experience in a number of stock markets on the day in October, 1987 known as "Black Monday", when some of the participants found that their assumption that trades could be made after relatively small price changes was in error. In this case, the results would be as follows: Bonds 0.2853*1.05*1.05 0.2853*1.05*1.05 0.2853*1.05*1.05 0.2853*1.05*1.05 Stocks 0.7423*1.26*1.26 0.7423*1.26*0.96 0.7423*0.96*1.26 0.7423*0.96*0.96 Total 1.4931 1.2125 1.2125 0.9987

gg gb bg bb

In this case, the Investment Firm actually makes money if the Stock reverses its behavior (state gb or bg) but is in trouble (may not be able to make its payments) if the stock price continues in the same direction (state gg or bb). Model risk is an important element whenever a dynamic strategy is adopted to provide a desired set of cash flows. Both firms that plan to hedge obligations and those who are counterparties for such firms must be keenly aware of the possibility that the underlying model is wrong in some sense or another. A stress test, in which changes in the underlying model are examined to estimate the magnitudes of likely deviation, can prove valuable in assessing the degree of the danger associated with this type of risk.

Options
Thus far, our examples have involved a specified set of cash flows at each of the nodes in the time-state tree. Futures and forward contracts have such attributes, as do many swap agreements. However, a great many financial arrangements involve one or more options: at certain times and under some or all conditions, one or both parties may change the pattern of remaining cash flows. Consider first a European Call Option which allows the option holder (buyer) to "call away" a security or stock index for a pre-specified amount at a given date. To illustrate, we use the previous example in which a Stock price can increase to 1.26 times its prior value or decrease to 0.96 times its prior value in each of two periods while a Bond grows to 1.05 times its prior value in each period. We wish to analyze an option to call away the stock for $1.10 at the end of the second period. The value of the Stock at the end of that period will depend on the final state of the world, as follows: gg gb bg bb $1.5876 $1.2096 $1.2096 $0.9216

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Clearly, it would be foolish to pay $1.10 for something worth less. Hence optimal exercise involves choosing to let the option expire in state bb and exercising it in every other state. The net value received in each state will thus be: gg gb bg bb $0.4876 $0.1096 $0.1096 $0

In terms of the full vector of possible cash flows, c: g b gg gb bg bb 0 0 0.4876 0.1096 0.1096 0

The cost of providing these flows with a dynamic strategy equals p*c: $ 0.0816 The replicating portfolio (strategy) is n: B0 S0 Bg Sg Bb Sb -0.5220 0.6036 -1.0476 1.2600 -0.3340 0.3653

The initial position involves the investment of $0.0816 of the investor's money plus $0.5220 of borrowed funds to purchase $0.6036 of the Stock. Subsequently, the positions are adjusted, depending on the state of the world, but in each case the strategy combines borrowing (a short position in the Bond) with investment (a long position in the Stock). A European option may be exercised only on its expiration date . An American option may be exercised at any date up to and including its expiration date. Analysis of the latter is somewhat more complex than that of the former. Consider an American put option that allows the holder to "put" (sell) the Stock to the option writer (seller) at a price of $1.20 at either time period 1 or time period 2. If the option is held until time period 2, it should be left to expire worthless in all but state bb. In this case, the option will be worth $0.2784 since it can be used to sell a stock worth only $0.9216 for $1.20.
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The figure below shows the situation diagramatically. The values in the boxes for time period 2 indicate the cash flows if the option is held until time period 2 and then exercised optimally.

Should the option be exercised at the end of period 1? Consider first the situation if the first year is Good. The Stock will be worth $1.26. If the option were exercised, the holder would sell something worth $1.26 for $1.20, thereby losing $0.06. Moreover, the game would be over. It is immediately apparent that it is better to continue (to get zero) than to exercise and obtain $ -0.06. The situation at the end of a Bad year 1 is not as clear. Since the Stock will be worth $0.96, immediate exercise will net $0.24, as shown in the diagram. Is it better to take this amount or to continue to hold the option in the hope of receiving either 0 (state bg) or 0.2784 (state bb) at the end of the next year? The question can be posed in terms of alternative vectors of cash flows. Which is better? c1: g b gg gb bg bb or c2: g b gg gb bg bb 0 0.24 0 0 0 0 0 0 0 0 0 0.2784

The answer is easily found by pricing the two alternatives:


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p*c1 = 0.1237 p*c2 = 0.1600 Clearly, it is better to exercise the put at the end of year 1 if the stock price falls. Planning to do so makes the option worth $0.1600 at the outset. Planning to not do so makes it worth only $0.1237. The figure below shows the tree after it has been "pruned" to include only optimal paths.

The procedure for pruning is simple conceptually. First, the tree is priced, using the standard securities, so that the value of a payment at each node is known. Then one starts at the end, working back one node at a time. The present value of the cash flows associated with one decision (here, to exercise the option) is compared with the present value of the cash flows associated with the alternative decision (here, to not exercise the option). The better choice is retained and the poorer one discarded. The process is performed first for all the nodes at the last time period. Then it is performed for all the nodes at the penultimate (next-to-last) period, then for the period before that, and so on. To speed up the process, each node can be assigned a present value based on optimal choices at subsequent nodes. The set of such values for the nodes at time period t can then be used when evaluating choices for nodes at time period t-1. The final result will be a set of rules for making optimal choices, a corresponding set of cash flows, and the associated present value which will be the largest possible, given the alternatives. If a contract between party A and party B gives B one or more options, how should party A arrive at an appropriate price? One might assume that party B will act optimally and hence follow the procedure described above. However, in many cases option-holders do not do this. For example, homeowners who borrow money via mortgages often retain an option to prepay their loan at fixed amounts, regardless of the course of interest rates. Pools of such mortgages are frequently assembled and sold as an Investment Product. The value of such a pool will depend critically on the nature of prepayments by the individual mortgagees. Consider a borrower who has a $100 8% loan with one year to run. She can either pay $108 in a year or $100 today. If the current rate of interest is 7%, it is to her advantage to "pay off" the loan for $100 with money borrowed at 7%, thus replacing an obligation to pay $108 with one to pay $107. If, on the other hand, interest rates are 9%, it would be undesirable for her to pay off the loan. In practice, a mortgagee may fail to prepay a loan when interest rates fall below the rate at which the mortgage
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was issued, due to costs or inattention. Moreover, some will pay off loans when interest rates are above the initial rate, due to a need to sell a house, etc.. The prices of mortgage pool securities are typically higher than they would be if borrowers always exercised optimally in a narrow sense. Those who analyze such products incorporate a prepayment model in their calculations, based on observed behavior of a class of borrowers. Profits can be made by analysts who utilize a model superior to that reflected in market prices. On the other hand, losses can be incurred by those with inferior models. To a major extent, the competition among active managers of funds that utilize mortgage instruments is a competition among prepayment models. When both parties to an agreement retain options, valuation requires assumptions about the behavior of each one. Thus a convertible callable bond provides the issuer with an option to call the bond from the holder under certain conditions and an option for the holder to convert the bond into the issuer's stock under some conditions. If each party is assumed to exercise optimally, valuation can proceed using the general procedure outlined above. Otherwise, more complex assumptions are required. Whatever the model used to predict choices made when options are available, the goal is to reduce the problem to one involving a vector of time and state-contingent cash flows. If markets for the associated securities are sufficiently complete, the value of an Investment Product with options and a replicating dynamic strategy can be determined.

Derivatives
The instruments that we have examined in the last few examples are all derivatives -- Investment Products whose value depends on the values of one or more underlying securities. We have considered only cases in which a derivative is tied to one security value. Such instances are well suited to binomial models of the behavior of the value of the underlying security. More complex derivatives may be based on the behavior of the prices of two or more securities or on values of non-investment vehicles (e.g. the average temperature in July at a particular resort). The farther the underlying value from that of a traded security, the less likely it is that a replicating portfolio can be determined and the derivative's value established definitively. In such cases perfect hedging is impossible and the specter of counterparty risk looms especially large. It is an overstatement to say that an Investor can attain any desired pattern of time and state-contingent cash flows via either Investment Products or dynamic strategies. However, the range of possibilities is very large indeed and growing larger by the day. This leaves the Analyst with two key questions: what set of payments is the most desirable and what is the best way to achieve the desired outcome? If an Investment Product is utilized, there is the danger that the counterparty will fail to make all required payments, at least in some circumstances. The more exotic the derivative, the greater such counterparty risk is likely to be. On the other hand, if the Investor undertakes a dynamic strategy, he or she is directly (rather than indirectly) subject to model risk. An Investor who chooses a derivative Investment Product will need to examine the assets and other liabilities of the counterparty. One who chooses a dynamic strategy will have to examine the credentials and methods utilized by his or her Analyst.

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Interest Rates and Bond Yields

Interest Rates and Bond Yields

Contents:
q q q q q

Multi-period Discount Factors Multi-period Interest Rates Bond Yields Duration Forward Interest Rates

Multi-period Discount Factors


A nominal discount factor is the present value of one unit of currency to be paid with certainty at a stated future time. This definition suffices, whatever the time period. In a multi-period setting there is one discount factor for every time period. Thus df(1) could be the present value (at time 0) of $1 certain at the end of time period 1, df(2) the present value at time 0 of $1 certain at the end of time period 2, etc.. The vector of such values df {1*periods} is known as the discount function. It can be used to value any vector of cash flows known to be certain. If cf {periods*1} is such a vector, its present value is simply: pv = df*cf In this equation, pv is termed the discounted present value of the cash flows. The one-period example generalizes to a multi-period setting in another respect. The discount factor for a given period will equal the sum of the atomic prices for that period. This follows because the purchase of one unit of every time-state claim for a specified time will guarantee one unit of the currency at that period. The cost of such a bundle is the cost of one unit of currency certain at that date, and hence equals the associated discount factor. In many countries, nominal discount factors are easily discovered. For example, in the United States, financial publications report recent prices of U.S. Treasury Bills and "Strips", each of which promises a fixed dollar payment at one specified date. Since the Treasury has the power to print dollars, payments on such securities can be considered certain, absent revolution, etc.. The reported prices on any given day thus constitute the discount function at the time.
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Real discount factors are another matter. In some countries the government issues bonds with payments linked to a price index. Such bonds typically provide both coupon payments at periodic intervals and a final principal payment at maturity. If there are enough issues with sufficiently different maturities, at least some elements of discount function can be determined. Consider a case in which there are three bonds. The one-year bond promises a payment of 103 real or "constant dollars" (e.g. Apples) in a year. The two-year bond promises a payment of 4 constant dollars in one year and 104 in two. The three-year bond promises a payment of 3 constant dollars in years 1 and 2 and 103 in year 3. The current prices are $100, $101 and $98, respectively. What are the real discount factors (i.e. the present value of $1 of purchasing power in each of the next three years?). To answer the question we construct a {periods*bonds} cash flow matrix Q: Bond1 103 0 0 Bond2 4 104 0 Bond3 3 3 103

Yr1 Yr2 Yr3

and a price vector p {1*periods}: Bond1 100 Bond2 101 Bond3 98

The price of each bond should equal its discounted present value. Thus: df*Q = p where df {1*periods} is the discount function. We wish to find df, given Q and p. Multiplying both sides of the equation by inv(Q) gives: df = p*inv(Q) In this case, df {1*periods) is: Yr1 0.9709 Yr2 0.9338 Yr3 0.8960

Thus a claim for 1 real dollar in year 1 is worth $0.9709 now, a claim for 1 real dollar in year 2 is worth $0.9338 now, and so on. Any desired set of real payments over the next three years can be valued using this discount function.
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To find the combination of such bonds that will replicate a desired set of cash flows we utilize the formula: Q*n = c where n {bonds*1} is a portfolio of bonds and c {periods*1} is the desired set of payments. From this it follows that n=inv(Q)*c. Thus if the desired set of payments is c: Yr1 Yr2 Yr2 300 200 100

The replicating portfolio is n: Bond1 Bond2 Bond3 2.8107 1.8951 0.9709

Whether for real or nominal units of a currency, if a discount function can be determined from the values and characteristics of default-free instruments, any corresponding vector of cash flows can be valued and replicated. Moreover, any such vector can be "traded for" any other with the same present value. The set of such combinations forms the default-free opportunity set available to the Investor. The Analyst can help determine the set, but ultimately the Investor must select either one of its members or a vector of cash flows that is not fully default-free.

Multi-period Interest Rates


While a discount factor provides a natural and direct measure of the present value of a certain future cash flow, it is sometimes convenient to focus on a related and more familiar figure. If an investment grows from a value of x to a value of x*(1+i) in one period, it can be said to have "earned interest" at the rate i. The concept can be extended to multiple periods by assuming that interest compounds once per period. Thus if an investment grows from V0 to V2 in two periods, the equivalent interest rate is found by solving the equation: (1+i)*(1+i) = V2/V0 or: (1+i)^2 = V2/V0

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The ratio of the ending value to the beginning value is termed the (t-period) value relative. For an investment held t periods, the associated interest rate is computed from: (1+i) = (Vt/V0)^(1/t) Interest rates are generally used to describe securities for which payments are certain. In a one-period setting, such securities can be termed riskless. In a multi-period setting it is preferable to describe them as default-free since their values may fluctuate, making them risky if sold before the final payment has been made. There is a one-to-one relationship between a discount factor and the corresponding interest rate. If df(t) is the discount factor for time t, one unit of the numeraire will grow to 1/df(t) units with certainty by time t. Thus i(t), the default-free interest rate for time t is given by: i(t) = ((1/df(t))^(1/t)) -1

With the value of the "t-period interest rate", one can discount any certain payment to be obtained at that date. Let P(t) be an amount to be paid at t and i(t) the corresponding interest rate. Then the present value pvis given by: pv = P(t) / ( (1+i(t)) ^ t)

Since there is a one-to-one relationship between a discount factor and the associated interest rate, either may be used to calculate a present value. Moreover, give one of them, the other can be determined with little effort. Consider the following discount function df: Yr1 0.9400 Yr2 0.8800 Yr3 0.8200

The corresponding value relatives are given by vr = 1./df: Yr1 1.0638 Yr2 1.1364 Yr3 1.2195

Using the MATLAB notation of [1:3] to generate the vector [1 2 3], the interest rates can be computed as i = (vr.^(1./[1:3]))-1: Yr1 0.0638 Yr2 0.0660 Yr3 0.0684

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or: Yr1 6.38% Yr2 6.60% Yr3 6.84%

These values, when plotted, give one version of the current yield curve or term structure of interest rates. In this case it is upward-sloping, with long-term rates greater than short-term rates. In these calculations, we have computed interest rates assuming compounding once per period. One could as easily use a definition based on compounding more than once per period; or not at all; or continuously. When processing an interest rate, it is important to know which definition was used so that errors do not creep into subsequent calculations. The possibility of alternative definitions makes the use of discount factors a safer approach. Moreover, a case can be made for the thesis that a discount factor, being a price, is a fundamental characteristic of an economy, while an interest rate is a derived construct. This being said, interest rates are ubiquitous, helpful for comparisons of prices of payments at different times, and necessary for communication with those used to more traditional characterizations of financial markets.

Bond Yields
Many bonds, both traditional and index-linked, provide coupon payments periodically and a final principal payment at maturity. Consider, for example, a bond that provides payments cf of: Yr1 Yr2 Yr3 6 6 106

Given the previous discount function, such a bond has a present value of $97.84. Based on its initial par value of $100, the yield is 6% per year. However, given the fact that it is selling for $97.84, the effective yield is greater. To reflect this, analysts often use a derived figure, the yield-to-maturity. This is a constant interest rate that makes the present value of all the bond's payments equal its price. In this case, we seek a value for i that will satisfy the equation: 6/(1+y) + 6/((1+y)^2) + 106/((1+y)^3) = 97.84 This can be done by trial and error, preferably using an intelligent algorithm to find the result (to a desired degree of accuracy). In this case, i is approximately 6.82%. A set of yields-to-maturity for bonds with varying coupons and maturities will typically not plot on a single curve. Nonetheless, some analysts crossplot yield-to-maturity and maturity date for a set of bonds, then fit a "yield curve" through the resulting scatter of plots. The result may be helpful, but should not be
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used for valuation purposes.

Duration
The maturity of a bond provides important information for its valuation. The values of longer-term bonds are generally affected more by changes in interest rates, especially longer-term rates. However, for coupon bonds, maturity is a somewhat crude indicator of interest rate sensitivity. A high-coupon bond will be exposed more to short and intermediate-term rates than will a low coupon bond with the same maturity, while a zero-coupon bond will be exposed only to the interest rate associated with its maturity. To provide a somewhat better measure than maturity, Analysts often compute the duration of a set of cash flows. Let df be a {1*periods}vector of discount factors and cf a {periods*1} vector of cash flows. The duration of cf is a weighted average of the times at which payments are made, with each payment weighted by its present value relative to that of the vector as a whole. In the previous example, the bond has cash flows cf: Yr1 Yr2 Yr3 6 6 106

The market discount function df is: Yr1 0.9400 Yr2 0.8800 Yr3 0.8200

The present values of the cash flows are v = df.*cf'': Yr1 5.6400 Yr2 5.2800 Yr3 86.9200

To compute weights we divide by total value, w = v/(df*cf), giving: Yr1 0.0576 Yr2 0.0540 Yr3 0.8884

In MATLAB, the expression [1:3]'produces the {periods*1} vector of time periods: Yr1 Yr2 Yr3 1 2 3

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The duration, given by d = w*([1:3]'), is 2.8307 years -- somewhat less than the maturity of 3 years. Well and good, but what use can be made of duration? In some circumstances, quite a bit. In others, somewhat less. We make the calculation to better understand the reaction of the value of a vector of cash flow to a change in one or more interest rates. In practice, of course, many such rates along the term structure may change at the same time. In general, if the discount function changes from df1 to df2, the present value of cash flow vector cf will experience a change in value equal to: dV = (df2 - df1)*cf How can one number summarize the effect on value of a change in potentially many different interest rates along the discount function? Of necessity, a change in the yield-to-maturity of a bond will cause a predictable change in the value of that bond or set of cash flows, since there is a one-to-one relationship between the two. The relationship holds as well for most cash flow vectors. In such case the term internal rate of return is utilized, instead of yield-to-maturity. If there are sufficiently many positive and negative cash flows in a vector, the internal rate of return may not be unique, causing potential mischief if one relies upon it. However, this cannot happen if the vector consists of a series of negative (positive) flows, followed by a series of positive (negative) flows -- that is, if there is only one reversal of sign. In practice, a bond's duration is usually calculated with a discount function based on its own yield-tomaturity, that is: [ 1/(1+y) 1/((1+y)^2) 1/((1+y)^3) ]

Now, consider c(t), the cash for the t'th period. Using the bond's yield-to-maturity, Its present value is: v(t) = c(t)/((1+y)^t) If there is a very small change dy in y, the change in v(t) will be: dv(t) = (c(t)*(-t*(1+y)^(-t-1))) * dy or dv(t) = (v(t)*-t) * (dy/(1+y))

Summing all such terms we have the total change in value dv: dv = sum(dv(t)) = - sum(v(t)*t) * (dy/(1+y))
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Finally, the proportional change in value, dv/v is: dv/v = sum(dv(t)/v) = - sum((v(t)/v)*t) * (dy/(1+y)

But the term inside the parentheses preceded with "sum" is the duration, calculated using the bond's own yield-to-maturity. Thus we have: dv/v = - d * (dy/(1+y)) Sometimes the duration is divided by (1+y) to give the modified duration. Letting md represent this, we have: dv/v = - md * dy Thus the modified duration indicates the negative percentage change in the value of the bond per percentage change in its own yield-to-maturity. The minus sign indicates that an increase (decrease) a bond's yield-to-maturity is accompanied by a decrease (increase) in its value. Duration (modified or not) is of no interest unless one can establish a relationship between a bond's own yield-to-maturity and some market rate of interest. For example, assume y = y20+.01, where y20 is the interest rate on 20-year zero coupon government bonds. In this case: dy = dy20 and: dv/v = md * dy20

which relates the percentage change in the bond's value to the change in a market rate of interest. The concept of duration that is especially relevant for Analysts who counsel the managers of definedbenefit pension funds. Many such funds have obligations to pay future pensions that are fixed in nominal (e.g. dollar) terms, at least formally. Moreover, the bulk of the cash flows must be paid at dates far into the future. The present value of the liabilities of such a plan can be computed in the usual way and its yield-to-maturity (internal rate of return) or discount rate, determined, using market rates of interest. In many cases, the discount rate will be very close to a long-term rate of interest (e.g. that for 20-year bonds). Since term structures of interest rates tend to be quite flat at the long end, any change in the longterm rate of interest will be accompanied by a roughly equal change in the discount rate for a typical pension plan of this type. Thus the duration of the plan's cash flows provides a good estimate of the sensitivity of the present value of its liabilities to a change in long-term interest rates. Any imbalance between the duration of the assets in a pension fund held to meet those liabilities and the duration of the
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liabilities may well provide an indication of the extent to which the fund is taking on interest rate risk.

Forward Interest Rates


In our most recent example, the discount function df was: Yr1 0.9400 Yr2 0.8800 Yr3 0.8200

with associated interest rates: Yr1 0.0638 Yr2 0.0660 Yr3 0.0684

For example, $1 invested at a rate of 6.60% per year, compounded yearly, would grow to $1/0.88 dollars at the end of two years. This interest rate could be termed the 2-year spot rate to emphasize the fact that it assumes an investment that begins immediately and lasts for two years. A different type of interest rate involves an agreement made immediately for investment at a later date and repayment at an even later date. For example, one might agree today to borrow $1 in a year and repay $1 plus a stated amount of interest one year later (i.e. two years' hence). The interest rate in question is termed a forward interest rate to emphasize the fact that it covers an interval that begins at a date forward (i.e. in the future). Of particular interest are forward rates covering periods that last only one period. Such rates can be denoted by their starting date. Hence the 1 year forward rate covers the period from the end of year 1 to the end of year 2, but on terms negotiated today. Given the discount function, it is possible to arrange today to borrow 1/df(1) dollars at the end of year one and pay 1/df(2) dollars at the end of year 2 for a zero net investment, since each "side" will have a present value of $1. Hence, arbitrage decrees that any forward contract covering the same period will have the same results. This insures that: (1/df(1)) * (1+f(1)) = (1/df(2)) where f(1) is the forward rate for the period beginning at the end of year 1 and ending at the end of year 2. Re-arranging the equation above gives the simpler form: f(1) = (df(1)/df(2)) - 1 More generally:
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f(t) = (df(t)/df(t+1)) - 1 In the special case in which t = 0, the "forward rate" will, in fact, be the spot rate for a one-year loan, since df(0), the present value of $1 today, is $1. To obtain the full vector of forward rates, we create a lagged vector dfl of all but the last discount factor, preceded by the present value of $1 today: dfl = [ 1 df(1:2)] Yr1 1.00 Yr2 0.94 Yr3 0.88

Dividing each element of the original discount function by the corresponding element in this vector, then subtracting 1 gives the forward rate vector f: f = (dfl ./ df) - 1 f(0) 0.0638 f(1) 0.0682 f(2) 0.0732

Thus one dollar grows to $1.0638*1.0682 in two years and $1.0638*1.0682*1.0732 in three years. Of necessity, these calculations reach the same conclusion as do those based on the respective spot interest rates. However, the latter use different rates for the same year (e.g. year 2), depending on the investment being analyzed, while the former do not. Thus forward rates are closer to economic reality and can be used with far less risk of error. Forward rates are especially useful when an Analyst is trying to predict future levels of inflation for estimating liabilities of a pension plan with benefits tied to salary levels, which are in turn, affected by changes in the cost of living. A standard assumption holds that a forward interest rate is the sum of two components: (1) a liquidity premium (sometimes called a term premium) and (2) an expectation concerning the spot rate that will hold at the time. Thus the two-year forward rate in our example (7.32%) might be considered to be the sum of a normal liquidity premium for such obligations of 1.0% and a consensus expectation of market participants that the one-year spot rate will equal 6.32% for year 3. The spot rate, in turn, may be assumed to equal an expected one-year real return of, say, 1.5% plus an expected level of inflation equal to 6.32%-1.5%, or 4.82%. Combining the two calculations gives: Forward Rate - Liquidity Premium - Expected Short-term Real Return ---------------------------------file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/mia_prc4.htm (10 of 11) [15/10/2001 10:50:27]

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Expected Inflation Here: 7.32 -1.00 -1.50 -----4.82 A common set of assumptions holds that liquidity premia increase at a decreasing rate as maturity increases and that expected short-term real returns are constant. This implies that the term structure of forward rates will have the same shape as the liquidity premium function in periods in which inflation is expected to remain constant. If the forward curve is steeper, inflation is presumably expected to increase. If it is flatter or downward-sloping, inflation can be expected to decrease. Procedures such as this applied to the set of forward interest rates allow an Analyst to estimate levels of future inflation that are consistent with current market yields. As usual, the estimates are only as good as the assumptions, but are likely to be better than the use of some average historic inflation level, especially in periods in which term structures of interest rates are unusually steep, unusually flat, or actually downward-sloping.

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Forward Prices

Forward Prices

Contents:
q q q q q q

Forward Prices Atomic Forward Prices Properties of Atomic Forward Prices Valuation Using Atomic Forward Prices Prices and Probabilities Return Swaps

Forward Prices
We have used the term price to refer to an amount to be paid at the present time for a time-state claim or bundle of such claims. Not surprisingly, the magnitude of such a value is specified at the present time. Thus party A might agree to deliver a dollar next year if the weather is good, in return for which party B delivers 0.285 dollars immediately. It is, of course, possible to agree today to an exchange in which both receipts and payments will occur in the future. Forward interest rates represent the terms of such an arrangement. Similar procedures can be followed when contingencies are involved. For example, party A could agree to deliver 7 dollars next year if the weather is good while party B agrees to deliver 3 dollars next year if the weather is bad. In this case, both "sides" of the transaction are contingent and will take place (if at all) in the future. Of particular interest are cases in which all payments are in the future, but one involves payments that are not state-dependent. For example, party A might agree to deliver one dollar next year if the weather is good while party B agrees to deliver 0.30 dollars next year no matter what the weather has been. In this case we would say that the forward price of a good weather dollar is 0.30 dollars delivered next year: party B bought one good weather dollar for 0.30 dollars to be delivered (with certainty) one year hence.. A forward price involves a future payment date. Thus in a multi-period setting, one could have a oneyear forward price for a given set of time-state claims, a two-year forward price for the same set of claims, etc.. The first would indicate an amount that would have to be paid in one year to purchase the set of claims. The second would indicate an amount that would have to be paid in two years to purchase the
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set of claims, etc.. In each case, the price would be determined at the present time and the agreed-upon amount would have to be paid at the specified future time, regardless of the nature of ensuing events.

Atomic Forward Prices


We have said that an atomic price is the present value of a "pure security" -- i.e. a claim that pays one unit of a stated commodity or currency at a specified time and state of the world. For present purposes we focus on claims that pay in currency terms. In particular, we assume that one unit of such a claim pays $1 at the stated time if and only if the state of the world occurs. We define an atomic forward price as an amount that must be paid with certainty for such a claim, with payment to be made at the same time as the possible payment in question. Thus in our example the atomic forward price for one good-weather dollar is $0.30. By extension, we may say that the forward price for a bundle of claims that share the same payment date, but differ only in the states of the world in which they are to be paid is the amount to be paid with certainty at the common date for which the bundle can be obtained. Note that at time 0 there will be a forward price for, say, a claim or combination of claims that will be paid (if at all) at time 3. At time 1 there will be a potentially different forward price for the same set of claims. However, contracts struck at time 0 will require payment of the initial amount at time 3, even though contracts newly negotiated at time 1 will require a different amount. This means that a deal negotiated at time 0 that had a net present value of zero at the time may well have a negative or positive net present value at time 1, depending on the events that transpired in the first period. Realistic accounting calls for both parties to adjust their books to reflect the new value, thereby marking to market the positions involved.

The Relationship between Prices and Forward Prices


Arbitrage ensures that there is a very close relationship between prices and forward prices. Consider an economy in which a security promising $1 in year 1 if the weather is good commands a price of $0.285. Assume that an investment firm offers you such a security in return for a promise to pay $0.305 at the end of the year. Is this a good deal? To obtain the answer one must consider the rate at which present (certain) dollars can be exchanged for certain future dollars. Assume that in this economy the one-period discount factor is 0.95. Thus one can exchange one certain future dollar for 0.95 present dollars. Alternatively, one can exchange 1/0.95, or 1.052632 certain future dollars for one present dollar (the one-period interest rate is 5.2632 percent per period). Assume that you wish to buy a good weather dollar security but pay for it at the end of the year.
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You could agree to pay $0.305 at the time to the investment firm. Alternatively, you could borrow $0.285 in order to buy such a security on the open market. You would, of course, have to repay the loan, which would require the payment of $0.285/0.95, or $0.285*1.052632 at the end of the year. But this is $0.300! Thus the investment firm was trying to make you agree to pay $0.305 in a year for something "worth" (obtainable elsewhere for) a promised payment of $0.300. In a market populated by astute Analysts, the investment firm would find that it had no takers for this product. If it were willing to take the other side of the offer, clever analysts could make money with neither risk nor investment via arbitrage between its terms and those available directly or indirectly in public markets. Sooner or later, arbitrage will force equality between the present price of a set of time-state claims and the discounted forward price, using the appropriate discount factor (or, equivalently default-free interest rate). Thus, if fc(t) is the forward price to be paid at time t for the claim, df(t) is the discount factor for time t, and pc is the present price of the claim: pc = df(t) * fc(t) Given a present price, one can determine the appropriate forward price, or vice-versa, using the appropriate discount factor.

Properties of Atomic Forward Prices


It is important to understand the precise meaning of an atomic forward price. Consider the forward price of 0.300 for a dollar in year 1 if the weather has been good. What net payments would the forward purchaser of such an atomic claim have to make? The answer depends on the weather. If the weather is good: Pay: Receive: net $ 0.300 $ 1.000 ----$ 0.700

If the weather is bad: Pay: Receive: net $ 0.300 $ 0.000 ----- $ 0.300

In fact, the two parties could as well agree that if the weather is good, A will pay B $0.70, but if the weather is bad, A will receive $0.30 from B.
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Forward Prices

Forward atomic prices can, of course, be computed directly from (present) atomic prices and the discount factor. Assume that the present value of $1 if the weather is bad is $0.665. Then the atomic forward prices are: good weather dollars: bad weather dollars: 0.285/0.95 = 0.300 0.665/0.95 = 0.700

Note that they sum to 1.000. This is hardly a surprise. Consider the effect of buying one unit of every time-state claim. Such a bundle of claims will guarantee the receipt of $1.00 no matter what state may occur. It will also require the payment of an amount equal to the sum of all the corresponding forward atomic prices. If this sum is less than 1.000, one can get something for nothing by buying a package of equal amounts of all such claims. If it is more than 1.000, one can get something for nothing by selling such a package. Arbitrage will thus ensure that the sum will be 1.000. Thus: The sum of the forward atomic prices for a given date must be 1.000.

Valuation Using Atomic Forward Prices


The relationship between prices and forward prices allows one to value a set of time-state claims in two steps. First, all claims for a given time period are analyzed and their collective forward value determined. This is repeated for each time period. Finally, the resultant values are discounted, using the discount function, to obtain the overall present value. Consider our previous example with two states of the world at time 1 (g and b) and four states at time 2 (gg, gb , bg, and bb). The prices were given by p: g 0.2857 b 0.6667 gg 0.0816 gb 0.1905 bg 0.1905 bb 0.4444

The associated discount function df is thus: Yr1 Yr2 0.9524 0.9070

The forward prices for year 1 are: g 0.30 b 0.70

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and those for year 2 are: gg 0.0900 gb 0.2100 bg 0.2100 bb 0.4900

Now, consider the task of valuing the following set of claims c: g b gg gb bg bb 5 3 15 12 11 5

Given the atomic prices p the result can be determined by simple matrix multiplication: p*c = 11.2562

Here is the alternative. First, compute the forward value of the time 1 claims: State g b Payment 5 3 Forward Price .30 .70 Forward Value 1.50 2.10 ------3.60

Next, the forward value of the time 2 claims: State gg gb bg bb Payment 15 12 11 5 Forward Price 0.09 0.21 0.21 0.49 Forward Value 1.35 2.52 2.31 2.45 -----8.63

Finally, the discounted present value of both sets of claims:

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Forward Prices

Time 1 2

Future Value 3.60 8.63

Discount Factor 0.9523 0.9070

Present Value 3.4286 7.8277 -------11.2562

Prices and Probabilities


Thus far, nothing has been said about probabilities. This is just as well, for there is no "law of one probability". Market participants can hold radically different opinions concerning the probabilities of various states of the world. No matter -- the markets will still function. Prices will be set, valuation can be performed, replicating strategies can be determined, packages of state-contingent claims can be valued using atomic prices or the combination of atomic forward prices and discount factors, and so on. Despite these facts, there is a great temptation to interpret atomic forward prices as probabilities. All such prices for a given time sum to 1.0, as must any set of probabilities assigned rationally to the states in question. The forward value of a set of claims for a given time period could be interpreted as the expected value of the payments if only the atomic forward prices were probabilities. If so, one could argue that to value a set of claims one only need discount the expected values, using riskless rates of interest. But there is no reason to expect that the atomic forward price of a time-state claim equals the probability assigned to it by a single market participant or even a consensus of market participants. Quite the contrary. Hence it is dangerous to equate an atomic forward price with any notion of the probability that the associated state will occur. Nonetheless, many Analysts accept the danger inherent in such a position, while recognizing the fact that prices and probabilities need not be the same. Commonly, they may use the term risk-neutral probability instead of "atomic forward price", then argue that valuation involves discounting (at riskless rates of interest) the (pseudo-) expected payments at each period, with riskneutral probabilities used to calculate expected values. The rationalization for this approach rests on two observations. As we will discuss subsequently, if investors were all risk-neutral and agreed on the probabilities of the various states of the world, the atomic forward price for a time-state claim would equal the agreed-upon probability of its occurrence. But if there is anything known about investors it is that they are risk-averse, not risk-neutral. Moreover, they do not all agree on probabilities. Hence atomic forward prices are not probabilities in any simple sense. Despite these objections, those who use this nomenclature can still get the right answers. However, the economics of the situation are at best hidden from sight and may in many cases be overlooked entirely. Most importantly, it is easy to slip over the line and equate prices ("risk-neutral probabilities") with real probabilities. We attempt to avoid the confusion that such an approach can entail. Here, prices are prices
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Forward Prices

and probabilities are probabilities. The relationships among them are complex and need to be addressed explicitly, which we do in other sections.

Return Swaps
We conclude this section with yet one more example that illustrates that prices alone can provide all the needed answers for many important practical problems. A very popular arrangement encouraged by financial engineers can be termed a return swap. Consider the following case. Investor A promises to pay investor B the return on a notional value of $1 of a Stock, while B promises to pay A the return on a value of $1 of a Bond. We utilize our Stock that can increase by 26% or decrease by 4% in a year, and the Bond that will increase by 5% for certain. In a one-period setting, the return on an asset is simply the value-relative minus 1. Thus the net cash flows are. State good bad Bond 0.05 0.05 Stock 0.26 -0.04 A to B 0.21 -0.09 B to A -0.21 0.09

The final columns of the table summarize the net payments between the counterparties to this swap in each of the possible states of the world. In practice only one payment is made: $0.21 from A to B if the weather is good or $0.09 from B to A if the weather is bad. The obvious question: is this fair? The answer, shown below, is clearly yes. The present value of the amounts paid by A to B is precisely zero! Needless to say, so is the present value of the amounts paid by B to A. Present Value 0.0598 -0.0598 ------0.0000

State good bad

A to B 0.21 -0.09

price 0.285 0.665

This is a very general result, and depends in no way on the simplified world analyzed here. As long as both parties will make the required payments, any swap of the return on a marketable security for the return on another one with equal value will be "fair" (i.e. have zero net present value at the time the deal is struck). To see this, consider how one could "manufacture" the return on a security from other instruments. For simplicity, assume that the goal is to produce the dollar returns on the Stock in question: +$0.26 if the
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weather is good and -$0.04 if the weather is bad. The trick is to purchase one unit of the stock, and take out a loan that will require payment of $1.00 at the end of the year. The net results will then be: Stock Value 1.26 0.96 Loan Payment -1.00 -1.00

State good bad as desired.

Net 0.26 -0.04

The cost of this strategy is $1.00 (for the stock) less the cost of the loan, which is 1/1.05, or $0.9524. But the latter is the discount factor for the time in question. Thus the present value of a promise to receive the return on the stock at time period 1 is 1-df(1) which is, in turn, the discount on a 1-year zero-coupon bond. While we reached this conclusion for the Stock in our example, the result would have been the same if any other asset had been utilized, as a careful review of the argument will indicate. Moreover, with suitable modification, it would hold for other time periods. To generalize: The present value of a guarantee to pay the return on an asset with a notional value of $X is the discount on a riskless loan that requires payment of $X at the end of the period over which the return is guaranteed. Since a return swap involves exchange of two promises with the same present value, it is thus fair. In practice, there is often some uncertainty concerning the ability of one or both counterparties to make all promised (contingent) payments. When this is the case, one or both present values must be decreased (or promised payments increased) to account for credit risk. Careful evaluation of such risk is critical for success in the swap business.

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Macro-Investment Analysis

Probabilities
q q q

Production, Consumption and Market Clearing Risk Premia Consumption and Investment Choices

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Production, Consumption and Market-Clearing

Production, Consumption and Market-Clearing

Contents:
q q q q q q q q

Production Wealth Production Possibilities Optimal Production Consumption Optimal Consumption The Societal Aggregate Product The Market Portfolio

Production
In most of the prior examples, production was very simple. The economy consisted of one or more apple producers, each of whom grew trees with the same output (63 apples if the weather was good, 48 apples if the weather was bad). Consider now a slightly more complex firm: one that will produce 20 apples today, 63 apples in the future if the weather is good and 48 apples in the future if the weather is bad. This production plan can be plotted as a point in a three-dimensional diagram in which the axes plot apples today, apples next year if the weather is good, and apples next year if the weather is bad, as shown below.

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As before, assume that it is possible to swap any one of the three time-state claims for one or more of the other two. Any two swap ratios can be utilized to summarize all possibilities. As before we use the prices (present values) of the atomic securities, each of which represents a payment for one and only one future state of the world. While a firm's production plan will plot as one point in this type of diagram, by utilizing swaps (including traditional market exchanges), the firm can achieve any point on a plane that goes through that point. The plane is easily constructed, once the production plan and market prices (swap terms) are known. If the firm issues more than one class of security, each class will plot at a particular point on a lower plane, but the total value of the various classes will be the same. The set of decisions taken by the firm to move to different points on one or more planes can be considered its financing plan. Of course, the shareholders need not consume the mix corresponding to the point selected by the firm via the combination of its production plan and its financing plan. They, too, can utilize swaps (market exchanges) to collectively achieve any desired points on any desired planes of their own that collectively have the same value as the firm's production plan. Typically, each shareholder will obtain one point on his or her own plane, and utilize market trades to transform it into another point. The total of the consumption-investment combinations chosen by the shareholders will, of course, lie on the plane going through the firm's production point and have the same value as the production plan. In a world of full information and zero transactions costs, it is the distance from the origin of the plane on which a firm's production plan plots that matters. The particular location chosen on the plane (or sub-planes) is, in such a setting, irrelevant to shareholders. If the firm does not choose a point or points that they collectively prefer, they can utilize market exchanges to move to such a point or points themselves.

Wealth
In our simple world, the measure of the value of a production plan is the distance from the origin of the plane that represents combinations of time-state claims that can be obtained from it. Given market prices, all such planes are parallel to one another, so one can measure the desirability of any such plane using virtually any chosen dimension. It is conventional to do this using the "now" axis. In other words, the desirability of a production plan is measured in terms of the number of present goods for which it could be traded. Equivalently, we measure the present value of the plan. The term wealth is often used to indicate a person's present value. For a firm financed entirely through equity, the goal of management can be stated as the maximization of shareholder wealth. The analogous criterion for a firm with more complex financing is the maximization of the wealth of those holding claims on the firm's production (the firm's stakeholders). Given the ability of a firm's stakeholders to trade time-state claims on their own, the financing plan chosen by a firm should be irrelevant. So should any swaps made by the firm, once its production plan is in place. The key issues concern the "trades with nature" that result in the production plan. In the type of world we have described, management should concentrate on choosing a plan that will produce the maximum possible present value for required investment. Aspects of financing via issuance of different types of securities, risk-reduction via swaps, etc. are of no importance. More generally, a firm should undertake new projects if and only if their value exceeds the cost of marketable alternatives with the same timestate payments. The manner in which the needed resources are obtained is (at best) of secondary importance. While such statements are correct in the world under discussion, they are hardly likely to apply without qualification in the world as it is. Transactions costs, asymmetric information, concentration of managers' human and other capital in the firms for which they work, and a host of other issues make some corporate financial decisions more advantageous than others. However, such aspects cannot be adequately analyzed until the essential framework for understanding economies without such features has been built. Hence we continue to deal with our simple frictionless world in which information concerning time-state payoffs is known to all.

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Production Possibilities
Consider a firm with given resources. It will typically have to choose among a number of alternative production plans. Some will be inefficient. In this context, a plan is inefficient if there is an alternative plan that provides more of at least one time-state claim and no less of any time-state claims. Inefficient plans can be rejected out of hand, since each is dominated by at least one other alternative. But this will typically still leave for consideration a number of efficient plans -- i.e. plans that are not inefficient. Efficient plans will generally plot on a "hill" in a diagram with time-state payments on the axes -- a hill that "bulges out" from the origin of the diagram. As long as production technologies may be undertaken at any desired scale with proportionate results, this surface is guaranteed never to "cave in". Consider two plans, X and Y. Point X might represent planting an entire orchard with one type of apple tree, and point Y planting it with another type. Now consider a plan in which half the orchard is planted with one type of tree and the other half with the other. If each tree has the same characteristics, no matter how many are planted, the result will lie half-way between points X and Y in every dimension -- i.e. on the straight line connecting the points in the diagram. If no better alternative can be found, at least this linear set of combinations will be available. Thus the surface will not cave in. If a better alternative is in fact available, the surface will bulge out. The set of efficient production possibilities can be termed the production possibility frontier. If it bulges out, the technology evidences decreasing returns to scale -- a widely-observed phenomenon. A rather crude analogy holds that it looks something like an upside-down mixing bowl (although perhaps a somewhat irregular one).

Optimal Production
Insuring that production is efficient is, at base, a technical issue. This criterion can be met without reference to market prices. However, the choice of the best (optimal) plan from among the efficient plans requires the use of market prices. The rule is simple: for given resources, among such plans select the one with the largest present value. Graphically, this involves selecting the point on the production possibility frontier at which a value plane (every point on which has the same market value) is tangent to (touches but does not intersect) the frontier. This point represents the wealth-maximizing production plan. Its selection is the only important decision made by management in our setting. In the real world, it is still likely to be by far the most important decision for a firm -- considerably more important than financing decisions. Again, a crude analogy: think of the valuation plane as a cookie sheet. Then the optimal production plan lies at the point at which the cookie sheet touches a point on the upside-down mixing bowl.

Consumption
Firms (producers) play a key role in an economy. Individuals (consumers) are the other key players. Ultimately, of course, all resources (including both physical and human capital) are owned by individuals, so people function in both roles. Given his or her resources, an individual will "own" a particular combination of time-state claims. For example, a worker may expect to receive a salary of 100 apples today and a salary of 110 apples in the future if the weather is good or 90 apples if the weather is bad. Such an endowment will plot as a point in the kind of diagram we have been using. However, given the ability to trade in markets, the individual can choose to consume any point lying on the value plane that includes his or her endowment point. This can be done by lending, borrowing, or any of a host of investment transactions. An individual's wealth can be measured by the amount of present consumption that he or she could obtain by exchanging all future prospects for present values, plus the value of present prospects already attained. Acting in one's role as producer, it is desirable to choose a career, location, education, etc. to maximize this present value. We ignore here the importance of intangibles that are not fully tradable, such as peace of mind, integrity, etc., (but do not wish to leave the impression that they are unimportant). In any event, given such decisions, the individual as consumer faces a value plane representing the available combinations of time-state claims. This is sometimes termed a budget plane or consumption opportunity set.

Optimal Consumption
It is trivial, but nonetheless correct, to suggest that a consumer should select from among available consumption combinations the one that he
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or she likes best. Ultimately, this depends on individual preferences. However, it is possible to argue that for most people such preferences are likely to have certain characteristics. It is useful to consider sets of time-state claims among which a consumer exhibits indifference. For example, if a given consumer considers combinations X, Y and Z equally desirable, we say that he or she is indifferent among them. Graphically, they lie on the same indifference surface. A given consumers' preferences can then be represented by a set of such surfaces. Such surfaces will not intersect, since this would involve a contradiction. Assuming non-satiation of preferences, i.e. that each time-state claim is a good (more is better), such surfaces will not have the appearance of the production possibility surface. Rather, they are likely to "curve away" from the origin in a diagram with time-state payments on the axes. In most cases, they will have the appearance of mixing bowls that are "right-side up". Of course, there will be many of them, each representing a set of alternatives preferred to that on the surface below (closer to the origin). The appearance will thus be something like that a set of nested mixing bowls. The figure below shows one "cut" of this relationship. The horizontal axis plots an amount consumed in the present, while the vertical axis plots an amount consumed for certain in the future. In such a trade-off, only the timing of consumption is of relevance, since there is no uncertainty.

Each curve in the figure shows combinations of these two consumption items among which the investor is indifferent. Only a few such curves are shown, of the very many that could be drawn. The key assumption is that each curve becomes flatter as one goes from the upper left portion to the lower right portion. Equivalently, the added amount of the good on the X axis that the consumer will require to give up a unit of the good on the Y axis will be larger, the larger the amount of X and smaller the amount of Y. The figure below shows another type of trade-off. Here the amount consumed in the present is assumed to be fixed, with only the amounts to be consumed under each of the two possible future states to be determined. The vertical axis plots the amount consumed if the weather is good, while the horizontal axis plots the amount consumed if the weather is bad. Needless to say, the diagram reflects preferences when these are still contingent claims -- i.e. before the actual weather pattern is known.

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Here, too the consumer is assumed to have indifference curves that get flatter as one moves from the upper-left to the lower-right. In a sense, this is no different than in the first figure. However, given the nature of the goods in question, there are further implications. Consider combinations X and Y. Since they are on the same indifference curve, the consumer considers one as desirable as the other. For convenience, we denote payments B and G in bad and good weather, respectively, as [B G]. In the figure, X is thus [20 80] and Y is [50 40]. Now consider combination Z, which pays [35 60] and plots midway between X and Y. Clearly, the individual would prefer it, since it lies on a higher (better) indifference curve. Now assume that there are two consumers, each with the preferences shown in the figure. Assume, moreover, that one holds securities providing combination X, while the other holds securities providing combination Y. Together, their portfolios will pay [70 120]. Imagine that a clever entrepreneur sets up a mutual fund, suggesting that both consumers "invest" their shares in return for half the payments received by the fund. Under this arrangement, each will obtain [35 60]. But this is combination Z. The first consumer has traded X for Z, and is happier. The second consumer has traded Y for Z and is also happier. In fact, the entrepreneur could take a bit of the action and still make both consumers (who are now investors) happier. Needless to say, the increased happiness is an ex ante construct in this case. After the fact, one of the two investors will be better off, and the other worse off, than had the change not been made. But this involves hindsight, which always is characterized by 20/20 vision. As the example illustrates, consumers with preferences of the assumed sort will find it desirable to diversify. In an important sense, they are risk-averse.

The Societal Aggregate Product


Each producer in an economy of the sort we have analyzed will choose a production plan based on available resources, technological possibilities and current market prices. Similarly, each consumer will choose a consumption plan based on wealth, preferences and market prices. But what will assure that the total amount of each time-state claim provided by producers will equal the total amount that consumers collectively wish to consume? The answer, of course, lies in the role of prices in a market economy.

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Given a set of prices, if consumers wish to consume more of one time-state claim than producers wish to produce, there will be "buying pressure" (the quantity demanded will exceed the quantity supplied), and the price will rise. Conversely, if consumers wish to consume less of a time-state claim than producers wish to produce, there will be "selling pressure" (the quantity supplied will exceed the quantity demanded) and the price will fall. Such changes will continue until equilibrium is achieved -- i.e. the market for each time-state claim clears (quantity demanded equals quantity supplied). The prices that accomplish this are termed equilibrium prices. There is no point debating the "causes" of such prices. Both supply (production opportunities) and demand (consumer preferences) determine them. Equilibrium prices result from the interaction of both forces, as well as the initial distribution of wealth (including human abilities). When an equilibrium is achieved, the set of the amounts of time-state claims produced and the set of the amounts consumed will be the same. This combination can be termed the societal aggregate product. Assume that in a society the aggregate product in dollars or apples is qtotal: Present Future if Bad Weather Future if Good Weather 100 50 150

Denote the three alternatives as N (now), B (future if weather is bad) and G (future if weather is good). Assume that, as before, the equilibrium price of 1B is 0.665N, and the equilibrium price of 1G is 0.285N. Thus the price vector p is:

Present 1.000

Future if Bad 0.665

Future if Good 0.285

The value of the aggregate product, p*qtotal is $176.00. Assume there are two people in this society, each with the same initial wealth ($88.00). If their preferences were the same, each could select [50 ; 25; 75 ] of [N ; B ; G ], and the markets would clear (equivalently, their aggregate preferred holdings would equal the aggregate product). If their preferences and/or wealths differed, they would generally choose different mixes. However, for the markets to clear, their aggregate preferred holdings must equal the aggregate product. Equivalently, we might represent each individual's consumption choices in terms of the relative values of the holdings. Assume that individual X's wealth is $59.00 and that she chooses [40; 20; 20]. In this context it seems appropriate to call her investor X. Her consumption proportions will then be those shown below. Holding 40 20 20 Price 1.000 0.665 0.285 Value 40.00 13.30 5.70 -----59.00 Proportion 0.6780 0.2254 0.0966 -----1.0000

N B G

Thus Investor X has chosen to consume 67.8% of her wealth now, and to invest the remaining 32.2%. Of the amount invested, 70% (0.2254/0.3220) will be used to purchase claims that pay off in state B and 30% (0.0966/0.3220) to purchase claims that pay off in state G (or some combination of other securities that gives the same overall set of exposures). In this situation, Investor Y will have a wealth of $117.00 and choose the following portfolio: Holding 60 30 130 Price 1.000 0.665 0.285 Value 60.00 19.95 37.05 -----117.00 Proportion 0.5128 0.1705 0.3167 -----1.0000

N B G

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We can also characterize the aggregate product in proportional terms; thus: Holding 100 50 150 Price 1.000 0.665 0.285 Value 100.00 33.25 42.75 -----176.00 Proportion 0.5682 0.1889 0.2429 -----1.0000

N B G

In this world, Investor X has 33.52% of total wealth (59.00/176.00) while Investor Y has the remaining 66.48%. If we were to compute a wealth-weighted average of their two consumption mixes (expressed in proportions), we would obtain the aggregate mix (also expressed in proportions). In this sense, consumers collectively consume the aggregate product of current and contingent goods.

The Market Portfolio


Now consider a related set of calculations in which only future claims are included. The resulting three investment portfolios would then be characterized as follows: Investor X -----------Holding B 20 G 20

Price 0.665 0.285

Value 13.30 5.70 -----19.00

Proportion 0.70 0.30 ----1.00

Investor Y ----------Holding B 30 G 130

Price 0.665 0.285

Value 19.95 37.05 -----57.00

Proportion 0.35 0.65 ----1.00

Society ------B G Holding 50 150 Price 0.665 0.285 Value 33.25 42.75 -----76.00 Proportion 0.4375 0.5625 ------1.0000

The aggregate portfolio is often termed the market portfolio. In terms of invested wealth, Investor X has 25% (19.00/76.00) while Investor Y has 75% (57.00/76.00) of the total. Relative to the market, Investor X is overweighted in B (70.0%, compared with 43.75%) and underweighted in G (30.0%, compared with 56.25%), while Investor Y is underweighted in B (35.0%, compared with 43.75%) and overweighted in G (65.0%, compared with 56.25%). However, their weighted average holdings will equal those of "the market" precisely. Not surprisingly, if one or more investors chooses to hold less than market proportions of a security, other investors must choose to hold more than market proportions, and the total value of the first group's underweighting must equal that of the second group's overweighting. In one sense, this is simply an accounting identity: that which is, must be held. But in a world in which prices have adjusted to achieve equilibrium, no one holds more or less than desired. Thus investors who underweight or overweight relative to the market portfolio do so voluntarily ( for what must seem to them at the time good reasons). An investor can choose to hold securities in market proportions. On average, taking wealth into account, investors must do so. In this sense,
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investing in the market portfolio represents a default position. The Analyst must thus address two key questions: Should the overall portfolio diverge from the market? If so, which types of securities should be underweighted and which ones should be overweighted? Practical and theoretical problems abound, but it is important to ask the right questions.

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Risk Premia

Risk Premia

Contents:
q q q q q q q q q q

Probabilities Expected Returns Risk Premia The Market Risk Premium Forward Prices and Probabilities Atomic Risk Premia Determinants of the Market Risk Premium Atomic Risk Premia Determinants of Atomic Risk Premia Determinants of Security Risk Premia

Probabilities
Hopefully, the reader will agree that a rather substantial amount was accomplished in prior sections of this work. Yet he or she may not have recognized a rather remarkable aspect of the analysis to this point: probability played no direct role whatever! Instead, most of the results followed from the law of one price. The importance of this law should not be underestimated. Whenever it is violated, "the same thing" can be obtained at two different prices. Better yet, it can be purchased for one price and sold at a higher price. In some instances it may take a clever analyst to determine how to construct "the same thing" synthetically via combinations of marketable instruments. Nonetheless, the stakes are high enough to discover how to do so, for the result will be an arbitrage, with concomitant prospects of increased wealth. Modern markets populated by investors and investment professionals driven by greed and cupidity are unlikely to the characterized by large and persistent violations of the law of one price. Thus results that rely on it are likely to be quite robust. In the real world, characterized as it is by transactions costs, differences in information, and so on, prices of things that are "almost the same" may not be equal, but they are nonetheless likely to be close to one another

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Unhappily, there is no such thing as the "law of one probability". Thus Investor X may believe that there is a 40% probability that the weather will be good (and hence a 60% chance that it will be bad), while Investor Y believes that there is a 50% probability that it will be good (and hence a 50% probability that it will be bad). Their beliefs will undoubtedly influence their attitudes towards the associated time-state claims, and hence the equilibrium prices for such claims. But markets can clear without investors reaching any agreement concerning such probabilities. Despite this, much of modern financial theory is built around the notion that there is a single set of probabilities for various outcomes. In some cases it is simply assumed that all investors agree concerning such probabilities. In others, the probabilities utilized for calculations are assumed to be those of a "consensus of well-informed investors". Often the latter characterization represents a rationale for a model built on the foundations of the former (more extreme) assumption. To proceed, we join the theorists who make such heroic assumptions. In particular, we assume that all individuals in our simple economy agree on the probabilities associated with future states of the world. For our initial examples, we assume that they believe our two states are equally probable. Representing probabilities by the vector prob: Bad Weather 0.50 Good Weather 0.50

Not surprisingly, as long as the states of the world that have been enumerated are mutually exclusive and exhaustive (i.e., one and only one will occur), the sum of such probabilities must equal 1.0. Other than this, little can be said ex cathedra, since the concept applied here is that of subjective probability (people's beliefs about the relative likelihoods of various events), not that of objective probability (with its accompanying notion that there is a "true" set of such likelihoods). Whatever the source of such probabilities, we assume for now that they exist and that all market participants agree both about them and about the results of computations involving them -- to which we now turn.

Expected Returns
The expected value of an uncertain variable is obtained by weighting every possible outcome by the associated probability. Equivalently, it is a probability-weighted average of the possibilities. The one-period return from a security is the change in its value plus any distributions received at the end of the period, all divided by the initial value. Consider the Stock that we have been following that will increase in value by 26% if the weather is good but decrease by 4% if the weather is bad. Its return vector r is:
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Risk Premia

Good Weather Bad Weather

0.26 -0.04

The expected return on the Stock will thus equal prob*r, or 0.11 (11.0 percent). We can, of course, compute expected returns for a number of securities in one stage. Assume that a Bond offers a guaranteed return of 5% and that the Market portfolio consists of 60% Stocks and 40% Bonds. Consider the matrix R of returns for the Stock, the Market and the Bond shown below: Stock -0.04 0.26 Market -0.004 0.176 Bond 0.05 0.05

Bad Weather Good Weather

As is so often the case in life, as one goes across the columns, good news (a better return in bad times) accompanies bad news (a poorer return in good times). The expected returns are e = prob*R: Stock 0.110 Market 0.086 Bond 0.050

Not surprisingly, the expected return of the riskless bond is its certain return. For each of the other choices, the expected return is neither the highest possible value nor the lowest. Rather, it is a "middle value". Note that for the Market and the Stock, under no circumstances can the actual return equal the expected value. No matter what, the actual value will deviate from the expectation. Moreover, in this case the magnitude of the deviation from the expected return is larger for the Stock than for the Market. In this sense, the Stock is riskier than the Market, which is in turn riskier than the Bond.

Risk Premia
The difference between the expected return on a security or portfolio and the "riskless rate of interest" (the certain return on a riskless security) is often termed its risk premium. Underlying the terminology is the notion that there should be a premium (higher expected return) for bearing risk. As we will see, however, there is no reason why such premia should be associated with all types of risk. An equivalent definition of a risk premium is: the expected excess return on a security or portfolio, where excess return is the difference between an actual return and that of a riskless security.

The Market Risk Premium


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In our example, the expected return on the Market portfolio is 8.60%, and the market risk premium is 3.60% (8.60% - 5.00%). The associated risk can be measured by the likely divergence between the actual return and the expected return. If the weather is Good, the difference will be 9.00% (17.6% - 8.6%). If the weather is bad, the difference will be -9.00% (-0.4% - 8.6%). Since the two outcomes are equally likely, the absolute value of the divergence will be 9.00%. The market portfolio provides an excess return of 12.60% (3.60 + 9.00) if the weather is good and an excess return of -5.40% (3.60 - 9.00) if the weather is bad. The potential gain over the riskless rate (12.60%) is thus 2.33 times as large as the potential loss relative to the riskless rate (5.40%). This may seem particularly generous, given the assumption that the two situations are equally likely. However, such a relationship is not uncommon in actual markets. Since Stocks and Bonds are issued by firms, the Market Portfolio represents a package of claims on all the productive assets of such firms. Equivalently, it is the set of claims that would be held if only equity financing had been utilized by firms. Given the use of Bonds and Stocks as financing vehicles by a firm, an investor can create an "all-equity" version of the firm synthetically, by holding a portfolio with its bonds and stocks in market value proportions. Conversely, if a firm is financed solely by equity, an investor who would have preferred the payment pattern associated with a "levered" stock could create the latter synthetically by borrowing money, then using both the borrowed money and his or her own funds to buy stock in the unlevered firm. These relationships form the basis for the original Modigliani-Miller theorem: in a world of the sort we are analyzing, "home-made leverage" (borrowing) can serve as a substitute for "firm-made leverage" (borrowing); hence, corporate financing decisions do not matter. In our example, one can, of course, create pure securities synthetically. The security price vector ps and payoff matrix Q can be written as: ps: Bond 1.00 Q: Good Bad Bond 1.05 1.05 Stock 1.26 0.96 Stock 1.00

The state prices, given by p = ps*inv(Q) are: Good 0.2857 Bad 0.6667

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giving value-relatives vr = 1 ./ p: Good 3.50 and returns (vr-1): Good 2.50 Bad 0.50 Bad 1.50

A security that promises to pay off only if the weather is good will provide a return equal to 250% of the amount invested if the weather is good, and -100% if it is not. A security that promises to pay off only if the weather is bad will return 50% if the weather is bad and -100% if it is not. The return matrix Q is thus: Good Security 2.50 -1.00 Bad Security -1.00 0.50

Good Bad

and the expected return vector e = prob*Q is: Good Security 0.75 Bad Security -0.25

The "Good Security" has an expected return of 75%, while the "Bad Security" has an expected return of minus 25%. Clearly, the Good Security has a very high risk premium: 75% - 5%, or 70%. This might not seem too surprising, given the extreme risk involved. However, the Bad Security actually has a negative risk premium (i.e. a "risk discount"): -25% - 5% = -30%. Yet it too is very risky. Obviously, this world is not one in which just any kind of risk is rewarded with a risk premium. What is going on here?

Forward Prices and Probabilities


Part of the answer to the question can be found by comparing the forward prices of pure securities with the probabilities that the associated states will occur. Recall that the forward price for a pure security is
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the amount that one must agree today to pay at a future date. As we argued earlier, arbitrage will ensure that this is simply the current price for the contingent claim plus interest for the period in question. But this implies that the ratio of a current atomic price to the sum of such prices will be the same as the ratio of the corresponding forward price to the sum of such prices. As always, the sum of the forward prices is 1.0. As indicated earlier, this must be the case, since by purchasing one unit of every time-state claim, one is guaranteed a payment of $1 at the future date. Clearly the cost of obtaining this, if paid at the future date, must be $1. Thus forward prices, like probabilities, sum to 1.0. Since the sum of a set of forward prices for a given date must equal 1.0, it follows that the atomic forward price vector f will equal p./sum(p). In this case: Good 0.30 Bad 0.70

Now, compare the forward prices for the states with their probabilities: Good 0.30 0.50 Bad 0.70 0.50

Forward Price Probability

The forward price for a state need not equal its probability. In our example, one such price (Good) is lower, and the other (Bad) is higher than the probability that the state will actually occur. Note, however, that since both sums must equal 1.0, if any price is below its associated probability, at least one other must be above its associated probability. In this example, equilibrium has been achieved when prices are such that a payment of $1 if the weather is good is "cheap" -- it only costs $0.30 (forward) to obtain a payment with an expected value of $0.50 (0.50*$1). On the other hand, a payment of $1 if the weather is bad is "expensive" -- it costs $0.70 (forward) to obtain a payment with an expected value of $0.50 (0.50*$1). Why are people willing to pay these prices? The answer is not too surprising. Other things equal, one would prefer to have goods and services when there are not as many available. Thus payments under bad conditions are more highly prized than those under good conditions. In this case, the society produces less when the weather is Bad than when it is Good. All contingent claims are not equal. The fewer there are, the more valuable another one will be. This aspect of our example captures an important feature of most economies. To see this, consider an alternative scenario in which each of the forward prices of the securities is $0.50, and thus equal to the probability of the associated state.

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As before, the riskless rate of interest would be 5.0%. What would be the expected return on the Market Portfolio? Assume that it still offers payments of $1.26 if the weather is Good and $0.96 if the weather is bad. The state prices would each equal 0.50/1.05, or 0.4762. We thus have: p: Good 0.4762 q: Good Bad price = p*q: 1.0571 prob: Good 0.50 Bad 0.50 1.26 0.96 Bad 0.4762

expected value = prob*q: 1.11 expected return = (expected future value/price) - 1: 0.05 Thus the expected return on the market would equal 5% -- the riskless rate of interest. There would be no risk premium at all! In fact, in a world of this sort, there would be no risk premium on any security -- every single one would have an expected return equal to the riskless rate, as we will show.

Determinants of the Market Risk Premium


Consider the vector f of forward prices. Given a cash flow vector c, we may calculate an associated forward value fv: fv = f*c The forward value of a set of (contingent) cash flows is an amount agreed upon in the present that must be paid for the set at a specified date in the future. In our case, there is only one future period, so the payment date coincides with the date at which cash flows (if any) will be received.

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The expected value of c is calculated by multiplying each possibility by its probability, then summing. As before, assume that the probabilities of the states are included in vector prob. Then the expected value ev will be given by: ev = prob*c We know that arbitrage will insure that the present value pv of a set of claims will equal its forward value discounted at the riskless rate of interest. Thus: pv = fv/(1+i) The expected value relative evr for an investment is its expected value divided by its present value (price): evr = ev/pv But this can be stated in terms of the forward value, using the arbitrage relationship between present and forward values: evr = (ev/fv)*(1+i) The expected value relative for a riskless security is, of course, 1+i. Thus the expected value relative for an investment will be greater than that for a riskless security if ev/fv is greater than one. In such cases the investment will provide a risk premium. If ev/fv is less than one, the expected value relative for the investment will be less than that for a riskless security, and the investment will "provide" a risk discount. An investment for which the expected value is equal to the forward value will offer an expected value relative equal to that of a riskless security and will provide neither a risk premium nor a risk discount. This shows why the risk premium will be zero for every security or portfolio if the forward price for each state equals the associated probability (i.e. f equals prob). In such a world, the expected value (ev) will equal the forward value (fv) in every case, and every expected value relative will equal 1+i. Hence the expected return on every security will equal the riskless rate of interest and there will be no risk premia. For there to be a market risk premium, some atomic forward prices must differ from the probabilities of the associated states.

Atomic Risk Premia


The expected return on an investment is:

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(ev/pv) -1 while its risk premium is: ((ev/pv) - 1) -i or (ev/pv) - (1+i) where i is the riskless rate of interest. The arbitrage relationship between a present value and an associated forward value insures that the risk premium for an investment will also equal: (ev/fv)*(1+i) - (1+i) or ((ev/fv) - 1) * (1+i) As shown earlier, an investment will have a risk premium if ev/fv is greater than 1.0, a risk discount if ev/fv is less than 1.0, and neither if ev/fv equals 1.0. Clearly, it is crucial to understand the determinants of differences in ev/fv across atomic securities in order to understand the nature of risk premia. For an atomic security, the expected value will equal the probability of the associated state. Thus the vector of probabilities, prob is the vector of expected values. Moreover, the vector of atomic forward prices f is the vector of forward values. Thus the vector of ev/fv values can be computed directly via the formula: prob ./ f Note that since both vectors must sum to 1.0, either all the ratios will equal 1.0, or some will be below 1.0 and others above it.

Determinants of Atomic Risk Premia


Why should one atomic risk premium differ from another? And if there are differences, what might explain them? As in other realms of economics, we would expect market prices to adjust until there is good news to go with every piece of bad news. This suggests that higher risk premia (good news) should be associated with states in which additional goods and services are of less value (bad news). But when are additional amounts of consumption of less value? When the amount available for consumption is large. Hence, states of plenty should have high risk premia (ev/fv, or prob/f values) while states of scarcity have low risk premia (ev/fv or prob/f values).

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In a one-good economy, the notion of aggregate output is unambiguous. In such a case, if aggregate output in state s1 exceeds that in s2, then the ratio of probability to forward price will be higher for state s1 than for state s2. If the aggregate output in two states is the same, then the ratio of probability to forward price should be the same for the two states. We deal later with cases involving multiple goods. Consider the following example: c 40 50 60 70 prob' 0.25 0.25 0.25 0.25 ----1.00 f' 0.35 0.30 0.20 0.15 ---1.00 f'-prob' 0.10 0.05 -0.05 -0.10 ---0.00

Note that the transposes of the last three vectors have been shown for convenience. The expected value for the market portfolio (c) is given by prob*c; it is 55.0. The forward value for the market portfolio is given by f*c; it is 51.5. The market portfolio thus has an expected value relative equal to (55.0/51.5)*(1+i). Assume that the interest rate is .06 (6%). Then the market portfolio has an expected value relative of 1.132 and hence a risk premium of 0.132-0.06, or 0.072 (7.2%). In this case, prob*c is 55.0 and f*c is 51.5. Thus (f-prob)*c must be -3.5. Moving from vector prob to vector f as a multiplier of c lowered the value of the product, and hence implied the presence of a risk premium. Consider the results of multiplying a vector x times c, where x can equal vector prob, vector f, or something in between. We wish to move from x=prob to x=f by a series of small steps. To see how this might be done, consider the final vector in the table: f'-prob', each entry of which equals the sum of all the steps to be taken. Since the entries in this vector must sum to zero, some will be positive and others negative. Moreover, the sum of the positive numbers must equal the sum of the negative numbers. Finally, given our assumptions about atomic risk premia and the ordering of states by increasing aggregate consumption, the positive numbers will all precede the negative numbers. Given these relationships, we can move from x=prob to x=f by a series of steps, each of which involves adding a fixed amount (e.g. 0.05) to an entry in x for one state of the world and subtracting an equal amount from one or more entries for states of the world in which aggregate output is larger. But each such step must lower the value of x*c, since the amount chosen is first multiplied by one level of output, and then by one or more larger levels of output. with the first amount added to the total product and the second (larger) amount subtracted from it. Since each such step will lower the product of the two vectors, the total effect of all such steps must
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lower the product. This gives the key result that: If atomic risk premia increase with aggregate output, (1) the expected value for the market portfolio will exceed its forward price, and (2) the expected return on the market portfolio will exceed the riskless rate of interest. In simpler terms: If atomic risk premia increase with aggregate output, there will be a market risk premium. While there may be other explanations for such a risk premium, the diminishing value of added consumption as more consumption becomes available appears to be by far the most plausible cause. Indeed, it is tempting to conclude that: If there is a market risk premium, atomic risk premia increase with aggregate output. We hereby yield to that temptation. Over the long run, portfolios comprising large numbers of risky securities tend to provide higher returns than do short-term riskless deposits. This is consistent with the existence of a market risk premium in the sense that we have used the term. We consider this strong presumptive evidence that on average, people consider additional consumption more valuable in states of scarcity than in states of plenty.

Determinants of Security Risk Premia


Not all atomic securities offer risk premia (ev/fv>1). Some offer risk discounts (ev/fv<1). But all are risky. Thus there is not a simple relationship between risk and expected return. This is true not only for atomic securities, but also for more traditional ones. The key issue in determining the presence and magnitude of a risk premium is the distribution of the value of a security's cash flows across various states. If more of its value comes from states with high ev/fv (probability / forward price) ratios than from those with low ev/fv (probability / forward price) ratios, the security will generally provide a risk premium. But since states with high ev/fv ratios are generally associated with times of abundance, this is equivalent to saying that an investment which pays more in good times and less in bad times will generally offer a risk premium. Indeed, the greater the extent to which an investment is a "fair weather friend" (bad news), the greater will be its expected return (good news). This is an important corollary of the general theorem that in a competitive economic market, bad news is likely to accompany good news. Investors demand higher expected returns from securities that are likely to fail them when they most need help.
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To summarize, some risky securities will provide a risk premium. However, the premium will be associated with the risk of doing badly when times are bad. There is no reason to expected higher returns to be associated with any type of risk -- just "bad times risk".

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Consumption and Investment Choices

Consumption and Investment Choices

Contents:
q q q q q q q q q

Consumer Utility Consumer Utility Functions The Expected Utility Maxim Risk Tolerance Maximizing Expected Consumer Utility Representative Investors Market Efficiency Betting and Tailoring Active and Passive Management

Consumer Utility
Normative financial economics concerns optimal decisions made by individuals, firms and/or institutions. In an important sense, much of the subject matter of investments deals with optimal choices of investment and consumption. Thus far we assumed that the investor/consumer makes optimal choices from among alternative combinations of present and contingent future consumption opportunities. Initially, we suggested that the individual picks the combination that he or she likes best. This hardly offers much help. Imagine an Analyst saying to a client: "do what's best". Our second characterization of investor behavior utilized the concept of indifference curves or, more generally, indifference surfaces. The conclusion was somewhat more elegant, although hardly more useful: pick the combination from the opportunity line (or plane or hyperplane) on the highest (best) indifference surface. At this point, we have provided little help for the Analyst seeking to offer direction to individuals or institutions seeking advice on either the optimal amount to be invested or the particular investments that should be undertaken.

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As we will see, an Analyst can provide useful advice concerning such decisions. Individuals may differ in preferences, circumstances, constraints and predictions. A rather rich body of analytic methods can be invoked to help take such differences into account. Such techniques provide a core set of normative methods for investment management. Here we will deal with three aspects that may lead informed individuals to adopt different strategies: differences in preferences, differences in wealth and differences in predictions. We leave for later the analysis of differences in constraints, other circumstances, and so on. A formal construct that helps to highlight the differences among utility-based, wealth-based and prediction-based investment decisions uses the concept of consumer utility and the assumption that the goal of the consumer is to maximize the expected value of such utility. In this scheme, (1) consumer utility summarizes an individual's preferences, (2) possible combinations of consumption are related to wealth, and (3) the probabilities utilized to compute expected utility can be considered predictions. In principle, one can thus determine the extent to which investment decisions differ due to differences in predictions as opposed to differences in preferences or differences in wealth. In practice, such a neat taxonomy is difficult to attain. Nonetheless, every investment decision should be scrutinized in an attempt to determine (as best possible) the role that each such type of difference plays.

Consumer Utility Functions


Consider an individual trying to select a combination of apples today, apples in the future if the weather is good, and apples in the future if the weather is bad. We represent a consumption plan as a vector c in which the elements are the levels of consumption in every time and state; in this case: [consumption now, consumption later if the weather is good, consumption later if the weather is bad]. Consider a particular consumption plan, for example, [80,100,50]. Note that the consumer will, in fact, attain one of two of the mutually exclusive sets of consumption: if the weather is good: Now: 80 Future: 100 if the weather is bad Now: 80 Future: 50 It is generally assumed that consumer utility functions are such that all types of consumption are goods (i.e., more is preferred to less, other things equal). It is generally also assumed that in such functions, marginal utility (the added utility from one added unit) decreases as the number of units increases (i.e. there are decreasing returns to scale in consumption).

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In some cases the utility associated with a given amount of future consumption will differ, depending on the state of the world in which the consumption takes place; for example, 5 apples might give more satisfaction on a rainy day than on a sunny one. In such cases, we say that the consumer has statedependent utility. The utility associated with additional consumption in one time period may depend on the amounts consumed in prior time periods. Consumers may fall into habits so that both the absolute amount of consumption and any change from previous levels may be of importance. In many cases Analysts will take neither of these possible complications into account. Instead, they assume that utility is separable and additive -- that is, that there is a utility associated with each time period and state of the world and that the total utility is simply the sum of these sources of utility. Moreover, they assume that the utility associated with each time and state is of a particularly simple form. Vector c, which represents a consumption plan, includes entries for at least two time periods; in our case: now and later. Let tp be a vector of the same length with coefficients indicating the consumer/investor's time preference. For example: now 1.0 future (good weather) 0.95 future (bad weather) 0.95

This indicates that a given amount of consumption in the future provides 0.95 times as much utility as the same amount of consumption now. If there were a third time period, the entries for that period in vector tp would typically be smaller than those for the second time period, and so on. One possibility would be to make the entries for the second period some constant d, those for the third period d^2, those for the fourth period d^3, etc.. This would allow the investor's time preference to be summarized with one number (d). In any event, all entries in vector tp that refer to a given time period will be the same. Regarding utility itself, Analysts often make another restrictive assumption. They assume that the utility associated with a given time and state can be written as: tp(ts)*u(c(ts)) where ts is the time and state, tp(ts) is the time preference parameter for the associated time, c(ts) is the consumption planned for the time and state, and u(c(ts)) is the utility associated with that consumption, not taking into account the time at which it is received. This rules out, for example, the possibility that an Investor may have one attitude concerning risk in period 2 and a different attitude concerning risk in period 3. Only one task remains -- to specify the utility function u(). Possible forms are discussed in subsequent
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sections. Suffice it to say that at the very least, utility should increase with consumption, but at a decreasing rate. Equivalently, the marginal utility (change in utility per unit change in consumption) should decrease as consumption increases.

The Expected Utility Maxim


We have associated an amount of consumer utility with each possible level of consumption. However, in fact some of the levels will not be realized. To take this into account, we multiply each utility level by the probability that the consumption in question will be attained. The sum of all such values is the expected utility of the consumption plan. We assume that the consumer's objective is to select from among all feasible plans, the one that provides the maximum expected utility. The latter is known as the expected utility maxim principle. Let prob be a vector of the same length as c with probabilities assigned to each time and state by the Investor (consumer) and/or the Analyst. In this vector, the sum of all entries for a given time period will equal one. For example: now 1.0 future (good weather) 0.50 future (bad weather) 0.50

If there were entries for a third period, the sum of those entries would also be 1.0, and so on. We are now in a position to write a formula for the expected utility eu of a consumption plan c. It is: eu = sum (prob.*tp.*u(c)); Given a vector of atomic security prices p, the optimal consumption/investment problem can then be stated as: Select: to Maximize: Subject to: c eu p*c <= W

where W is the consumer/investor's wealth. The decision variables are the levels of planned consumption. The optimization problem is to select values for these variables that maximize the objective function without violating the inequality constraint. It can be solved either through a "search procedure" or, in some cases, by directly finding the values that satisfy a set of conditions that must obtain when the optimum solution for such a problem is found. Microsoft's Excel spreadsheet includes a solver procedure that employs an intelligent search
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method to solve problems of this sort. MATLAB's optimization toolbox also provides functions that can be used for the purpose.

Risk Tolerance
Given the expected utility maxim, we can see more directly the relationship between the curvature of the utility function and an Investor's tolerance for risk. To do so, we utilize a simple function of the following form: u(c) = c.^k

where k is a positive constant between 0 and 1. The greater the value of k, the less curved will be the function; if k were to equal 1.0, the curve would become a straight line. Consider an investment that offers a probability of 0.50 that consumption will equal 80 apples (Good) and a probability of 0.50 that it will equal 20 apples (Bad). The table below shows the utility associated with each outcome for an investor with k=0.375. The expected utility -- the probability-weighted average of these two utility values -- is shown as well. k = 0.375 Utility 5.172 3.075 -------Expected Utility 4.124 43.73 Consumption 80 20

Good Bad

Certainty Equivalent

The expected utility maxim assumes that an investor will be indifferent between two investments if they offer the same expected utility. But the expected utility of a certain investment will equal its utility. The certainty-equivalent for a risky investment can be defined as an amount to be received with certainty that the investor would just be willing to accept instead of the risky investment. Here, we seek the value of c for which: c.^k = 4.124 The answer, also shown in the table above, is 43.73 apples. Thus although the investment offers an expected consumption of 50 apples (0.50*20 + 0.50*80), this investor considers it only as desirable as 43.73 apples for certain.

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Now consider the investor with a utility function for which k=0.500. The corresponding calculations are shown in the table below. She considers the investment as desirable as 45.00 apples for certain. In a sense she "likes it better" than the first investor. If one had to pay 44 apples to obtain the investment, the first investor would pass the opportunity by, while the second one would seize it with pleasure. k = 0.500 Utility 8.944 4.472 -------Expected Utility 6.708 45.00 Consumption 80 20

Good Bad

Certainty Equivalent

The greater the value of k in a utility function of the type we have posited, the greater will be the certainty equivalent for a given risky investment. Hence we can say that the greater the value of k, the greater the investor's tolerance for risk and the smaller his or her aversion to risk. More generally, the smaller the curvature of the utility function, the greater is an investor's tolerance for risk.

Maximizing Expected Consumer Utility


Given our simplifying assumptions, the expected utility of a consumption plan will depend on the consumer's time-preference, risk tolerance, and assessment of the probabilities of the alternative states of the world. In our example, there are only two such states. Since the probability of bad weather will equal one minus the probability of good weather, we may focus on three parameters: two reflecting a consumer's preferences (time preference and risk tolerance), and one reflecting his or her predictions. Given a set of prices p and a level of wealth W, a consumer/investor will choose a consumption plan c that maximizes expected utility, taking into account his or her time preference, risk tolerance and probability assessments. Note that the latter three aspects are not directly observable, while the former are, at least in principle. Investors with the same wealth facing the same set of prices can and often will differ in their choices of planned consumption. In general, those with greater preference for present as opposed to future consumption will consume more in the present and save less. Those with greater risk tolerance will take greater risk in their investment portfolio. And, other things equal, those who attach higher (lower) probabilities to certain events will invest more (less) in securities that pay off when those events take place. To illustrate, we consider an investor with the following expected utility function: eu = cn^k + prg*d*(cg^k) + (1-prg)*d*(cb^k)

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Here, the arguments of the function, cn, cg and cb, are consumption now, consumption in the future if the weather is good, and consumption in the future if the weather is bad, respectively. The three parameters of the function are k (a measure of risk tolerance), d (a measure of time preference), and prg (the estimated probability of good weather). As in earlier examples, we assume that the prices are [1.00 0.285 and 0.665] for the three types of consumption (cn, cg and cb, respectively). Investors whose preferences can be described with this type of utility function will react to increases in wealth by adjusting their plans proportionately. Thus, compared with an Investor with a wealth of 100, an investor with a wealth of 200 will consume twice as many apples today, and select a consumption plan involving twice as many apples if the weather is good and twice as many apples if the weather is bad. The savings rate and portfolio composition will be the same for any two investors that have (1) the same risk tolerance (more precisely, the same value of k) and (2) the same time-preference (more precisely, the same value of d), and (3) the same probability assessment (more precisely, the same value of prg) . Such invariance with respect to wealth is not a generally observed relationship, indicating that this form of an expected utility function does not capture the preferences of all investors. However, for now allows us to avoid issues associated with the effects of differences in wealth. Consider an Investor with a wealth of 100 for whom k=0.375, d=0.96, and prg=0.50. Her optimal consumption plan c in units will be [48.76 112.27 28.94]. The values of the components (p.*c) will be: Now 48.76 Good Weather 32.00 Bad Weather 19.24

She will spend 48.76% of her wealth on present consumption and invest 51.24%. Her investment portfolio will consist of claims on apples if the weather is good with a value of 32.00 and claims on apples if the weather is bad with a value of 19.24. Thus the proportion of the portfolio's value invested in good weather apples is 32.00/51.24, or 62.45%. This example might seem extreme, since the investor spends only 48.76% of her wealth and invests the remaining 51.24% -- a seemingly extremely high savings rate. However, recall that we are dealing here with total wealth, including the present value of future income. It is important to recognize that an individual's wealth prior to retirement includes the value of his or her human capital. It should be included, along with financial and physical capital, when considering total wealth and when making plans for savings and risk-taking. Among other things, this suggests that younger investors (for whom human capital is likely to represent a majority of wealth) may choose to invest their physical and financial capital rather differently than older investors (for whom human capital may represent a minority of wealth). It also suggests that the nature of one's human capital should be taken into account when determining the appropriate investment of the non-human capital that is not consumed. The next table shows the relationship between k and the decisions of interest. Each row portrays the optimal choice for a different investor. The first three columns indicate the parameters used in the analysis. The final columns show the values of, respectively, the amount consumed in the present, the

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amount planned to be consumed if the weather is good and the amount planned to be consumed if the weather is bad. The eighth row contains the results obtained earlier. The other rows show results for Investors that are alike with regard to time-preference and prediction but differ in risk tolerance. prg 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 k 0.2000 0.2250 0.2500 0.2750 0.3000 0.3250 0.3500 0.3750 0.4000 0.4250 0.4500 0.4750 0.5000 0.5250 0.5500 0.5750 0.6000 d 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 consumed 50.2676 50.1184 49.9600 49.7729 49.4887 49.3278 49.0605 48.7561 48.4089 48.0107 47.5525 47.0219 46.4062 45.6875 44.8436 43.8488 42.6711 good 27.4901 27.9926 28.5286 29.1149 29.7447 30.4329 31.1812 31.9981 32.8932 33.8783 34.9661 36.1728 37.5155 39.0175 40.7054 42.6102 44.7683 bad 22.2422 21.8890 21.5114 21.1121 20.7666 20.2394 19.7583 19.2458 18.6978 18.1109 17.4814 16.8053 16.0783 15.2951 14.4510 13.5410 12.5606

As the table shows, investors with greater tolerance for risk will invest a greater proportion of their portfolios in the good pure security. Recall that it has a larger expected return but greater underperformance in bad times. Thus investors whose utility decreases at a slower rate (higher k) with decreases in wealth are more willing to take the risk of doing badly in bad times. Note that such investors also devote a slightly smaller portion of wealth to present consumption, and hence a larger portion of wealth to investment, since future prospects are somewhat more attractive to them than to those who are more concerned with the risk such investments entail. The next table provides the same type of analysis for a group of investors who differ in time-preference but are, in other respects, like our original investor. prg 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 k 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 d 0.9000 0.9100 0.9200 0.9300 0.9400 0.9500 0.9600 0.9700 consumed 51.3375 50.8964 50.4588 50.0265 49.5981 49.1757 48.7561 48.3429 good 30.3861 30.6614 30.9350 31.2052 31.4720 31.7361 31.9981 32.2557 bad 18.2765 18.4422 18.6062 18.7684 18.9299 19.0883 19.2458 19.4014

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0.5000 0.5000

0.3750 0.3750

0.9800 0.9900

47.9336 47.5279

32.5117 32.7655

19.5547 19.7066

As the table shows, investors with greater preference for future consumption will consume less and invest more. While the absolute values of the claims for consumption in the good and bad states of the world are affected, their relative values are not. Investors with this type of utility function will change only their savings rate when their time-preference changes. The composition of their portfolios will not be affected. The final table completes the analysis by showing a group of investors with different assessments of the probabilities associated with the alternative future states of the world, but who are like our investor in other respects. prg 0.4000 0.4200 0.4400 0.4600 0.4800 0.5000 0.5200 0.5400 0.5600 0.5800 0.6000 k 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 0.3750 d 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 0.9600 consumed 50.3109 50.0734 49.7994 49.4864 49.1391 48.7561 48.3435 47.8998 47.4280 46.9306 46.4086 good 23.1037 24.8632 26.6357 28.4204 30.2092 31.9981 33.7809 35.5540 37.3134 39.0545 40.7727 bad 26.5854 25.0634 23.5648 22.0932 20.6517 19.2458 17.8756 16.5462 15.2586 14.0150 12.8187

Note the dramatic effects of differences in predictions. Optimists, who assign a higher probability to good weather, will invest considerably larger portions of their portfolios in good weather apples (securities with higher expected returns and possibilities for greater underperformance). They invest more of their wealth as well. Differences in opinions really do make horse races (as has been said).

Representative Investors
Recall that an Investor who assigned a probability of 0.50 to good weather, and had a utility function with k=0.375 and d = 0.96 and wealth of 100 would choose a consumption plan (in units) of [48.76 112.27 28.94]. Now, assume that in the aggregate social product, the proportions of the three types of consumption are precisely the same. If so, our candidate can be considered a representative Investor. Why so? Because a society with aggregate consumption of [48.76*z 112.27*z 28.94*z] (where z is a positive constant) and prices [1.00 0.285 0.665] could be populated entirely by a set of identical investors, each of whom had this specific utility function. The existence of such preferences and predictions on the part of every investor would be consistent with the attributes of equilibrium that would be observed in such a society. Since preferences and predictions cannot generally be observed by the
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outside analyst (financial or other), it is helpful to determine at least some possible attributes for such elements from observed magnitudes. By construction, a representative investor will find it optimal to (1) save at the societal savings rate, and (2) hold the market portfolio. Hence, any investor who assigns the same probabilities to states of the world , has the same risk tolerance, the same impatience and (in the general case) the same wealth as a representative investor should also save at the societal savings rate and hold the market portfolio. The concept of a representative investor thus provides a useful benchmark against which one can compare oneself. Other things equal, if an Investor makes different probability assessments from the representative investor, it will be optimal to "tilt" holdings towards securities that pay more in states that the Investor feels are more likely than does the representative Investor. Other things equal, if an Investor has greater (less) tolerance for risk than the representative Investor, he or she should hold a portfolio with a higher (lower) expected return than the market portfolio. Other things equal, if an investor is more (less) patient, he or she should save more (less) than is typical in the society. This type of comparison is complicated by the fact that the representative Investor may not be unique. For example, the world we have described could instead be populated by some other set of representative investors. In one sense, this does not matter. Any one of the possible set of representative investors can be used as a benchmark with which one can compare oneself. However, most analyses of optimal consumption and investment decisions go farther, as we will see.

Market Efficiency
We say that a securities market is efficient relative to a given set of information if the prices of securities are the same as they would be if all participants had that information and processed it appropriately. Note that this definition does not require the holdings to be the same as they would be if all the participants had the information and processed it appropriately. Consider the situation in which Investor A is overly optimistic about the prospects for a firm., while Investor B is overly pessimistic. Under these conditions, the price of the firm's stock might be precisely the same as it would be if A and B had each made informed predictions. If so, we would say that the market was efficient because the average of Investor's opinions was, in a rather broad sense, correct. Note, however, that under the posited conditions, Investor A would hold "too much" of the security, and investor B "too little", relative to the amounts they would hold (and should have held) had they obtained the same information and processed it appropriately. Key to the notion of market efficiency is that of what we will call fully-informed probabilities. Such probabilities would be assessed by a sophisticated Analyst with access to a defined set of information. In effect, such probabilities "take the information into account" in an efficient manner. Using this construct, we can say that a market is efficient relative to a given set of information if security prices are the same as they would be if every Investor utilized fully-informed probabilities. Under these conditions, it makes sense to concentrate on a representative Investor who uses fully-informed
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probabilities. The risk tolerance of such an Investor is likely to be roughly (or exactly) equal to a wealthweighted average of the risk tolerances of the Investors in the society (the latter is sometimes termed the societal risk tolerance). Similarly, the impatience of this representative Investor is likely to be roughly (or exactly) equal to a wealth-weighted average of the degrees of impatience of the consumer/investors in the society (sometimes termed the societal degree of impatience).

Betting and Tailoring


There are three possible reasons why Investors X and Y may wish to hold different portfolios. Two relate to preferences and one to predictions. First, Investors' attitudes toward risk and return may differ. An outside expert cannot argue that such differences (if fully informed) are "wrong", any more than an outside expert can tell a consumer whether he or she should prefer beer to wine. If Investors understand the characteristics of alternative investment vehicles and agree on their prospects and probabilities, differences in holdings can be said to be utilitybased or consistent with market efficiency. Adjusting portfolio holdings (and/or consumption/investment decisions) to suit differences in utility can be considered tailoring. The second reason for differences in holdings is associated with differences in levels of wealth. Wealthier individuals generally invest a greater absolute amount of money. Some may invest a greater percentage of their wealth, others a smaller percentage, and yet others the same percentage. Some wealthier individuals choose investment portfolios that are riskier, others portfolios with the same risk, and yet others portfolios with less risk. Differences in holdings that arise due to differences in Investor wealth are, like differences due to underlying preferences, consistent with efficient markets. Implementing strategies designed to accommodate such differences can thus also be considered tailoring. The third reason is different. Investors (or their financial advisors) may disagree about the probabilities of alternative future states of the world. (Here we assume that all agree about the possible states of the world and the payments associated with various securities in each of the states; in this setting, the only disagreements about the future relate to the probabilities associated with alternative states.) Such disagreements can arise when investors utilize disparate sets of information and/or process a given set of information differently (although at a more profound level, the latter can be considered a variant of the former). Despite this, the wealth-weighted average probabilities assessed by investors may be equivalent to fullyinformed probabilities, since the probabilities assessed by those with greater amounts invested (and hence greater incentive to gather information and process it well) are weighted more heavily in computing the averages. This notion underlies the often-made assumption that consensus probabilities are equal to fully-informed probabilities. Loosely speaking, we can term an investor's probability assessments to be deviant if they differ from

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those of the consensus of investors. If security prices do not reflect efficient-market probabilities, at least some investors whose holdings are based on deviant predictions may profit from such differences. On the other hand, if markets are efficient, differences in holdings based on deviant predictions will generally prove undesirable in the long run, leading only to added transactions costs and lack of appropriate diversification. In either event, adjusting portfolio holdings (and/or the consumption/investment decision) to suit differences from consensus estimates of the likelihoods of alternative scenarios can be considered prediction-based, and inconsistent with market efficiency. In the vernacular, such choices can simply be termed betting.

Active and Passive Management


Those who concentrate on tailoring holdings to suit an investor's preferences and/or circumstances generally employ investment approaches that the investment industry classifies under the heading passive management. Those who bet on differences in predictions generally employ approaches classified under the heading active management. Tailoring decisions tend to be designed to implement a strategy that requires only small changes over time. Such decisions typically involve small and relatively infrequent changes, and hence can be considered "passive". Bets, however, are likely to change rather dramatically, as new information is revealed and investors react differently to such information. Investors making decisions based on differential predictions are likely to generate a significant number of trades, and are thus appropriately termed "active".

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Macro-Investment Analysis

Risk and Return


q q q q q

Mean, Variance and Distributions Portfolio Choice Multi-period Returns Portfolio Characteristics Two-asset Portfolios

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Mean, Variance and Distributions

Contents:
q q q q q q q q q q q q q

The Mean-variance Paradigm Expected Value Probabilities Standard Deviation Continuous and Discrete Outcomes Cumulative Distributions Normal Distributions Joint Normality Shortfall Measures Shortfall Probability Measures of Likely Shortfall Value at Risk Shortfall and other Risk Measures

The Mean-variance Paradigm


The world is, unhappily, very complex. Before one can analyze, one must abstract. The time-state paradigm provides a procedure for doing so. Its power lies in the straightforward way that it accommodates time, risk, and options. But this power comes at a price. In general, one must assume a relatively simple structure (e.g. two possible outcomes in each trading period) and the existence of markets that are sufficiently complete to allow replication and valuation of desired patterns of payments and/or consumption over time. Despite these limitations, the time-state paradigm is eminently practical in a number of settings. Dynamic strategies involving broad asset classes are frequently analyzed using it. It is also the paradigm of choice when derivative securities are the focus of attention. However, when the goal is to consider many possible combinations of many different financial instruments, use of the time-state approach poses a number of problems. One must either assume a limited number of outcomes in each trading interval, making most of the securities redundant, or many such outcomes, making the assumption of complete markets unrealistic. Clearly, a Hobson's choice.
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In 1952, Markowitz proposed a paradigm for dealing with issues concerning choices which involve many possible financial instruments. Formally, it deals with only two discrete time periods (e.g. "now" and "a year from now"), or, equivalently, one accounting period (e.g. "one year"). In this scheme, the goal of an Investor is to select the portfolio of securities that will provide the best distribution of future consumption, given his or her investment budget. Two measures of the prospects provided by such a portfolio are assumed to be sufficient for evaluating its desirability: the expected or mean value at the end of the accounting period and the standard deviation or its square, the variance, of that value. If the initial investment budget is positive, there will be a one-to-one relationship between these end-of-period measures and comparable measures relating to the percentage change in value, or return over the period. Thus Markowitz' approach is often framed in terms of the expected return of a portfolio and its standard deviation of return, with the latter serving as a measure of risk. The Markowitz paradigm is often characterized as dealing with portfolio risk and (expected) return or, more simply, risk and return. More precisely, it can be termed the mean-variance paradigm.

Expected Value
Assume that a portfolio will have a future (end-of-period) value of v1 in state 1, v2 in state 2, etc.. let v = [v1,v2,...vm] be a {1*m} element vector, where m is the number of possible states of the world. To compute the portfolio's expected future value, we need someone's estimate of the probabilities associated with the states. Let pr = [pr1,pr2,...,prm] be such a vector. The expected value is, as usual, a weighted average of the possible outcomes, with the probabilities of the outcomes used as weights: ev = pr*v' If the current value of the portfolio is p, we can compute a vector of value-relatives (future/present values): vr = v/p And a vector of returns (proportional changes in value): r = (v-p)/p The portfolio's expected value-relative can be computed either directly or indirectly: evr = (pr*v')/p = ev/p Similarly, the portfolio's expected return will be:

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er = (pr*(v-p)')/p = ((pr*v')-p)/p = (ev-p)/p In the special case in which every outcome is equally likely, the expected value can be computed by simply taking the (arithmetic) mean of the possible values. In MATLAB: ev = mean(v) Note that the mean function can be used with a matrix -- the result will be a row vector in which each element is the mean of the corresponding column in the original. This can prove handy with a matrix in which each column represents a different asset and each row a different state of the world, with the latter assumed to be equally likely.

Probabilities
Probability estimates are essential in the mean-variance approach. Unless all Investors agree about such probabilities, one cannot talk about "the" expected value or expected return (or risk, for that matter) of a portfolio, security, asset class or investment plan. Two different Analysts might well provide different estimates of expected values for the same investment product. Indeed, one of the key functions than an Analyst can perform for an Investor is the provision of informed estimates of the probabilities of various outcomes and the associated risks and expected values of alternative investment strategies. Normative applications of the mean-variance paradigm often accept the possibility of disagreement among Investors and Analysts concerning probability estimates. Positive applications usually assume either that there is agreement concerning such probabilities or that prices are set as if there were agreement on a set of consensus probability estimates. It is important to emphasize the fact that the mean-variance approach calls for the use of estimates of the probabilities of alternative future possible events in the next period. Historic frequencies of such events in past periods may prove helpful when forming such forward-looking estimates, but one should consider taking into account any additional information that might prove helpful. The world changes, and the future need not be like the past, even probabilistically. Issues concerning ways to implement the meanvariance approach can and should be separated from issues concerning its structure, assumptions, and implications.

Standard Deviation
If the future value of a portfolio will be vs in state s and the expected future value is ev, the deviation, or surprise, in state s will equal (vs-ev). More generally, if v is the vector of possible future values, the vector of deviations, state by state, will be: d = v - ev
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In this vector, a positive deviation represents a happy surprise, a negative deviation an unhappy surprise, and a zero deviation no surprise at all. Roughly: the greater the "spread" of the possible deviations, the greater the uncertainty about the actual outcome. To measure risk in a fully useful manner we need to take into account not only the possible surprises, but also the probabilities associated with them. Simply weighting each deviation by its probability won't do, since the answer will always equal zero. One alternative uses the expected or mean absolute deviation (mad): mad = pr*abs(d)' In practice, it is difficult to use mad measures when considering combinations of securities and portfolios. Mean-variance theory thus utilizes the expected squared deviation, known as the variance: var = pr*(d.^2)' Variance is often the preferred measure for calculation, but for communication (e.g between an Analyst and an Investor), variance is usually inferior to its square root, the standard deviation: sd = sqrt(var) = sqrt(pr*(d.^2)') Standard deviation is measured in the same units as the original outcomes (e.g. future values or returns), while variance is measured in such units squared (e.g. values squared or returns squared). We again emphasize that standard deviation is used in this context as a forward-looking measure of risk, since it is based on probabilities of future outcomes, however derived. One can assume that future risk is similar to past variability, but this is neither required nor, in certain cases, desirable. MATLAB provides a function for computing the standard deviation of a series of values, and one that can be used to compute the variance of such values. In each case, the computations assume that the outcomes are equally probable. In addition, it is assumed that the values are drawn from a sample distribution taken from a larger population., and that the variance and standard deviation of the population are to be estimated. For reasons that we will not cover here, the best estimate of the population variance will equal the sample variance times n/(n-1), where n is the number of sample values. Correspondingly, the best estimate of the population standard deviation will equal the sample standard deviation times the square root of n/(n-1). MATLAB'a functions make this correction automatically, as do many functions included with spreadsheet software. When estimates of this type are desired, one can use std(v) to find the estimated population standard deviation where v is a vector of sample values. Alternatively, one can use cov(v) to
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find the estimated population variance. Note that both functions are inherently designed to process historic data in order to make predictions about future results and hence implicitly assume that future "samples" will be drawn from the same "population" as were prior ones. In some cases this assumption may be entirely justified; in others it may not.

Continuous and Discrete Outcomes


Thus far, we have dealt with a world in which a future value can take on one of a discrete set of specified values, with a probability associated with each value. The mean-variance approach can be utilized in such a setting, and we will do this from time to time for expository purposes. However, its natural setting is in a world in which outcomes can lie at any point along a continuum of values. Statisticians use the term random variable to denote a variable that can take on any of a number of such values. In a discrete setting, the actual value of a variable will be drawn from a vector (e.g. v) having a finite number of possible outcomes, with the probability of drawing each value given by the corresponding entry in an associated probability vector (e.g. pr). The set of values (v) and the associated probabilities (pr) constitute a discrete probability distribution. In a continuous setting, a value will be drawn from a continuous probability distribution, the parameters and form of which indicate the range of outcomes and the associated probabilities.

Cumulative Distributions
The most informative way to portray a distribution utilizes a plot of the probability that the actual outcome will be less than or equal to each of a set of possible values. Let v be a vector of values, sorted in ascending order, and pr a vector of the probabilities associated with each of the corresponding values. For example: v = [ 10 20 30];

pr = [ 0.20 0.30 0.50]; The probability that the actual outcome will be less than or equal to 10 is 0.20. The probability that the actual outcome will be less than or equal to 20 is (0.20+0.30), or 0.50, and the probability that the outcome will be less than or equal to 30 is 1.00. To produce a vector of these probabilities we can use the MATLAB cumsum function, which creates a new vector in which each element is the cumulative sum of all the elements up to and including the comparable position in the original vector. In this case: cumsum(pr) =

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0.2000

0.5000

1.0000

The figure below shows the associated cumulative probability distribution. Note that it is a step function, reflecting the discrete nature of the outcomes.

It is, of course, much simpler to simply plot the points, and let MATLAB connect them with straight lines. Here are the required statements: plot(v,cumsum(pr)); xlabel('outcome'); ylabel('Probability actual <= outcome'); In this case the result is:

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The greater the number of points and the nearer together they are, the closer will be this type of plot to the more accurate step function. In the case of a continuous distribution, there will be no difference at all.

Normal Distributions
A uniformly-distributed random variable can take on any value within a specified range (e.g., zero to one) with equal probability. Most programming languages and spreadsheets provide functions that can generate close approximations to such variables (purists would, however, call them pseudo-random variables, since they are not completely random). In MATLAB, the function rand(r,c) generates an {r*c} element matrix of such numbers. Consider the process of generating 1000 sets of 1000 such numbers, then taking the mean (unweighted average) of each set. In MATLAB: z = mean(rand(1000,1000)) A histogram showing the frequency distribution of the mean values in each of 25 "bins" can be obtained with the statement: hist(z,25) The figure below shows the results obtained in this manner in one experiment.

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Note that the distribution is approximately "bell-shaped" and roughly symmetric. This is not surprising since the central limit theorem holds that the distribution of the sum or average of a set of unrelated variables will approach a particular form as the number of variables increases. The form is that of the normal distribution, given by the equations: nd = (x - ev)/sd; p(x) = (1/sqrt(2*pi))*exp(-(nd^2)/2) where p(x) is proportional to the probability that the actual value will equal x; ev and sd stand for the expected value and standard deviation, respectively, of the distribution, and nd is the deviation of x from ev in standard deviation units. The figure below plots p(x) for various values of nd.

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More practical is the cumulative normal distribution . MATLAB does not provide such a function, but it offers the next best thing. The expression erf(x)/sqrt(2)) gives the probability that a normally-distributed random variable will fall between -x and +x standard deviations of the mean. This forms the basis for our function cnd(nd) where nd is a standardized deviation and cnd(nd) is the probability that the actual outcome will be less than nd. The figure below shows the values of cnd(nd) for nd from -3 to +3 (in steps of 0.1), using the MATLAB statements: nd = -3:0.1:3; pr = cnd(nd) plot(nd,pr); grid; xlabel('deviation'); ylabel('Probability actual <= outcome');

The cumulative normal distribution can be used to determine probabilities that a normally-distributed outcome will lie within a given range. For example, the probability that an outcome will like within one standard deviation of the mean is: cnd(1)-cnd(-1)

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0.6827 Thus there are roughly two chances out of three that the outcome will lie within this range. Some characterize an investment's prospects by giving its mean and standard deviation in the form: e +/- sd (read as e plus or minus sd); thus an asset mix might be said to offer returns of 10+/-15. If the return can be assumed to be normally-distributed, this means that there are roughly two chances out of three that the actual return will lie between -5% (10-15) and 25% (10+25). The probability that a normally-distributed return will be within two standard deviations of the mean is given by: cnd(2)-cnd(-2) 0.9545 Thus if a normally-distributed investment is characterized by 10+/-15, the chances are roughly 95% that its actual return will lie between -20% (10 - 2*15) and 40% (10+2*15). In MATLAB one can produce normally-distributed random variables with an expected value of zero and a standard deviation of 1.0 directly using the function randn. Thus: z = ev + randn(100,10)*sd will produce a {100*10} matrix z of random numbers from a distribution with a mean of ev and a standard deviation of sd.

Joint Normality
While the central limit theorem provides a powerful inducement to assume that investment returns and values are normally distributed, it is not sufficient in its own right. While most investment results depend on many events and most portfolios contain many securities, it is unlikely that the influences on overall results are unrelated. If, for example, the health of an economy is not normally distributed, and if it affects most securities to at least some extent, even the value of a diversified portfolio will have a non-normal distribution. To solve this problem at a formal level, Analysts often assume that the return or value of every investment is normally distributed as is the value or return of any possible combination of investments. Since knowledge of the expected value and standard deviation of a normal distribution is sufficient to calculate the probability of every possible outcome, this very convenient assumption implies that the expected value and standard deviation are sufficient statistics for investment choices in which an end-ofperiod value or return is the sole source of an Investor's utility.
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If the value or return of every possible investment and combination of investments is normally distributed, we say that the set of such variables is jointly normally distributed .The mean-variance approach is well suited for application in such an environment.

Shortfall Measures
Some argue that standard deviation is a flawed measure of risk since it takes into account both happy and unhappy surprises, while most people associate the concept of risk with only the latter. Alternative measures focus on "downside risk" or likely "shortfall". Each requires the specification of an additional parameter -- the point from which shortfall is to be measured. This threshold may be zero, a riskless rate of return, or some level below which the Investor's disappointment with the outcome is assumed to be especially great.

Shortfall Probability
The simplest shortfall measure is the probability of a shortfall below a stated threshold. This can be read directly from a graph of the associated cumulative distribution. For example, assume that the probability that a return will be less than 10% is desired. In the figure below, find 10% on the horizontal axis. Go up to the curve, then over to the vertical axis. The result is 0.5. Thus there is a 50% probability that the return will fall below the selected threshold of 10%.

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Measures of Likely Shortfall


More complex shortfall measures take into account all possible outcomes below the selected threshold and their probabilities to obtain an estimate of the "likely" magnitude of the shortfall. Let r be a vector of possible returns and pr a vector of the associated probabilities. For example: r = [-10 0 10 20]

pr = [.1 .2 .3 .4] Assume that the desired threshold is 10 (%). The positions in r which contain returns below the threshold can be found simply using the MATLAB expression: r<threshold 1 1 0 0

To produce a vector of shortfalls we subtract the threshold from each return, then multiply the resulting

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vector by the vector that contains zeros in all positions in which the difference is positive: sf = (r-threshold).*(r<threshold) -20 -10 0 0

To find the expected shortfall multiply each of these values times the associated probability: pr*sf' -4 An alternative is the semi-variance, which is the expected squared shortfall: pr*(sf.^2)' 60 The square root of the semi-variance is termed the semi-standard deviation. In a sense, it is the "downside" counterpart of the standard deviation. In the case at hand: sqrt(pr*(sf.^2)') 7.7460 The expected shortfall, the semi-variance and the semi-standard deviation are all unconditional measures. For example, the expected shortfall is the expected value of the shortfall, whether there is one or not. All outcomes that exceed the threshold are treated equally (as zero shortfalls), no matter what their magnitude. Alternative measures answer a somewhat different set of questions. For example, one might wish to know the size of the expected shortfall if there is one. More directly: conditional on the existence of a shortfall, how large is it likely to be? To compute a conditional measure, only states of the world in which a shortfall occurs are considered. The desired probabilities are those conditional on such a situation arising. In our example, only the first two states of the world produce shortfalls. The associated unconditional probabilities are 0.1 and 0.2. Thus the probability of a shortfall is 0.3. The conditional probabilities for the two states are 0.3333 (=0.1/0.3) and 0.6667 (=0.2/0.3).More generally, we divide each unconditional probability by the probability of a shortfall. To find the latter we need a vector of the unconditional probabilities for states in which there is a shortfall: pr.*(r<threshold)

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0.1000

0.2000

The sum of these values is the probability of a shortfall: prsf = sum(pr.*(r<threshold)) 0.3000 To find the conditional expected shortfall, we could divide each unconditional probability by this value, then multiply by the shortfall vector. Equivalently, we could simply divide the unconditional expected shortfall by the probability of a shortfall: pr*sf'/prsf -13.3333 Earlier we found that the expected shortfall is 4%. However, if there is a shortfall, the expected amount is 13.33%. Similarly, the conditional semi-variance equals the unconditional semi-variance divided by the probability of a shortfall. From this it follows that the conditional semi-standard deviation equals the unconditional semi-standard deviation divided by the square root of the probability of a shortfall.

Value at Risk
Another measure of downside risk is based on a specified probability. In effect one asks the question: what is the (almost) worst thing that can happen? A probability px is selected. The associated (almost) worst thing that can happen is given by a return or future value x, such that there is only a 1% probability that the actual outcome will be worse than x. Assume, for example, that a bad outcome is specified as one that will not be underperformed more than 10% (px) of the time. In the case shown in the previous figure, this is easily determined. Locate 0.1 (10%) on the vertical axis. Then go over to the curve and down to the horizontal axis. The result is -10%. Thus the (10%) worst case involves a return of -10%. When the result of this kind of calculation involves a negative change in value, the change is often termed the value at risk. Thus, in our example, if the current amount invested were $500,000, we would say that the value at risk is $50,000. Value at risk is often calculated for short holding periods (e.g. a day or a week). In such cases the expected return is often assumed to be zero. This allows the Analyst to concentrate on the shape of the
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distribution of returns and its standard deviation, thereby lending at least a somewhat greater sense of objectivity to the result.

Shortfall and other Risk Measures


In many cases it proves helpful to summarize the prospects of an investment strategy in terms of (1) its expected outcome and (2) a measure of downside risk or likely shortfall, even though the analysis leading to its choice utilized standard deviation as a measure of risk. Among strategies with equal expected outcomes there is often a one-to-one correspondence between standard deviation and each of several alternative risk measures, including downside ones. Since calculations are far easier when standard deviation is utilized, we follow common practice by utilizing it in much of what follows. When issues of communication are paramount, however, we will include transformations to alternative measures that focus attention on bad outcomes rather than all outcomes.

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function y = cnd(x) % pr = cnd(nd) % computes the probability that a variable will be less % than x standard deviations % example: pr = cnd(1.5) % copyright, 1995, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Nov. 2, 1995 if x > 0 y = 0.5 + erf(x/sqrt(2))/2; else y = 0.5 - erf(-x/sqrt(2))/2; end

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Portfolio Choice

Portfolio Choice

Contents:
q q q q q q q q q q q

Efficient Portfolios Roles of the Analyst and the Investor Indifference Curves Expected Utility Approximating an Investor's Utility Function Negative Exponential Utility Functions Inferring Investor Risk Tolerance Risk Tolerance and Risk Properties of Portfolio Utility Effects of Increases in Wealth Risk-adjusted Expected Return

Efficient Portfolios
An Investor must choose between two portfolios. The end-of-period value of each one is normally distributed. Portfolio A has an expected value of $10,000 and a standard deviation of $15,000. Portfolio B has an expected return of $14,000 and a standard deviation of $15,000. Which will provide the greatest expected utility? The answer is not difficult to obtain. As long as the Investor's utility increases with wealth and does not depend on the state of the world in which the wealth is obtained, portfolio B is better. This can be seen in the plot of the cumulative distributions, shown below:

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Take any possible outcome -- for example, $5,000. This is (5,000-10,000)/15,000 standard deviations from the expected value of portfolio A. The probability that the actual outcome will fall short of this amount is cnd((5000-10000)/15000) or 0.3694. On the other hand, this outcome is (5,000-14,000)/15,000 standard deviations from the expected value of portfolio B. The probability that the actual outcome will fall short of this amount is cnd((5000-14000)/15000) or 0.2743. Clearly, it is better to have a smaller chance of a shortfall below $5,000; in this respect, B is preferred to A. But the result will be the same for every possible outcome, as the figure shows. Portfolio B thus dominates portfolio A for any Investor who prefers more wealth to less and who has a state-independent utility function. Formally, this is termed a case of first-degree stochastic dominance. More simply put: mean-variance theory assumes that among portfolios with the same standard deviation, the one with the greatest expected value is the best. Now examine the figure below in which each circle plots the expected value and standard deviation of a different portfolio.

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Consider the portfolios shown by the red circles in the figure that plot on curve XzzYZ. Each provides the maximum expected value for a given level of standard deviation. If all the portfolio returns are normally distributed, then any Investor for whom more wealth is better than less and for whom only wealth matters should choose from among the portfolios on this curve. What about the portfolios on the section of the curve from Y to Z? The one plotting at point Y provides a greater expected value and a smaller standard deviation than any of the portfolios between Y and Z. Moreover, for every portfolio on the section between Y and Z there are alternatives with the same expected return but lower standard deviations. For example, portfolio zz offers the same expected return as Z but a lower standard deviation (indeed, the lowest possible, in this case). The figure below plots the cumulative distributions for these two portfolios.

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Portfolio zz dominates Z over the lower half of the range of possible outcomes, but Z provides larger chances of obtaining higher values. To deal with such a case, Markowitz proposed that Investors be assumed to be risk-averse -- more precisely, each Investor's marginal utility of wealth is assumed to decline with wealth. In this case, an Investor with decreasing marginal utility of wealth will prefer zz to Z, since moving from Z to zz will improve bad outcomes symmetrically with reductions in good outcomes, and the gain in utility from each of the former reductions will exceed the loss in utility from the corresponding latter reduction. Formally, this is a case of second-degree stochastic dominance. Mean-variance theory assumes that Investors prefer (1) higher expected returns for a given level of standard deviation and (2) lower standard deviations for a given a level of expected return. Portfolios that provide the maximum expected return for a given standard deviation and the minimum standard deviation for a given expected return are termed efficient portfolios. All others are inefficient. In practice the curve plotting the maximum expected value for each level of risk will usually be upwardsloping throughout the range of feasible values. Sections such as YZ are rare. Thus it generally suffices to assume only that Investors prefer greater expected return for given risk, placing a considerably smaller burden on the Analyst who advocates a focus on only efficient portfolios. The figure below provides an illustration, with expected returns expressed in terms of excess returns over and above a riskless rate of interest.

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In this figure each point represents a portfolio. Given the Investor's budget and the joint distribution of security and portfolio values, there are many such points, only a few of which are shown in the figure. The set of all such points make up a feasible region of mean-variance (or mean-standard deviation) combinations. Efficient portfolios plot on the upper left-hand border of this region, shown as a red curved line in this case. For obvious reasons this border is often termed the efficient frontier.

Roles of the Analyst and the Investor


By its nature, our delineation of the roles of the Analyst and the Investor suggests a division of labor. The Analyst is presumed to be an expert on capital markets, while the Investor knows his or her circumstances, tastes, obligations, future opportunities, etc.. Their joint goal is to bring all this information together to achieve the best possible plan for the Investor's savings and investment. Central in this enterprise is the selection of an asset mix for a long-term investment policy. Such a policy asset mix plays a key role in many investment plans. Its choice is often the first (and sometimes the only) joint undertaking of the Analyst and the Investor. In principle, four ingredients are needed for a complete analysis of this type. In discrete terms: (1) estimates of possible payments made by various investment products at different times and in different states of the world, (2) estimates of the probabilities associated with these times and states of the world, (3) the Investor's utility function for consumption at different times and in different states of the world, and (4) the Investor's current wealth, projected future income and required payments at various times in various states of the world. Since the first two aspects are the same for every Investor, it pays to share the cost of obtaining information about them among many Investors. Economies of scale thus provide the primary justification for the existence of the Analyst, to whom this material is directed.

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In mean-variance analyses, payments (item 1) and probabilities (item 2) are summarized in the meanvariance feasible region. By assuming that all Investors are risk-averse, the Analyst can narrow the range of "sensible" investment opportunities to those that lie on the efficient frontier. In some cases this may suffice. The dialogue would be something like this: Analyst: Here is the tradeoff between risk (standard deviation) and (expected) return, using only efficient strategies. Which point do you want? Investor: I'll take that one (chooses a point). Analyst: OK. The asset mix for you is (writes down a mix, which indicates the percentage to be invested in each of several asset classes). In practice it is rarely this simple. While the mean-variance framework deals with only one period, actual investment policies are designed to last for many periods. Few Investors can relate one-period mean and variance to long-run outcomes. In most cases it falls to the Analyst to do so, taking into account information supplied by the Investor -- information that is unique to his or her situation. Take the example of a 55-year old with savings of $500,000. She plans to save an additional $50,000 per year for the next ten years, then "cash in" and move to Southern France. She cares only about the amount of money that she will have at that time. In such a circumstance an Analyst would generally do an asset allocation study. For example, five asset mixes might be selected from the efficient frontier, in order of increasing risk and expected return. For each mix a Monte Carlo analysis would be performed to estimate the probability distribution of the size of the Investor's retirement fund ten years hence. These would be shown to the Investor, who would pick the one she preferred. The dialogue would be something like: Analyst: Based on your current and planned future savings, I have estimated the likely range of retirement funds for each of five efficient investment strategies. The more conservative strategies run less risk of a truly disappointing outcome, but are likely to provide less under expected conditions. Here are depictions that show what might happen with each policy. Which do you prefer? Investor: This is not an easy choice. All things considered, this one (chooses a policy) seems best for me. Analyst: OK, here's the asset mix for you ....

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Indifference Curves
Mean-variance theory provides a neat separation between Investor preferences and capital market opportunities. The latter are summarized in the feasible mean-variance opportunity set and its efficient frontier. The former can be shown with a set of Investor indifference curves The diagram below shows portions of a map of the preferences of a specific Investor

Here are some answers obtained when this Investor was asked to choose between various pairs of meanvariance combinations: Choose between -------------W and Y V and Y X and Y W and Z V and X Z and Y Answer ----------W Y don't care W X don't care

These responses can be written using algebraic notation, with > meaning "is preferred to" (more properly:
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"would be chosen over"), < the converse, and = meaning "is equally desirable as" (more properly, "would let someone else choose" or "flip a coin"). Thus: W Y X W X Z > > = > > = Y V Y Z V Y

If the Investor has transitive preferences, we can combine all these responses, using the rules of algebra: W > X = Y = Z > V Thus if we know that W is preferred to Y and Y is preferred to V, we assume that if asked to choose between W and V, the Investor would pick W. This may seem obvious, but people often fail to make choices that are "rational" in this sense. Worse yet, when the preferences represent the results of choices made by a committee voting by majority rule, instances of intransitivity are common. In such cases the order in which votes are presented can easily affect the outcome. Thus W might win over Y in a first vote, and Y over V in a second vote, even though in an initial contest between W and V, the victory might have gone to V. The Analyst who works with Investment Committees must be aware of such possibilities: a difficult task indeed. Such is the world of practice. In the world of theory no such dangers lurk. The Investor is assumed to have transitive preferences which can, in principle, be graphed as a series of indifference curves of the type shown in the figure. The Investor is indifferent among all combinations of expected return and risk plotting on a single indifference curve (for example, X,Y and Z). He or she prefers any combination on a curve that cuts the expected return axis at a higher point to any combination that cuts it at a lower point. Thus W is preferred to X (or Y or Z or V), and X (or Y or Z) is preferred to V. The joint task of the Investor and the Analyst is to put the former on the highest possible indifference curve. This is shown below, with the red curve plotting the risk and return combinations available with efficient portfolios.

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In this case, point Y is optimal. Note that point E1 is inferior. Even though it represents an efficient meanvariance combination, it puts the Investor on the lowest curve shown, points on which are inferior to points on the middle curve, given his or her preferences. Of course, this Investor would prefer to be on the highest curve shown, but this is impossible, given current resources and capital market opportunities. It would be convenient if each Investor would present an Analyst with a complete map of his or her indifference curves. The Analyst could then recommend an asset mix virtually instantaneously. But the task is never this simple. As we will see, indifference curves are a useful construct, but in practice the Analyst generally focuses on only one portion of an Investor's entire indifference map -- which is just as well

Expected Utility
Mean-variance theory assumes that every Investor's utility function increases at a decreasing rate as wealth increases and is independent of the state of the world in which wealth is received. Even for Investors for whom this is the case, there are many possible relationships between utility and wealth. In discrete terms, if v is a column vector of end-of-period values, pr a row vector of corresponding probabilities, and u(v) the function relating the Investor's utility to end-of-period value (wealth), the expected utility of the portfolio that provides v and pr is: eu = pr*u(v)
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In continuous terms, if pr(v) is a probability distribution over end-of-period value (wealth) and u(v) is the Investor's utility function, the expected utility is the integral of u(v) weighted by pr(v). As noted earlier, if all portfolio distributions are normal, it is possible to determine the expected utility of each one, given an Investor's utility function. All mean-variance pairs that provide the same level of expected utility will lie on a single indifference curve. The set of all such curves will form the Investor's indifference map. There will be a great many indifference curves in the map representing an Investor's preferences. None, however, will intersect. To see why, consider a counterexample. Let points A and B lie on curve 1 and points B and C on curve 2, which intersects curve 1 at point B. If curve 2 represents a higher level of utility, then C is preferred to A. But B and C are equally desirable, as are B and A. The last two statements imply that A and C are equally desirable, if the Investor's preferences are transitive. But this contradicts the fact that C is preferred to A. Hence intersection of indifference curves make no sense. The best investment policy will lie at a point on the efficient frontier at which an indifference curve is tangent to (touches but does not intersect) the feasible region, as shown in the previous figure. In this case, point Y is optimal. It provides the level of expected utility associated with indifference curve XYZ. Note that the vertical intercept of this curve (point X) provides the same level of expected utility. But it represents a certain (standard deviation = 0) outcome. Hence we can say that the optimal combination is as desirable for this Investor as the amount X for certain. The latter is often termed the certainty-equivalent of the selected point. This interpretation provides a useful reformulation of the optimization problem: Maximize the certainty-equivalent value for the Investor in question. Note that the value of the objective function in this formulation depends on both the characteristics of the investment (its mean and variance) and the preferences of the Investor (his or her utility function).

Approximating an Investor's Utility Function


Some work in decision theory has attempt to elicit an individual's utility function via a series of questions concerning choices under uncertainty. For example: Would you rather have $10,000 for certain or a 50/50 chance of receiving $0 or $25,000? What probability of receiving $10,000 is as good as
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$5,000 for certain? and so on. Cognitive psychologists have shown that most individuals make choices in such situations that are inconsistent with the hypothesis that they attempt to maximize the expected value of a utility function that increases smoothly with wealth at a decreasing rate. Further, the choices presented to the individuals in questions such as those shown above often involve outcomes far from those associated with likely investment results. And in some cases "what if" situations may not be taken sufficiently seriously by the respondent to elicit carefully considered choices. An alternative approach concentrates on the Investor's preferences in the region in which the optimal investment is likely to lie, then uses a specific form as a local approximation to his or her (potentially more complex) preference function in that region. The first step involves a kind of crude asset allocation study. A representative ("long run") risk-return tradeoff is used to produce probability distributions of an outcome with meaning to the Investor. For example, the Investor might be shown a separate probability distribution of projected real annual income in retirement for each of five alternatives, say, A,B,C,D and E, -- each based on an efficient investment strategy with a greater short-term risk and expected return than its predecessor. Each of the distributions would be presented in its entirety or in part (with, for example, "likely", "poor" and "bad" outcomes shown), depending on the best manner in which to communicate such information to the Investor in question. After studying the alternative distributions (however presented), the Investor picks one. If it lies at one extreme (e.g. A or E), it may prove desirable to repeat the exercise with added alternatives extending the set of strategies beyond the point chosen. Sooner or later, the investor will select an "interior" alternative -say D. We do not know, of course, that this was the very best alternative, since some other strategy between the two adjacent alternatives (e.g. C and E) could well have been preferred. In practice, however, it is usually assumed that when an interior strategy is chosen, it was the best of all possibilities -- an assumption that places considerable responsibility on the Analyst to provide an appropriate set of alternatives. If the chosen strategy is in fact the best, we know that one of the Investor's indifference curves is tangent to the efficient frontier at the chosen point, as shown in the earlier diagram. Since we know the slope of the frontier at the optimal point, we also know the slope of the indifference curve at that point. But we do not know the slope of that indifference curve at other points nor the slopes of other indifference curves at various points. To deal with this, we need to assume more about the Investor's preferences, at least in the near neighborhood of the selected portfolio.

Negative Exponential Utility Functions


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A particularly useful utility function for mean-variance analysis is the negative exponential. In MATLAB notation: u = 1 - exp(-(c*w)) where w is a measure of wealth and c is a positive parameter. In standard utility theory the argument (w) is the absolute value of wealth at a future date. Some assume that such a function can be applied repeatedly for one-period decisions on sequential dates. However, for purposes of portfolio theory it is desirable to state utility in terms of return (the relative change in wealth over the future period): u = 1 - exp(-(c*r)) While this is simply a linear transform of the wealth-based version for a single period, it implies different behavior with respect to repeated one-period decisions, as we will see. The figure below provides three examples of this function. We state return in percentage terms (e.g. 10.0 for an increase in wealth of 10%). As indicated, the utility associated with a return of zero is taken as zero, although no change in behavior would be implied if a constant were added to each such function. The flattest curve in the figure, shown in yellow, is based on a value of 0.04 for the parameter c. The next flattest (red) curve is based on a c value of 0.05, and the steepest (green) curve a value of 0.06. In each case utility increases at a decreasing rate, exhibiting Investor risk aversion. Moreover, the greater the value of parameter c, the more curved the function and hence the more risk-averse the Investor in question.

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To see the effect of curvature (c) on risk aversion, we can compute the certainty-equivalent return for a given distribution for our three Investors. Assume that Investment X offers a fifty percent chance of obtaining a return of 10% and a fifty percent chance of breaking even (i.e. obtaining a return of 0%). The expected utility of such a gamble will be: eu = 0.5*(1-exp(-c*0)) + 0.5*(1-exp(-c*10))

We seek a return, rc, that will offer the same expected utility (which will, of course, be certain): eu = 1-exp(-c*rc)

Combining the two equations produces the following relationship: rc = -(1/c)*log(.5*exp(-c*0)+.5*exp(-c*10)) giving the following values for our three Investors: c ---0.04 0.05 rc -----4.5033 4.3814

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0.06

4.2610

Even though the expected return from the investment is 5.0%, all three of these Investors will accept a smaller amount for certain to give up the investment. However, the amounts differ. The Investor for whom c=0.04 would be indifferent between the investment in question and 4.5033 percent for certain. The second Investor would be willing to accept a lower certain return (4.3814 percent), reflecting greater risk aversion. The third Investor, even more averse to risk, will accept even less (4.2610 percent) in return for giving up the investment. The greater is parameter c, the greater is the Investor's risk aversion. The negative exponential utility function is especially convenient in a world of normally-distributed outcomes. Recall that expected utility is the integral of the utility function using the probability distribution as weights. If the former is negative exponential and the latter is normal, it will be the case that expected utility will be a simple function of the mean and variance of the distribution: eu = e - (v/t) Here, e is the expected outcome, v is the variance of the outcome, and t equals (2/c), where c is the parameter from the investor's utility function. For our three Investors:

c ---0.04 0.05 0.06

t ---50.0 40.0 33.3

Parameter t measures the Investor's risk tolerance. Not surprisingly, the greater an Investor's risk aversion (c), the smaller is his or her risk tolerance (2/c). If the probability distribution of returns is not normal, the expected utility of an investment for an Investor with a negative exponential utility function is likely to differ somewhat from that given by the simple mean-variance formula. For example, consider the investment with a 50/50 chance of returning 0% or 10%. It offers an expected return of 5%, a standard deviation of 5% and a variance of 25. The distribution is far from normal. Nonetheless, the (e-v/t) formula provides good approximations even in this case, as can be seen by comparing its values with the exact certainty-equivalents calculated earlier for our three Investors: t ---50.0 40.0 33.3 exact -----4.5033 4.3814 4.2610 approx ----4.500 4.375 4.250

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Although the formula provides only approximate values when the distribution of returns is non-normal, it may nonetheless give very good approximations in such cases. Of course these statements rely on the assumption that an Investor's utility function is in fact negative exponential, which need not be the case. However, if we assume that in the region near the selected initial point, the Investor's utility function can be adequately approximated by a negative exponential function, we can continue to use (e-v/t) to measure the desirability of a portfolio for the Investor in question. This could be termed a certainty-equivalent, as before. However, such a local approximation to the Investor's utility function is unlikely to hold over a large enough region to make the true certainty-equivalent equal this value. Hence we will term (e-v/t) the portfolio's expected utility or simply, its portfolio utility: pu = e - (v/t)

Inferring Investor Risk Tolerance


Portfolio utility depends on both portfolio characteristics and the risk tolerance of the Investor in question. To emphasize this one could write: pu(p,k) = e(p) - v(p)/t(k) where e(p) is the expected value (or return) of portfolio p, v(p) is its variance, t(k) is Investor k's risk tolerance, and pu(p,k) is the utility of portfolio p for investor k. Portfolio utility is measured in the same units as e. Consider the set of all portfolios that provide a given level of utility, say pux. All such portfolios must satisfy the equation: pux = e(p) - v(p)/t(k) or: e(p) = pux + (1/t(k))*v(p) In a diagram with mean (e) on the vertical axis and variance (v) on the horizontal axis, such an indifference curve will plot as an upward-sloping straight line, the intercept of which will indicate the associated portfolio utility. The slope of such a line indicates the rate at which the Investor is willing to trade expected value (or return) for variance. But the slope is 1/t(k). Thus t(k), the reciprocal of this slope, is the rate at which the Investor is willing to trade variance for expected return. Indeed, we can define t(k) as Investor k's marginal rate of substitution of variance for expected value. If an Investor's risk tolerance were the same at all points in a mean/variance diagram, his or her indifference map would be a family of parallel lines, as shown below:
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In fact it is unlikely that risk tolerance is constant over wide ranges of outcomes. However, we can infer its level from the choice of a prototypical asset mix, then assume that it is constant in the near neighborhood of the mean and variance of that mix. Assume that the riskless rate of interest is 4% and that by investing in a diversified stock index portfolio it is possible to obtain an expected excess return over the riskless investment of 6% per year, with a standard deviation of 15% per year. If an amount x is invested in the stock index and an amount (1-x) in the riskless asset the return will be: R = x*Rs + (1-x)*rr where Rs is the return on the stock index and rr is the return on the riskless asset. The expected return of the combination will be: e = x*Es + (1-x)*rr where Es is the expected return on the stock index. Since the riskless asset has no risk, its standard deviation of return is zero. Hence the standard deviation of the combination will equal that of x*Rs. Examination of the formula for computing a standard deviation shows that the standard deviation of a positive constant times a variable will equal the constant times the standard deviation of that variable. Hence:

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s = x*Ss The net result of these relationships is that a combination in which x is invested in the stock index and (1x) is invested in the riskless asset will lie at a point on the straight line that connects the points plotting the two assets in mean/standard deviation space. If x = 0 the point will coincide with that of the riskless asset. If x = 1, it will coincide with that of the stock index. If x is between 0 and 1 the point will plot on the line between the two asset's points. If x is greater than one, it will plot on the extension of this line above the point representing the risky asset. The figure below shows the relationship for the case in question.

The portfolios shown in the diagram have the proportions: x ---0 25 50 75 100 1-x ---100 75 50 25 0

A B C D E

In this case the opportunity set (feasible region) is the straight line connecting the points. Since every feasible combination is efficient, the efficient frontier is the same line. Presumably there are other combinations of individual securities that lie below this line, but they have been excluded from the analysis. In any event, the frontier in this case can be described by the equation: e = 4 + (6/15)*s
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Now consider the same relationship plotted in a mean/variance diagram: e = rr + (6/15)*sqrt(v) In terms of e and v, the equation is non-linear, as shown in the figure below:

A relationship that plots as a line in mean/standard deviation space will plot as a curve that increases at a decreasing rate in a mean/variance diagram, as in this case. Assume that Investor I has been presented with the implications of policies A,B,C,D and E for his or her standard of living in retirement. After careful reflection, C was chosen. Assume moreover that a finer set of choices (e.g. between B and D) was presented and C was again chosen (or that the Analyst is willing to assume that such would have been the case had the further analysis been undertaken). In any event, we know that one of Investor I's indifference curves is tangent to the frontier at point C and must therefore have the same slope as the frontier at that point, as shown below:

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In this case: e = 4 + (6/15)*(v.^(1/2)) thus: de/dv =(1/2)*(6/15)*(v.^(-1/2)) or: de/dv = (1/2)*(6/15)*(1/s) Since the chosen point has a standard deviation of 7.5, the slope of the frontier at that point is: (1/2)*(6/15)*(1/7.5) or 6/225 The reciprocal is, of course, the Investor's risk tolerance. We thus infer that: t(k) = 225/6 = 37.5 Note that the riskless rate of interest does not appear in this calculation -- only the expected excess return
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and standard deviation of the risky asset. For further analyses we may assume that risk tolerance is constant in the near neighborhood of this point, as shown below:

While it is convenient to show the derivation of risk tolerance from a choice of investment in mean/variance space, it is more intuitive to examine the situation in mean-standard deviation space, as in the following figure.

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In this more familiar setting the efficient frontier plots as a straight line and each indifference curve increases at an increasing rate. Of course the point of tangency represents the same portfolio as before. Here too, the indifference curve and efficient frontier have the same slope (in this case, de/ds) at the chosen point. In these diagrams we have shown only a limited range for the inferred indifference curve and for a few others with the same risk tolerance -- all within the near neighborhood of the chosen efficient risk/return combination. This was done to emphasize the fact that the Investor's actual indifference curves may differ considerably in areas of the diagram that are far from the chosen point. However, for relatively modest changes in the opportunity set (feasible region) it may be perfectly acceptable to assume that the fitted indifference curves reflect the Investor's true preferences. In such instances one can simply search the new opportunity set for a new point of tangency with the set of indifference curves with the same risk tolerance as found in the initial study.

Risk tolerance and risk


If the efficient portfolio is linear in mean/standard deviation space, there is a one-to-one mapping between risk undertaken and risk tolerance, assuming efficient investment strategies are utilized. Let the efficient frontier be: e = a + b*s then:
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s = (e-a)/b and v = ((e-a)^2)/(b^2) The rate at which v can be substituted for e along the frontier is thus: dv/de = 2*(e-a)/(b^2) For an investment strategy to be optimal, this must equal the investor's risk tolerance t: t = 2*(e-a)/(b^2) = (2*(e-a)/b)/b But s=(e-a)/b. Thus: t = (2*s)/b and s = (b/2)*t It follows that, compared with an "average investor": an Investor with twice the risk tolerance should take twice the risk an Investor with half the risk tolerance should take half the risk Similarly: if Investor A optimally takes half the risk taken optimally by Investor B, then A has half as much tolerance for risk as B. Note that this neat correspondence depends on the assumption that the efficient risk-return tradeoff is linear. In practice this is often approximately true, so the relationship holds to at least a first approximation.

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Properties of Portfolio Utility


While portfolio utility indifference curves plot as parallel upward-sloping straight lines in mean/variance space, they have a more familiar look in more intuitive mean/standard deviation ("return/risk") diagrams, as we have seen. The equation for all combinations of e and s that provide a given level of portfolio utility pux is: e = pux + (s^2)/t Note that e is a quadratic function of s, and that: de/ds= 2*s/t Hence such a curve increases at an increasing rate as s increases. Moreover, all such curves have the same slope for a given value of s, as can be seen from the equation and inspection of the following enlarged version of the area near the chosen point in the previous diagram:

In a later section we will show that efficient frontiers will always increase at a non-increasing rate in mean/standard deviation space. More simply put, they will either be linear or increase at a decreasing rate. Since our assumed indifference curves increase at an increasing rate, this assures that one and only one efficient combination of risk and return will, in principle, be optimal in every case. It should, however, be said that in practice Investors often find it difficult to make a single choice from among
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alternative efficient combinations, indicating that preferences are not as neatly defined as our expected utility theory would suggest.

Effects of Increases in Wealth


In a one-period analysis it seems natural to measure outcomes in terms of end-of-period portfolio value, since this is a measure of wealth and, ultimately, consumption -- the source of utility. However, mean/variance analysis is seldom used in a strictly one-period setting. Rather, one derives a one-period portfolio utility function (more precisely, an Investor's one-period risk tolerance) from choices made in a multi-period setting (for example, as part of an asset allocation study). Although the connection between the formal one-period model and the selection of a multi-period strategy is somewhat inelegant, it is important to recall the context in which mean/variance analyses are in fact performed. For this reason it is generally preferable to cast mean/variance problems in terms of portfolio return, as we have done. This makes it more likely that the Analyst can utilize the same risk tolerance from period to period, at least until circumstances change in significant ways. To see this, consider an Investor with $100 in year 1 who chooses an asset mix with 50% invested in a riskless asset with a return of 4% and 50% invested in a stock index fund with an expected return of 10% and a standard deviation of 15%. Shown below are the opportunity set and the selected point in a diagram based on ending value (wealth).

Now assume that in year 2 the Investor has a portfolio worth $110 and adds another $90 so that a total of
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$200 is available for investment. The new opportunity set in terms of wealth is shown below. Note that it has the same slope as the one for year 1.

We know that the optimal mix lies at a point at which one of the Investor's indifference curves has the same slope as the opportunity set. But we have established that all indifference curves have the same slope for a given standard deviation. Since the new opportunity set is parallel to the old one, the Investor will choose the same standard deviation as before ($7.50). In this case, however, the associated mix will have only 25% invested in the stock index fund, which has a dollar standard deviation of $30.0 ($200*0.15). The dollar amount ($50) invested in the stock fund will, however, be the same as before. Investors with constant risk tolerance stated in terms of end-of-period value will exhibit constant absolute risk aversion, keeping constant their absolute exposure to risky assets as wealth increases. Since this results in a decrease in their relative exposure to such assets, they exhibit increasing relative risk aversion. While some Investors might have preferences with such characteristics, most, will have greater risk tolerances expressed in value terms, as their wealth increases. Consider now a portrayal of Investor preferences in terms of portfolio return, with risk tolerance indicating the Investor's willingness to trade variance of return for expected return. The figure below shows the situation in year 1. It also shows the situation in year 2. In such a situation, an Investor with constant risk tolerance expressed in terms of return would select the same relative mix of risky and riskless assets, no matter what his or her wealth -- behavior consistent with constant relative risk aversion.

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The assumption of constant relative risk aversion seems much closer to the preferences of most investors than does that of constant absolute risk aversion. Nonetheless, it is by no means guaranteed to reflect every Investor's attitude. Some may wish to take on more risk (standard deviation of return) as their wealth increases. Others may wish to take on less. Many Analysts counsel a decrease in such risk as one ages. Some strategies are based on acceptance of more or less risk, based on economic conditions. And so on. For these and other reasons it is important to at least consider strategies in which an Investor's risk tolerance (vis-a-vis one-period return) changes from time to time. However, such changes, if required at all, will likely be far more gradual than those associated with a constant risk tolerance expressed in terms of end-of-period value. Henceforth, unless stated otherwise, when we use the term risk tolerance, we will mean the Investor's marginal rate of substitution of the variance of one-period return for expected one-period return. Similarly, we will assume that portfolio utility is based on the expected return, variance of return and Investor risk tolerance based on one-period return. In cases involving zero-investment strategies we will sometimes be forced to deal in value terms. However, in such situations we will derive a utility function for end-of-period value from an assumed constant risk tolerance based on one-period return.

Risk-adjusted Expected Return


Some use the term risk-adjusted expected return or, more simply, risk-adjusted return, for the construct we have termed portfolio utility. We illustrate with an example:
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Expected return Risk (standard deviation) Variance Risk Tolerance Risk Penalty Risk-adjusted Expected Return

7.60 9.00 81.00 45.00 1.80 5.80

e sd v = sd^2 t v/t e - v/t

The expected return is 7.60%, but the investment has a risk of 9%. The Investor in question thus subtracts a risk penalty of 1.80% to obtain a risk-adjusted expected return of 5.80%. As stated earlier, the risk penalty depends on both the portfolio's risk and on the Investor's tolerance for risk. Other things equal, the greater the risk, the greater the risk penalty. And, other things equal, the greater the Investor's risk tolerance, the smaller the risk penalty. The Analyst's main task is to find the portfolio with the maximum risk-adjusted expected return (portfolio utility) for the Investor in question. The figure below shows the relationship between (1) portfolio utility for an Investor with a risk tolerance of 45 and (2) the percent invested in the stock index fund in our previous example (a riskless return of 4% and a stock index fund with an expected return of 10% and a standard deviation of 15%). In this case it is optimal to invest 60% in the stock index fund and 40% in the riskless asset. The characteristics of this solution are those shown in the preceding table.

Not surprisingly the "utility hill" plots as a quadratic function of the proportion invested in the risky asset. The Analyst's goal is to place the Investor at the top of this hill.

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Multi-period Returns

Multi-period Returns

Contents:
q q q

Compounded Returns Lognormal Distributions Discounting Projected Values

Compounded Returns
While one-period returns may be normally distributed, this will generally not be the case for the value of a portfolio many periods hence, due to the effects of compounding. If $1 is invested initially, the value will be (1+r1) at the end of period 1, where r1 is the rate of return in the first period. If money is neither withdrawn from nor added to the account so that (1+r1) is invested at the beginning of period 2, the value at the end of period 2 (v2) will be (1+r1)*(1+r2), where r2 is the rate of return in the second period: v2 = (1+r1)*(1+r2) Equivalently: v2 = 1 + r1 + r2 + r1*r2 The final term reflects the effects of compounding. If r1 and r2 are normally distributed, r1*r2 will not be, and hence neither will v2. Assume that in each period there is a 0.50 probability that $1 will become (e+sd) and a 0.50 probability that it will become (e-sd). For example, if e = 1.10 and sd=0.15:

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Note that this is not a normal distribution, but it is symmetric, with an expected value relative of e and a standard deviation of sd. With compounding, the ending values after two periods for an initial investment of $1 would be those shown in the following diagram:

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A somewhat different representation shows the one-period value relatives at each node in the diagram, rather than the cumulative values:

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In this case the one-period value relative distribution is the same at all points in the diagram: neither the ending values nor the probabilities associated with the branches change through time or depend on prior outcomes. Such returns are said to be independent and identically distributed (iid, for short). Since the distribution of possible one-period returns looks the same in such a situation, no matter what has happened in the past, returns can be said to follow a random walk. Note that this type of tree "folds back" on itself, so that there are only three distinct outcomes: (e+sd)*(e+sd) (e+sd)*(e-sd) (e-sd)*(e-sd) Expanding: e^2 + 2*sd + sd^2 e^2 - sd^2 e^2 - 2*sd + sd^2 : probability = 0.25 : probability = 0.50 : probability = 0.25 : probability = 0.25 : probability = 0.50 : probability = 0.25

The expected ending value is found by weighting each outcome by its probability. In this case it will be:
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ev2 = e^2 Perhaps not surprisingly, the two-period expected value is simply the one-period expected value relative squared. There is more to be said, however. Consider the distribution of the ending values:

Note that the distribution is not symmetric, since the largest value is farther to the right of the most likely value than the smallest value is to the left of the most likely value. The distribution is skewed to the right. Note also that 1.1875 (=0.95*1.25), the most likely outcome, known also as the mode, is smaller than the expected outcome (1.1^2=1.21). In our two-period case the most likely outcome (e+sd)*(e-sd) is also the median outcome: the probability of a smaller value is equal to the probability of a larger value. It is thus of considerable interest. Its value is: e^2 - sd^2 which is equal to the expected one-period value relative squared minus the one-period variance. It is convenient to translate this ending value into a "what if" value called, in some contexts, the geometric mean -- the return per period which, if obtained with no variance, would have produced the same ending value. Here: (1+g)^2 = e^2 - sd^2
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or: (1+g)^2 = (1+er)^2 - sd^2 where er is the one-period expected return. In this case: (1+g)^2 = (1 + .10)^2 - 0.15^2 = 1.21 - .0225 = 0.1875 and 1 + g = sqrt(1.1875) = 1.0897

Thus g = 8.97%, which is less than 10.0%, the one-period expected return. While this expression is perfectly usable, practitioners often adopt a simpler approximation. Expanding the squared expressions gives: 1 + 2*g + g^2 = 1 + 2*er + er^2 - sd^2 or: er - g = (g^2 - er^2)/2 + (sd^2)/2 Since er and g are generally significantly less than one (e.g. 0.10 and 0.09), both er^2 and g^2 will be even smaller (e.g. 0.0100 and 0.0081). Moreover, half the difference between g^2 and er^2 will be even smaller yet (e.g. -0.00095). Hence it will be approximately true that: er - g = (sd^2)/2 or g = er - (sd^2)/2 For example, if er = 0.10 and sd = 0.15, then: g = 0.10 - 0.0225/2 = 0.10 - 0.01125 = 0.08875 or 8.875%, only slightly different from the more precise estimate of 8.97%.

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If the return on a diversified stock market portfolio is assumed to be iid with a standard deviation of 15% per year, the median long-term return (g) will be approximately 1.125% ((0.15^2)/2) below the expected one-period return (e). If the standard deviation of return were 20%, the difference would be 2.0% ((0.20^2)/2). And so on. The geometric mean return will be less than the expected return (sometimes termed the arithmetic mean), as long as there is some variation in returns. Moreover, the difference between the geometric and arithmetic means will be greater, the greater the amount of such variance. What about longer periods? Consider the ending value of a portfolio n periods hence, where n is an even number. The most likely and median outcome will have n/2 "up moves" and n/2 "down moves". Hence, the n-period median ending value (evn) will be: evn = ( (e+sd)^(n/2))*((e-sd)^(n/2) ) = ((e+sd)*(e-sd))^(n/2) = (e^2 - sd^2)^(n/2)

The geometric mean will be the value that satisfies: (1+g)^n = (e^2 - sd^2)^(n/2) or: ((1+g)^2)^(n/2) = (e^2 - sd^2)^(n/2) or: (1+g)^2 = e^2 - sd^2

which is precisely the relationship found earlier.

Lognormal Distributions
It is common in asset allocation studies to assume that returns are independent and identically distributed. This has important implications for the distribution of long-term returns. Let v1,v2,...,vn be the value relatives for a portfolio in periods 1,2,..,n, respectively. Assuming an initial investment of $1 with periodic compounding and no withdrawals or additional investments, the ending value in period n will be:
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evn = v1*v2*...*vn Now, take the logarithm of each side: ln(evn) = ln(v1*v2*...*vn) or: ln(evn) = ln(v1) + ln(v2) + ... + ln(vn) Ex ante, each of the variables on the right-hand side is unknown. Each will be drawn from a distribution (that of ln(v)) and each draw will, by assumption, be independent of every other draw. Recall the central limit theorem, which holds that the sum of a set of independent random variables will have a distribution that will be closer and closer to normal, the greater the number of variables in the sum. For a sufficiently large value of n, ln(evn) will be normally distributed, or nearly so. We say that variable x has a lognormal distribution if the distribution of ln(x) is normal. Thus long-term compounded values tend to be lognormally distributed if returns are independent. Note that this result follows, no matter what the distributions of one-period returns may be, as long as the returns are independent. The figures below show distributions of ln(evn) and evn when evn is lognormally distributed.

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Note that the distribution of evn is skewed to the right, due to the relationship between evn and ln(evn) and the symmetry of the distribution of the latter. Note also that m -- the modal and median value of evn will be less than e, the expected value.
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To fix ideas, consider the two-period example discussed earlier. The one-period value relatives are: e+sd e-sd with probability = 0.50 with probability = 0.50

In logarithmic terms: ln(e+sd) with probability = 0.50 ln(e-sd) with probability = 0.50 The expected logarithm is thus: 0.50*ln(e+sd) + 0.50*ln(e-sd) = 0.50*(ln(e+sd)+ln(e-sd) = 0.50*ln((e+sd)*(e-sd)) = 0.50*ln(e^2 - sd^2) Let ln(1+g) represent this mean (for reasons that will become clear shortly). Then: ln(1+g) = 0.50*ln(e^2 - sd^2) and: (1+g)^2 = e^2 - sd^2 which is the formula obtained earlier for the geometric mean. We know that ln(1+g) is the mean of the distribution of ln(ev1). It follows that n*ln(1+g) is the mean of the distribution of ln(evn). But since the modal (median) ending value will equal the exponential of the mean value of the logarithm: median(evn) = (1+g)^n Thus the median outcome will equal the value obtained by compounding each period at the geometric mean rate of return. There is a 50% chance that the actual value will exceed this amount and a 50% chance that it will fall below it. In some cases it is necessary to determine the moments of the distribution of the logarithm of a lognormally-distributed value from those of the value itself or vice-versa. The formulas for doing so are slightly complicated but easily computed. Assume that log(y) is normally distributed with mean el and standard deviation sl. Then the mean (e), variance (v) and standard deviation (s) of y will equal:
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e = exp ( el + ( ( sl^2 ) / 2 )); v = exp ( 2*el + ( sl^2 ) ) * ( exp (sl^2) - 1); s = sqrt ( v ); where: exp ( z ) = the exponential of z (that is, e raised to the z'th power) If the mean and variance of y are known, the moments for the distribution of log(y) can be found by sequentially evaulating the equations below: b = sqrt ( log ( ( v / (e^2) ) + 1) ); a = 0.5 * log ( (e^2) / exp(b^2) ); where: log ( z ) = the natural logarithm of z

Discounting Projected Values


In corporate finance and investment practice it is common to project a set of cash flows, then discount them using an appropriate cost of capital or discount rate. If the resulting value is less than the cost of the investment, it is rejected. If the value exceeds the cost, the investment is accepted. Key to the validity of such a procedure is the choice of an appropriate cost of capital or discount rate. We will not attempt a complete discussion of this topic, but it is useful to analyze the arguments for using a geometric mean vis-a-vis an arithmetic mean for such purposes. Consider our example in which a standard market investment produces a return of (e+sd) with probability 0.50 and a return of (e-sd) with probability 0.50 in each period. The expected cost of capital for such an investment is e, while the geometric mean is given by: (1+g)^2 = e^2 - sd^2 Now consider a project that is expected to make a payment two periods hence of: (e+sd)*(e+sd) (e+sd)*(e-sd) (e-sd)*(e-sd) with probability 0.25 with probability 0.50 with probability 0.25

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We know that such a project is worth $1 since its payments can be replicated in the market for this amount. In practice those charged with assessing the project will be asked to produce a single set of cash flows over time (in this case, one number for the ending cash flow). A discount rate will then be used to compute the present value. If the project's cash flow is implicitly or explicitly estimated by taking all possibilities into account as well as the associated probabilities, the result will be equivalent to an expected value -- in this case, e^2. Clearly, such an estimate should be discounted using the expected return (arithmetic mean). Here: (e^2)/(e^2) = 1 which is the correct present value. This is the method advocated by many who have addressed the issue. However the argument for using the expected return as a discount rate assumes that that the projection process takes into account all possible future cash flows and the accompanying probabilities. In many cases a much simpler approach is utilized. Imagine a situation in which only the most likely (or "50/50") outcome was considered. In our example, the projected cash flow would then be: (e+sd)*(e-sd) = (1+g)^2 If this were discounted using the expected cost of capital, the resultant value would be less than $1 -clearly a wrong answer. The correct value would be obtained by discounting with the geometric mean: ((1+g)^2)/((1+g)^2) = 1 In practice cash flows are projected for many different periods. Moreover, the assumptions utilized to make such projections are often highly implicit. Those making projections may even adjust their estimates to assure a particular outcome if the "hurdle rate" (cost of capital) is known beforehand. Thus the nature of the overall process must be known before a "theoretically correct" procedure can be determined. In some cases an expected return may be appropriate discount rate, but in many instances a geometric mean (median return) may provide more correct results.

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Portfolio Characteristics

Portfolio Characteristics

Contents:
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Portfolio Expected Return Portfolio Risk Covariance Correlation Interpreting Correlation Coefficients Exponentially Weighted Covariances Function wcov Weighted Statistics Worksheet Portfolio Covariances Asset Covariances with a Portfolio Marginal Risks

Portfolio Expected Return


Thus far we have dealt with portfolios of at most two assets, with only one involving any risk. It is time to turn to the general relationship between the characteristics of a portfolio and the characteristics of its components. Let there be n assets and s states of the world, with R an {n*s} matrix in which the element in row i and column j is the return (or value) of asset i in state of the world j. Here is an example with n=3 and s=4: Good 5 10 25 Fair 5 8 12 Poor 5 6 2 Bad 5 -5 -20

Asset1 Asset2 Asset3

Let x be an {n*1} vector of asset holdings in a portfolio. For example: x

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Asset1 Asset2 Asset3

0.20 0.30 0.50

What will be the return of the portfolio in each of the states? This is easily computed. The {1*s} vector of portfolio returns in the states (rp) will be: rp = x'*R Here: Good 16.50 Fair 9.40 Poor 3.80 Bad -10.50

rp

Now, let p be an {s*1} vector of the probabilities of the various states of the world. In this case: p 0.40 0.30 0.20 0.10

Good Fair Poor Bad

The expected return (or value) of the portfolio will be: ep = rp*p In this case: ep = 9.13 It is useful to write the expression for expected return in terms of its fundamental components: ep = x'*R*p The product of the three terms can be computed in either of two ways. Above, we computed x'*R, then multiplied the result by p. Alternatively, we could have multiplied x' by the result obtained by multiplying R times p: ep = x'*(R*p) The parenthesized expression is an {n*1} vector in which each element is the expected return (or value )
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of one of the n securities. Let e be this vector: e = R*p Here: e 5.00 7.10 12.00

Asset1 Asset2 Asset3

Using these results we may write: ep = x'*e That is, the expected return (or value) of a portfolio is equal to the product of the vector of its asset holdings and the vector of asset expected returns (or values). This is the case whether the returns are discrete, as in this derivation, or continuous (that is, drawn from continuous distributions). The units utilized for the values in vectors x and e will depend on the application. In some cases, physical units (e.g. shares) may be appropriate for x; in others, values (e.g. dollars); and in yet others, proportions of total value. Whatever the units selected, to find the end-of-period value of a portfolio, the end-ofperiod values per unit of exposure should be placed in vector e and the number of units of each asset held placed in vector x. To find the expected return (or value-relative) for a portfolio, multiply the expected returns (or value-relatives) in vector e by the exposures to the assets in vector x. Whatever the application, the relationship between the expected outcome of a portfolio and the expected outcomes for its components is relatively simple and intuitive. For example, the expected return on a portfolio is a weighted average of the expected returns on its components, with the proportionate values used as weights. Since the relationship is linear, the marginal effect on portfolio expected return of a small change in the exposure to a single component will equal its expected outcome: d(ep)/d(x(j)) = e(j) If the expected outcome were the only relevant characteristic of a portfolio, it would be easy to make investment decisions. But risk is also relevant. And, as we will see, its determination presents a more substantial challenge.

Portfolio Risk
For present purposes we will use as a measure of portfolio risk the standard deviation of the distribution
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of its one-period return or the square of this value, the variance of returns. By definition, the variance of a portfolio's return is the expected value of the squared deviation of the actual return from the portfolio's expected return. It depends, in turn, on the possible asset returns (R), the probability distribution across states of the world (p) and the portfolio's composition (x). The relationship is, however, somewhat complex. To begin it is useful to create a matrix of deviations of security returns from their expectations. This can be accomplished by subtracting from each security return the corresponding expectation: d = R - e*ones(1,s) The result (d) shows the deviation (surprise) associated with each security in each of the states of the world. Here: Good 0.00 2.90 13.00 Fair Poor Bad 0.00 0.00 0.00 0.90 -1.10 -12.10 0.00 -10.00 -32.00

Asset1 Asset2 Asset3

The deviation (surprise) associated with the portfolio in each of the states of the world can be obtained by multiplying the transpose of the composition vector times the asset deviation matrix: dp = x'*d In this case: Good 7.37 Fair 0.27 Poor -5.33 Bad -19.63

dp

To determine the variance of the portfolio, we wish to take a probability-weighted sum of the squared deviations. A simple way to do so uses the dot-product operation, in which elements are treated one by one: vp = sum(p'.*(dp.^2)) However, there is a more elegant and (as will be seen) far more useful way to do the computation. First, we create a {s*s} matrix with the state probabilities on the main diagonal and zeros elsewhere. This can be done in one statement: P = diag(p);

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In this case, P will be: Good 0.40 0.00 0.00 0.00 Fair 0.00 0.30 0.00 0.00 Poor 0.00 0.00 0.20 0.00 Bad 0.00 0.00 0.00 0.10

Good Fair Poor Bad

The variance of the portfolio is then given by a more conventional matrix expression: vp = dp*P*dp' For our portfolio: vp = and sdp = sqrt(vp) = 8.1218 To see why the latter procedure for computing variance is more useful, we substitute the vectors used to compute dp: vp = (x'*d)*P*(x'*d)' There is an easier way to write the last portion. Remember that the transpose operation turns a matrix on its side. From this it follows that: (a*b)' = b'*a' For example, let a be a {ra*c} matrix and b a {c*rb} matrix. Then (a*b) is {ra*rb} and (a*b)' is {rb*ra}. Now consider the expression to the right of the equal sign. The first term (b') is of dimension {rb*c}, while the second is of dimension {c*ra}. Their product will thus be of dimension {rb*ra}. Since each element will represent the sum of the same set of products as in the result produced by the expression on the left, the resulting matrices will in fact be the same. We can use this result to note that: (x'*d)' = d'*x'' 65.9641

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But two transpose operations will simply turn a matrix on its side, then turn it back, giving the original matrix. Therefore: (x'*d)' = d'*x And the expression for portfolio variance can be written as: vp = (x'*d)*P*(d'*x) Of course the multiplications can be performed in any desired order. For example: vp = x'*(d*P*d')*x The parenthesized term is of great importance in portfolio analysis - - enough to warrant its own section in this exposition.

Covariance
The matrix described in the previous section is termed the covariance matrix for the assets in question. Each of its elements is said to measure the covariance between the corresponding assets. Using C to represent the covariance matrix: C = d*P*d' In this example: Asset1 0.00 0.00 0.00 Asset2 Asset3 0.00 0.00 18.49 56.00 56.00 190.00

Asset1 Asset2 Asset3

The variance of a portfolio depends on the portfolio's composition (x) and the covariance matrix for the assets in question: vp = x'*C*x which of course gives the same value found earlier (65.9641). Well and good. But what do the covariance numbers mean? How are we to interpret the fact that the covariance of Asset2 with Asset3 is 56.00, while that of Asset3 with itself is 190.00, and so on?

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Examination of the matrices involved in the computation of C provides the answer. Recall that C=d*P*d'. Consider the covariance of Asset2 and Asset3. It uses the information in row 2 of matrix d and that in column 3 of matrix d' (the latter is, of course, also in row 3 of matrix d). It also uses the vector of probabilities along the diagonal of matrix P. The net result, written in a slightly casual notation is that: C(2,3) = sum(d(2,s)*p'(s)*d(3,s)) where the sum is taken over the states of the world. As this expression shows, the covariance between two assets is a probability-weighted sum of the product of their deviations. To verify this we can adapt the expression above to make it legal in MATLAB: c23 = sum(d(2,:).*p'.*d(3,:))

The answer is 56.00, precisely equal to the value in the second row and third column of the covariance matrix. Put in terms of prospective results: the covariance between two assets is the expected value of the product of their deviations from their respective expected values. It immediately follows that the covariance of asset i with asset j is the same as the covariance of asset j with asset i. Thus the matrix is symmetric around its main diagonal -- note that the value in row 2, column 3 is the same as that in row 3, column 2. It also follows from the expression for covariance that the covariance of an asset with itself is its variance. The asset variances thus lie on the main diagonal of the covariance matrix. In this case: va = diag(C) Here: va 0.00 18.49 190.00

Asset1 Asset2 Asset3

The asset standard deviations are of course the square roots of these numbers: sda = sqrt(diag(C)) In this case: sda
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Asset1 Asset2 Asset3

0.00 4.30 13.78

Note that the first asset's return is certain. Hence its variance and standard deviation are zero. The second asset is risky, with a standard deviation of 4.30. The third is considerably more risky, with a standard deviation of 13.78. Since the covariance matrix includes asset variances along the main diagonal, the entire matrix is sometimes termed a variance-covariance matrix. For brevity we will use the simpler term covariance matrix, but it should be remembered that the diagonal elements are both covariances and variances. For the special case in which the probability of each state is the same, it is possible to compute the covariance matrix more simply using the standard MATLAB function cov. However, the function assumes that the inputs represent a sample of observations drawn from a larger population and hence adjusts the values in the matrix upwards to offset the bias associated with measuring deviations from a fitted mean. In effect, each value produced by the MATLAB function cov will equal the one given by our formulas times (s/(s-1)), where is the number of states (observations). To use the cov function, simply provide the matrix of observations, with each row representing a different observation (state) and each column a different asset class. For example, if the returns in our {n*s} matrix R were historic observations and we were willing to assume that they were equally probable we could compute: C = cov(R') which would give: Asset1 Asset2 Asset3 0.00 0.00 0.00 0.00 44.92 122.58 0.00 122.58 360.92

Asset1 Asset2 Asset3

These values are, of course, quite different from those found earlier, due to both the assumption of equal probabilities and the correction for bias. With this aside completed, we return to our forward-looking example.

Correlation
It is relatively easy to find a meaning for the elements on the main diagonal of the covariance matrix. But
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what of the remaining ones? How can one interpret the fact that the covariance of Asset2 with Asset3 is 56.00? The solution is to scale each covariance by the product of the standard deviations of the associated assets. The result is the correlation coefficient for the two assets, usually denoted by the Greek letter rho: rho(i,j) = C(i,j)/(sda(i)*sda(j)) The matrix of correlation coefficients is termed (unimaginatively) the correlation matrix. We denote it Corr. To compute it, we compute a matrix containing the products of the asset standard deviations: sda*sda': Asset1 0.00 0.00 0.00 Asset2 Asset3 0.00 0.00 18.49 59.27 59.27 190.00

Asset1 Asset2 Asset3

We need to divide each element in the covariance matrix by the corresponding element in this matrix. This can be done in one equation: Corr = C./(sda*sda') Giving: Asset1 NaN NaN NaN Asset2 NaN 1.00 0.94 Asset3 NaN 0.94 1.00

Asset1 Asset2 Asset3

Notice that the elements associated with asset pairs in which one of the assets is riskless are NaN (not a number), since they involve an attempt to divide zero (the covariance) by zero(the product of two standard deviations, one of which is zero). While the correlation of two assets, one of which is riskless, is not really a number, it sometimes proves helpful to set it to zero. This can be accomplished by adjusting the matrix of the cross-products of the standard deviations to have ones in the cells for which the true value is zero. A simple way to do this is to add to the original matrix a matrix with 1.0 in such positions. Since "true" is represented in MATLAB as 1.0, a single matrix expression does the job. Here is a set of statements that accomplishes the objective: z = sda*sda'; z = z + (z==0);
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CC = C./z; where CC is the desired correlation matrix. In this case: Asset1 0.00 0.00 0.00 Asset2 0.00 1.00 0.94 Asset3 0.00 0.94 1.00

Asset1 Asset2 Asset3

In most cases, the covariance matrix is known, and the correlation matrix derived from it as an aid in interpretation. However, there are cases in which standard deviations and correlations are estimated first, and the covariance matrix derived from those estimates. To do this, we simply reverse the terms in the definition of correlation. For the element in row i, column j: C(i,j) = rho(i,j)*sda(i)*sda(j) And, for the entire matrix: C =CC.*(sda*sda') Note that the adjusted matrix CC was used in the latter computation to avoid NaN values in the cells associated with the riskless asset.

Interpreting Correlation Coefficients


Asset covariances are the main ingredients for computing portfolio risks. But we have shown that standard deviations are much easier to interpret than are asset variances. Similarly, correlations often prove more useful for communicating relationships than do covariances. Correlation coefficients measure the extent of the association between two variables. Each such coefficient must lie between -1 and +1, inclusive. A positive coefficient indicates a positive association: a greater-than-expected outcome for one variable is likely to be associated with a greater- than-expected outcome for the other while a smaller-than-expected outcome for one is likely to be associated with a smaller-than-expected outcome for the other. A negative coefficient indicates a negative association: a greater-than-expected outcome for one variable is likely to be associated with a smaller-than-expected outcome for the other while a smaller-than- expected outcome for one is likely to be associated with a greater-than-expected outcome for the other. The figures below provide examples. In each case the probabilities of the points shown are assumed to be equal.

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In the above examples the variables are roughly jointly normally distributed with means of zero and standard deviations of 1.0 -- roughly, because each of the 100 points is drawn from such a joint distribution so the (sample) distribution of the actual results departs somewhat from the underlying (population) distribution.

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Note that in the case of perfect positive correlation (+1.0), the points fall precisely along an upwardsloping straight line. In this case it has a slope of approximately 45 degrees due to the nature of the variables. In general, the line may have a greater or smaller slope. Nonetheless, a necessary and sufficient condition for perfect positive correlation is that all possible outcomes plot on an upward-sloping straight line. In the case of perfect negative correlation the plot has the opposite characteristic. All points will plot on a downward-sloping straight line. Here too, the slope will depend on the magnitudes of the variables, but the line will be downward-sloping in any event. As the figures show, in the case of less-than-perfect positive correlation (between 0 and +1.0), the points will tend to follow an upward-sloping line, but will deviate from it. The closer the correlation coefficient is to zero, the greater will be such deviations and the more difficult it will be to see any positive relationship. In the case of less-than-perfect negative correlation (between 0 and -1), the points will tend to follow a downward-sloping line. Here too, the closer the correlation coefficient is to zero, the greater will be the deviations and the more obscure the relationship. If the correlation coefficient is zero, the best linear approximation of the relationship will be a flat line. This does not preclude the possibility that there is a non-linear relationship between the variables. The figure below shows a case in which the correlation coefficient is zero, but knowledge of the value of the variable on the horizontal axis would help a great deal if one wished to predict the value of the variable on the vertical axis. In this case the variables are uncorrelated, but they are not independent.

In the special case in which probabilities are equal, one can use the MATLAB function corrcoef to
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compute a correlation matrix directly from an {n*s} matrix of values of n assets in s different states of the world, with each row representing a different state (observation) and each column a different asset. For example: corrcoef(R') would give: Asset1 NaN NaN NaN Asset2 NaN 1.00 0.96 Asset3 NaN 0.96 1.00

Asset1 Asset2 Asset3

In this case the only source of the differences from our forward- looking estimates is the use of equal probabilities rather than the predicted probabilities. Since the correlation coefficient is the ratio of estimated variance to the product of two estimated standard deviations, any adjustment of the covariance matrix for sample bias cancels out, leaving the correlation coefficients unaffected.

Exponentially Weighted Covariances


Analysts frequently utilize historic returns to estimate the covariances among future returns. If all returns, past and future, were drawn from a stable joint distribution, it would be desirable to use as many observations from the past as possible in order to maximize the accuracy of the resultant estimates of the true underlying process that will generate future returns. However, if the parameters of the distribution are likely to have changed over time, the situation is more difficult. One can utilize a great deal of data, much of which may be of limited relevance for the future. Alternatively, a small amount of recent data can be employed, with the attendant danger of substantial estimation errors. Which is better -- a great deal of possibly irrelevant data or too little relevant data? There is no easy answer to the question. The optimal procedure ultimately will depend on the manner in which covariances evolve through time. Some Analysts approach the problem by limiting the historic data to, say, 60 monthly observations, with each observation assigned the same weight (probability). Others select only periods in which underlying conditions are assumed to have been similar to those existing at the present time (e.g. periods following recessions if a recession has recently been experienced). Yet others employ complex procedures in which covariances are assumed to be positively correlated but with a tendency to eventually revert to a long-run mean value. Here we focus on a simple procedure utilized in a number of asset allocation models that assumes that the future is more likely to be like the recent past than the distant past. In an exponential weighting scheme each historic observation is assigned a multiple of the weight assigned to its predecessor. For example, observation t could be assigned a weight equal to 2^(t/h)
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divided by a constant (k), with the latter set so that the sum of all the weights equaled 1.0. In such a scheme h can be interpreted as an assumed half-life. To see why, consider the weights assigned to months t and t-h: w(t) = (2^(t/h))/k w(t-h) = (2^((t-h)/h))/k Thus: w(t)/w(t-h) = (2^(t/h))/((2^t/h)/2) = 2 Thus if month t is the most recent month and h=60, the observation 60 months ago will be assigned half as much weight as the most recent month. The weight assigned to any month relative to that assigned to its predecessor will be: (2^(t/h))/(2^((t-1)/h)) which will equal 2^(1/h). Thus if a 60-month half life is utilized, each month's observation will be given a weight equal to 2^(1/60) or 1.0116 times that given the prior month (1.16% higher). It is relatively straightforward to compute a set of such weights using MATLAB. Assume that there are T observations. The vector of dates (1,2,...T) is given by: d = 1:1:T; The vector of 2^(t/h) values will be: w = 2.^(d/h) where h is the desired half-life. The weights can easily be normalized so that they sum to 1.0: p = w/sum(w) We denote the result p since the weights will serve as probabilities. In a sense, the assumption is made that the probability is p(t) that next month's returns will equal those that occurred in month t. Having selected a set of probabilities, we proceed as before to estimate expected returns, deviations and the covariance matrix:
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e = R*p; d = R - e*ones(1,T); C = d*diag(p)*d';

Function wcov
The library function wcov obviates the need to remember all these formulas. It takes as inputs a matrix of returns for n assets in s states (or from s historic time periods). For convenience, the return matrix can have assets in the rows and states (observations) in the columns or vice-versa. The function assumes (reasonably) that the number of states (observations) exceeds the number of assets and proceeds accordingly. To cover more cases, the half-life parameter can be specified as zero, in which event the states (observations) are given equal weights. The simplest way to utilize the function is as follows: C = wcov(R,h) where R is the matrix of returns, h is the half-life and C is the resultant covariance matrix. If more information is desired, one or more additional variables may be indicated. For example: [C,sda] = wcov(R,h)

will also return sda as the vector of standard deviations. The statement: [C,sda,CC] = wcov(R,h)

will also return CC as the matrix of correlation coefficients, following the convention that the correlation coefficient is zero if the corresponding covariance is zero. Finally, the statement: [C,sda,CC,e] = wcov(R,h) will also return the expected returns, based on the assumption that future probabilities equal the weights computed from the assumed half-life.
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Weighted Statistics Worksheet


The Weighted Statistics Worksheet allows you to compute both equal-weighted and exponentiallyweighted means, standard deviations and correlation coefficients. An example using returns for a set of Vanguard mutual funds from 1991 through 1995 provides a chance for you to experiment with different weighting schemes. Try a half-life of zero for equal weights, then compare the results with those obtained with other values (for example, 12, 24, .. 60). You might even wish to try a negative half-life to weight earlier observations more heavily than later ones. You may also wish to copy and paste other return series into the weighted statistics worksheet so that you can calculate the resulting historic statistics.

Portfolio Covariances
It is remarkably easy to determine the covariances between two portfolios. Recall the formula for computing the covariance of portfolio x: vp = x'*C*x where x is the vector with the portfolio composition and C is the covariance matrix for asset returns. Now, let xa represent one portfolio and xb another. For example: xa 0.10 0.50 0.40 xb 0.40 0.10 0.50

Asset1 Asset2 Asset3

Asset1 Asset2 Asset3

Assume that the covariance matrix (C) is: Asset1 0.00 0.00 0.00 Asset2 Asset3 0.00 0.00 18.49 56.00 56.00 190.00

Asset1 Asset2 Asset3

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The covariance between the two portfolios is given by: cab = xa'*C*xb Which in this case equals 55.16. The relationship can be extended to cover a case in which there are multiple portfolios. Let X be an {n*p} matrix containing information on the composition of p portfolios of n assets. For example: xa 0.10 0.50 0.40 xb 0.40 0.10 0.50

Asset1 Asset2 Asset3

Then the covariance matrix for the portfolios is given by: Cp = X'*C*X Which gives: xa 57.42 55.16 xb 55.16 53.28

xa xb

Note that the elements on the main diagonal indicate the variances of the two portfolios, while the other elements equal their covariance.

Asset Covariances with a Portfolio


It is straightforward to compute the covariance of each asset with a given portfolio. Recall the statement for the covariance of portfolio xa with portfolio xb: cab = xa'*C*xb This can be computed in two operations: cab = xa'*(C*xb) For example, with xb:

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Asset1 Asset2 Asset3 and C:

0.40 0.10 0.50

Asset1 Asset2 Asset3 then

Asset1 0.00 0.00 0.00

Asset2 Asset3 0.00 0.00 18.49 56.00 56.00 190.00

cab = xa'*cp where cp = C*xb, or: cp 0.00 29.85 100.60

Asset1 Asset2 Asset3

Now, assume that xa contains only the first asset: xa 1.00 0.00 0.00

Asset1 Asset2 Asset3

Clearly, the covariance of xa with xb will equal the first value in vector cp (0.00). If xa contained only the second asset, its covariance with xb would equal the second value in vector cp (29.85). And so on. The conclusion is not hard to reach. Vector cp contains the covariances of the asset classes with portfolio xb. More generally, if: cp = C*x

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then cp(i) is the covariance of asset i with portfolio x. Note that the covariance of an asset with a portfolio will be a weighted average of its covariances with all the assets (including itself), with the composition of the current portfolio used as weights.

Marginal Risks
The risk of a portfolio is not a linear function of the vector of its components. Rather, the variance of a portfolio is a quadratic function of its composition. This thwarts the intuition of most Analysts and Investors. Indeed, the nature of risk may be the single most important argument for the use of quantitative analysis in investment management. Neither Investors nor Analysts can be blamed for this fact. Nor can Harry Markowitz. Nature made risk a quadratic function. Markowitz only discovered it. Given this central fact of investment life, it follows that the impact on the risk of a portfolio of a small change in the amount invested in a particular asset is not simply a function of the risk of that asset. The impact will depend on the covariances of the asset with all the other assets currently in the portfolio and on the composition of the portfolio. Consider a portfolio x and a "difference vector" d. We wish to determine the effect on portfolio variance of a switch from portfolio x to portfolio x+d. The variance of x will be: vx = x'*C*x While that of (x+d) will be: vv = (x+d)'*C*(x+d) The latter can be expanded by noting first that (x+d)'=x'+d', giving: vv = (x'+d')*C*(x+d) then by multiplying out all the terms: vv = x'*C*x + x'*C*d + d'*C*x + d'*C*d Since the first term of the latter expression equals the variance of x, the change in variance is given by the sum of the last three terms:

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dvp = x'*C*d + d'*C*x + d'*C*d The first two terms are the same. This follows from the facts that: (1) the transpose of a scalar is the same scalar, (2) the transpose of a product of matrices is the product of their transposes, taken in reverse order and (3) the covariance matrix C is symmetric, so that its transpose equals the original matrix. Given this, we may write: dvp = 2*d'*C*x + d'*C*d We are interested here in the effect on variance of a small change in the holding of one asset. Thus d will contain only one small non-zero element. For example,if we wished to know the effect of a small change in the holdings of asset 2 we could set: d 0.00 0.01 0.00

Asset1 Asset2 Asset3

Since the elements in d will be either zero or very small (very much less than 1.0), the final term in the earlier expression (d'*C*d) will be even smaller. Indeed, as d approaches zero, the one element in d'*C*d will approach zero considerably faster, since it involves the square of the non-zero element in d. For purposes of computing the marginal effect of a change we may ignore the final term, giving: dvp = 2*d'*C*x or dvp = d'*2*C*x From this it follows that d(vp)/d(x(j)) will equal the j'th row of 2*C*x. More generally, 2*C*x is the vector of marginal risks of the asset classes: mr = 2*C*x with mr(j) indicating the change in portfolio variance per unit change in the amount invested in asset j. Note finally, that C*x is the vector of the covariances of the assets with portfolio x, which we have denoted cp. Thus: mr = 2*cp

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and two times the covariance of an asset with a portfolio indicates the marginal risk of that asset, given the composition of the portfolio. In our case: mr 0.00 59.70 201.20

Asset1 Asset2 Asset3

Thus variance would not be affected by a small change in the holding of asset 1. It would increase at a rate of 59.70 per unit change in Asset 2 and at a rate of 201.20 per unit change in Asset 3. Of course these figures hold only approximately for finite changes in the assets, with the error greater, the larger the underlying change. Moreover, they assume that only one element in the portfolio is changed. If the assets represent zero investment strategies this may be feasible. If, however, they are true investments, at least one holding will have to be decreased for another to be increased. We will take these aspects into account in later discussions. For now it suffices to have determined the vector of derivatives of variance with respect to asset holdings.

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Portfolios of Two Assets

Portfolios of Two Assets

Contents:
q q q q q q q

Characteristics of a Two-asset Portfolio Combining a Riskless Asset with a Risky Asset Combining Two Risky Assets Combining Two Perfectly Positively Correlated Risky Assets Combining Imperfectly Correlated Risky Assets Risk-return Tradeoffs in Mean-Variance Space The Excess Return Sharpe Ratio

Characteristics of a Two-asset Portfolio


The formulas and MATLAB functions discussed previously are sufficient to compute the characteristics of any portfolio. However, to better understand the economics of portfolio construction it is useful to consider the effects of combining two assets to form a portfolio. To economize on notation we omit parentheses. Thus x1 and x2 will be the proportions invested in assets 1 and 2 respectively, and e1 and e2 will be their expected returns. The expected return of the portfolio, ep, will then be:

ep = x1*e1 + x2*e2 Since the proportions will sum to 1.0 we may also write:

ep = e1 + x2*(e2-e1) The variance of the portfolio, vp, will be a function of the proportions invested in the assets, their return variances (v1 and v2), and the covariance between their returns (c12):

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vp = ((x1^2)*v1) + (x2^2)*v2) + 2*x1*x2*c12 Here too, we can substitute (1-x2) for x1 to obtain an expression relating the portfolio's variance to the amount invested in asset 2:

vp = v1 + 2*x2*(c12-v1) + (x2^2)*(v1-2*c12+v2) The standard deviation of return (sp) will, as always, be the square root of the variance:

sp = sqrt(vp) Throughout this section we will assume that asset 1 has less risk (v1&ltv2) and a smaller expected return (e1&lte2). We will be interested in the risk-return tradeoff associated with different combinations of the two assets and, in particular, the shape of the curves in mean-variance and mean-standard deviation space that result as more money is invested in the risky asset (that is, as x2 is increased and x1 decreased).

Combining a Riskless Asset with a Risky Asset


The figure below plots the locus of mean-standard deviation combinations for values of x2 between 0 and 1 when e1=6, e2=10, s1=0, s2=15 and c12=0.

In this case, as in every case involving a riskless and a risky asset, the relationship is linear. This is easily seen. Recall that ep is always linear in x2 as shown earlier. If asset 1 is riskless, sp will also be linear in x2, since both v1 and c12 will equal zero. In such a case:

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vp = (x2^2)*v2 sp = sqrt((x2^2)*v2) = abs(x2)*sqrt(v2) = abs(x2)*s2 where abs(x2) denotes the absolute value of x2. This result can be extended to cases in which it is possible to take short positions. First, assume one can either go long the riskless asset ('lend") or take a short position in it ("borrow") at the same interest rate (e1). The formulas above then apply directly. The figure below shows the results obtained by using leverage in this manner. For example, the point marked 1.5 is associated with x2=1.5 and x1=-0.5. It indicates that by "levering up" an investment in asset 2 by 50% an Investor can obtain a probability distribution of return on initial capital with an expected value of 12% and a standard deviation of 22.5%. The other points in the figure correspond to the indicated values of x2. Those above the original point involve borrowing (x1<0) while those below it involve lending (x1>0).

What if an Investor could short the risky security (x2<0) and invest the proceeds obtained from the short sale in the riskless security? Here too, the standard formulas apply. However, note that the variance will be positive, as will the standard deviation, since a negative number (x2) squared is always positive. The figure below shows the effects of negative x2 values.

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A qualification to this analysis is in order. A strategy involving short positions may require that additional capital be pledged to cover possible shortfalls between ending asset and liability values. Absent this, a higher rate will typically be charged for the short position so the income to the lender in states of the world in which the borrower is solvent will be sufficiently high to compensate for the shortfalls associated with the states of the world in which the borrower is insolvent. The figure below shows a simple case of this sort in which funds may be borrowed, but at a higher rate (8%) than the rate at which they may be lent (6%). Here the locus of the ep,sp combinations plots as two lines, the first associated with the lower lending rate, the second with the higher borrowing rate. As before, the risky asset offers an expected return of 10% and a risk of 15%. The efficient frontier is shown by the solid lines. The dashed line indicates the options that would be available if the Investor could lend at 8%. While points on it are infeasible, those plotting on its extension to the right of the point representing the risky asset are both feasible and efficient.

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In practice the rate charged for borrowing may increase with the amount borrowed. In such a case the locus of ep,sp combinations will increase at a decreasing rate as risk (sp) increases beyond the amount associated with a full unlevered investment in the risky asset (x2=1). Under these conditions there will eventually be decreasing returns to risk-taking.

Combining Two Risky Assets


When a portfolio includes two risky assets, the Analyst needs to take into account expected returns, variances and the covariance (or correlation) between the assets' returns. The differences from the earlier case in which one asset is riskless occur in the formula for portfolio variance. In terms of risks and correlations it is:

vp = ((x1^2)*(s1^2)) + (2*x1*x2*r12*s1*s2) + ((x2^2)*(s2^2)) where r12 is the correlation between the assets' returns.

Combining Two Perfectly Positively Correlated Risky Assets


To begin, consider the case in which two returns are perfectly positively correlated. Under these conditions:

vp = ((x1^2)*(s1^2)) + (2*x1*x2*s1*s2) + ((x2^2)*(s2^2)) The term on the right can be factored to obtain:

vp = (x1*s1 + x2*s2)^2 from which it follows that:

sp = abs(x1*s1 + x2*s2) where, abs(..) connotes the absolute value of the enclosed expression. As long as x1 and x2 are both nonnegative the expression itself will be non-negative since neither s1 nor s2 can ever be negative. However, if one of the two x values is sufficiently negative, the absolute value must be utilized explicitly.

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Consider combinations of long positions in the two assets (x1>=0, x2>=0). For any such combination:

sp = x1*s1 + x2*s2 And, as always:

ep = x1*e1 + x2*e2 In such a case both risk and return will be proportional to x2:

sp = s1 + x2*(s2-s1) ep = e1 + x2*(e2-e1) and all such portfolios will plot on a straight line connecting the points representing the two assets. In the figure below, e1=8,s1=5, e2=10, s2=15 and r12=1.0.

This relationship can be extended by allowing x2 to be either greater than one or less than zero. Of particular interest is the combination that gives the smallest possible risk: the minimum-variance portfolio. In this case it is possible to achieve a variance of zero! We seek a value x2 for which:

sp = s1 + x2*(s2-s1) = 0 This will be obtained when:


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x2 = -s1/(s2-s1) and

x1 = 1-x2 = 1 + (s1/(s1+s2) = s2/(s2-s1) In our example a riskless portfolio can be obtained by setting:

x2 = -5/(15-5) = -0.5 x1 = 1-x2 = 1.5 This can be accomplished by taking a short position in asset 2 equal to one-half the Investor's funds and investing the proceeds as well as the original amount of money in asset 1. In practice this may require the pledging of some other collateral to provide a sufficient guarantee to the lender of asset 2 that the short position can be covered when needed. The ability to form a riskless portfolio by taking offsetting positions in two perfectly positively correlated assets leads directly to a figure similar to that derived earlier when a riskless asset was combined with a risky one. Let the expected return on the zero-variance portfolio be:

e0 = e1 + x2min(*e2-e1) where:

x2min = -s1/(s2-s1) In the current example e0 will equal 7% (8-0.5*(10-8)). The set of portfolio risks and returns can then be derived by considering combinations of this riskless asset (portfolio) and either asset 1 or asset 2. Either view will provide the familiar graph associated with risky and a riskless asset. In this case:

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While all the combinations shown are feasible, only those on the upper line are efficient -- a point emphasized by the use of a dashed line for the dominated portion of the relationship.

Combining Imperfectly Correlated Risky Assets


While perfectly positively correlated risky assets do exist, they are the exception rather than the rule. In most cases correlation coefficients are less than 1.0. The implications of this fact for risk are central to an understanding of the effects of diversification. Consider a portfolio with long positions in two risky assets (x1>0, x2>0). As shown earlier, its variance will be:

vp = ((x1^2)*(s1^2)) + (2*x1*x2*r12*s1*s2) + ((x2^2)*(s2^2)) Now imagine two cases, similar in every respect (x1,x2,e1,e2,s1,s2) but correlation (r12). Let vp(1) be the variance of one portfolio, for which r12=1 and vp(r) be the variance of the other, for which r12=r, where r is less than 1. Only the middle term in the equation for portfolio variance will differ in the two calculations. Since all the components of that term but r12 are positive, it follows that vp(r)&ltvp(1). More generally, other things equal:

vp(r1) 0, x2>0 Other things equal, the smaller the correlation between two assets, the smaller will be the risk of a portfolio of long positions in the two assets.

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The figure below shows combinations of risk and return for such portfolios when e1=8,s1=5, e2=10 and s2=15. Each curve applies to a case with a different correlation between the two assets' returns. Not surprisingly, the cases are coincident at the end-points (x1=1,x2=0 and x1=0,x2=1). For all interior combinations, when the correlation coefficient is less than 1.0, risk is less than proportional to the risks of the two assets, with the extent of risk reduction greater, the smaller the correlation coefficient. Thus the yellow curve (r12=1.0) provides no risk reduction, only risk-averaging; the red curve (r12=0.5) provides some risk reduction, the green curve (r12=0) more, and the blue curve (r12=-0.5) even more.

The most powerful case of diversification arises when r12=-1.0. In this instance:

vp = ((x1^2)*(s1^2)) - (2*x1*x2*s1*s2) + ((x2^2)*(s2^2)) which can be factored to obtain:

vp = (x1*s1 - x2*s2)^2 and

sp = abs(x1*s1 - x2*s2) In such a case the minimum-variance portfolio will be riskless. To obtain it, we wish to set:

x1*s1 - x2*s2 = 0

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given: x1+x2 = 1 The solution is:

x2 = s1/(s1+s2) Thus if s1=5 and s2=15 and the two assets are perfectly negatively correlated, a riskless portfolio will be obtained with x2=5/(5+15)=0.25 and x1=0.75. Its expected return will equal 0.25*e1+0.75*e2 (here, 8.5%). The next figure repeats the results of the prior case and adds this new one (in white).

Once again we have obtained the familiar diagram in which there is a riskless asset. This should not be a surprise. Long positions in two perfectly negatively correlated assets are similar to (1) a long position in one of two perfectly positively correlated assets and (2) a short position in the other. In most cases asset correlations lie between -1.0 and +1.0. To cover all possibilities we need a general formula for the minimum-variance portfolio. For this we start with a reduced-form equation in which vp is expressed as a function of x2 (under the assumption that x1=1-x2):

vp = v1 + x2*(c12-v1) + (x2^2)*(v1-2*c12+v2) The derivative with respect to x2 is:

d(vp)/d(x2) = (c12-v1) + 2*x2*(v1-2*c12+v2)

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Setting this to zero gives:

x2min = (v1-c12)/(2*(v1-2*c12+v2)) The minimum-variance portfolio may have a lower risk than either of its component assets. It may also have a higher return. Consider the point at which x2=0. Here:

d(ep)/d(x2) = e2-e1 d(vp)/d(x2) = c12-v1 and:

d(ep)/d(vp) = (e2-e1)/(c12-v1) As usual, we assume that e2>e1. For the slope d(ep)/d(vp) to be negative we need:

c12-v1 <0 That is:

r12*s1*s2 or: r12 For example, if s1=5, s2=15, e2>e1 and r12<5/15, the minimum variance portfolio will dominate asset 1, offering both lower risk and higher expected return.

The figure below shows a case in which e1=8,s1=5, e2=10,s2=15 and r12=0.10. Here, the risk-return plot "bends backward" so that x1=1 is an inefficient portfolio. The minimum-variance portfolio is efficient, as are portfolios that combine it (in non-negative amounts) with asset 2.

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If r12 exceeds s1/s2, the minimum variance portfolio will require a short position in asset 1. The figure below shows a case in which e1=8,s1=5, e2=10,s2=15 and r12=0.80.

As before, all points above and to the right of the point representing the minimum-variance portfolio are efficient. In this case, asset 1 is efficient, as are all combinations involving asset 2 in amounts exceeding x2min. Note that the efficient frontier increases at a decreasing rate, exhibiting decreasing returns to riskbearing.

Risk-return Tradeoffs in Mean-Variance Space


We have seen that efficient combinations of two assets plot on a curve in mean-standard deviation space that increases at either a constant rate or at a decreasing rate as standard deviation is increased. What can be said about the shape of the frontier in mean-variance space?
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First, note that:

vp = sp^2 Thus:

d(vp) = 2*sp*d(sp) and:

d(sp) = d(vp)/(2*sp) From this it follows that:

d(ep)/d(vp) = (d(ep)/d(sp))/(2*sp) If d(ep)/d(sp) is constant as sp is increased, then d(ep)/d(vp) will be a decreasing function of sp. The figures below provide illustrations of the efficient frontiers in each of the two spaces when e1=6, s1=0, e2=10, s2=15 and the two assets are perfectly positively correlated..

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If two risky assets are less than perfectly correlated, d(ep)/d(sp) will decrease with sp and d(ep)/d(vp) will, in a sense, decrease at an even faster rate. The figures below provide illustrations of the frontier representing non-negative combinations of the two assets in each of the two spaces when e1=6,s1=5, e2=10, s2=15 and r12=0.5.

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When two assets are combined to form portfolios, the efficient frontier will plot as a curve with a decreasing slope in mean-variance space, no matter what the assets' characteristics. This implies that there will be a unique point of tangency with an indifference curve (line) from a family exhibiting constant risk tolerance (that is, for which utility = ep-vp/t). The figures below provide illustrations using the assets in the most recent example and a risk tolerance of 50. In each diagram the optimal portfolio lies at the point at which the green indifference curve is tangent to the efficient frontier. Of course the optimal portfolio is the same in each diagram. In this case the optimal mix has x1=0.5 and x2 =0.5. The expected return of the portfolio is 8.0%, its variance is 81.25, its standard deviation 9.0139 and it provides the Investor in question a utility of 6.375%. The latter can be seen by inspecting the vertical intercept of the green indifference curve. The points on the blue indifference curve provide a lower level of utility and thus are inappropriate for this Investor. Points on the red indifference curve provide a higher level of utility, but none is feasible in this case.

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The Excess Return Sharpe Ratio


A widely-used (and sometimes misused) measure of investment performance is the Sharpe Ratio, originally named the reward-to-variability ratio by its author, but now commonly given this eponymous description. Broadly defined, it is the ratio of the expected value of a zero-investment strategy to the standard deviation of that strategy. An important special case involves a zero-investment strategy in which funds are borrowed at a fixed rate and invested in a risky asset.
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Let x be invested in asset 2 and -x in asset 1. In our previous notation, this is equivalent to x2=x and x1=x. The expected return relative to the underlying or notional value x will be:

e = x*(e2-e1) while the standard deviation will be:

s = x*s2 The Sharpe Ratio for the strategy will thus be:

e/s = (x*(e2-e1))/(x*s2) or:

(e2-e1)/s2 Note that e2-e1 is the expected value of the difference between the return on asset 2 and the return on asset 1. The difference between the return of a risky asset and that of a riskless one is termed the risky asset's excess return:

xr2 = r2-r1 Since r1 is riskless, the standard deviation of xr2 will equal the standard deviation of r2. Thus the Sharpe Ratio for our strategy will be:

e(xr2)/s(xr2) that is, the expected excess return divided by the standard deviation of excess return. For specificity we will call this asset 2's excess return Sharpe Ratio (xrsr), although it is often termed simply the asset's Sharpe Ratio. Note that x, the scale of the zero-investment strategy, does not appear in the formula -- all strategies involving a given asset or portfolio have the same value of xrsr, no matter what their scale (assuming, of course, that the rate of interest is unaffected by the amount borrowed). Under these conditions, xrsr is
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scale-independent. To see one of the implications of this characteristic, consider a choice between two risky assets, a and b, in which only one can be chosen but long or short positions can be taken in a riskless asset. Assume that asset b has a higher excess return Sharpe Ratio. Which is better? The figure below provides an illustration.

For any desired level of risk, a portfolio "based on" asset b will provide a higher expected return than one based on asset a. In this context, the phrase "based on" connotes a combination of the asset in question and the riskless asset with the amount of the latter positive, negative or zero as required to obtain the desired level of risk. Thus if the level of risk offered by asset a is desired, the combination of asset b and lending that provides the risk and return shown by point z in the diagram should be selected, since it provides the same level of risk, but greater expected return. This will be true for any desired level of risk. Another way to see this is to consider an investment of x1 in asset 1 and x2 in asset 2 as (1) an investment in asset 1 and (2) a decision to take a position of size x2 in the zero-investment strategy in which asset 1 is shorted, with the proceeds from the short sale invested in asset 2. An institutional arrangement for the latter is a swap in which the Investor (party A) agrees to pay a fixed rate (the return on asset 1) to a counterparty (party B) and the latter agrees to pay a rate based on the return of a risky asset (asset 2). Both rates are multiplied by a notional amount, then netted to determine the final value transferred from one party ("the winner") to the other ("the loser"). In this situation the Investor will receive r1 on his or her direct investment and x*(r1-r2) on the swap,

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where x is the ratio of the notional value of the swap to the value of the Investor's original funds. Overall, the return will be:

r1 + x*(r2-r1) or:

r1*(1-x) + x*r2 Thus x plays the role of x2 in our original formulation, while (1-x) plays the role of x1. While x represents a natural measure for use when contracting for a zero-investment strategy, in many cases a more useful measure of scale is the standard deviation of ending value. In this case we normalize it, dividing by amount of the Investor's initial fund to obtain the resultant standard deviation of overall return:

sp = x*s2 We are now ready to re-examine the choice between two mutually exclusive risky assets under the assumption that it is possible to take long or short positions as desired, either directly or indirectly via derivative strategies such as swaps. In the present view, one must select between two zero-investment strategies. One provides e(xra)/s(xra) per unit of risk, while the other provides e(xrb)/s(xrb) per unit of risk. Assume that a fixed amount of risk, sp, is desired. Then the expected returns of the two strategies will be:

ea = e1+ ((e(xra)/s(sra))*sp and

eb = e1+ ((e(xrb)/s(srb))*sp Clearly the strategy with the larger ratio of expected excess return to standard deviation of excess return is better. But this ratio is the excess return Sharpe Ratio. In a situation of this sort one should pick the alternative that provides the highest reward per unit of variability. More simply put: among mutually exclusive risky portfolios, pick the one with the greatest expected return Sharpe Ratio. Practitioners often compute excess return Sharpe Ratios based on historic returns for mutual funds and
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other investment products. The usefulness of such measures may be limited due to lack of conformance with the assumptions that we have made in this section. First, the distribution of historic returns may be a poor surrogate for the distribution of next period's return. Second, it may not be possible to borrow at the same rate of interest used in the calculations of excess return. Finally, the Investor may have other assets and/or liabilities, and the funds being compared may provide different degrees of correlation with them. Since the Sharpe Ratio takes into account only expected return and risk, it may fail to lead to the best investment if correlations with important assets and liabilities differ significantly among the alternatives. Despite these caveats, the Sharpe Ratio is a useful measure that can combine aspects of both expected return and risk in one number. The excess return Sharpe Ratio represents one application of the broader concept. Later sections present other examples.

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Macro-Investment Analysis

Optimization
q q q

The Gradient Method Optimal Portfolios without Bounds on Holdings The Critical Line Method

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The Gradient Method

The Gradient Method

Contents:
q q q q q q q q q q

Optimization Procedures The Standard Asset Allocation Problem A Three-Asset Example The Utility Hill Asset Marginal Utility The Optimal Feasible Swap The Optimal Feasible Amount to Swap An Algorithm for the Standard Problem Function GQP The Optimization Worksheet

Optimization Procedures
The goal of the Analyst is to help the Investor "do what is best". Their joint objective should be to make a set of investment decisions that will provide the maximum possible utility for the Investor. In some cases this can be formalized as a problem involving the maximization of an objective function (such as the utility of a portfolio for the Investor) subject to one or more constraints (such as those imposed by the Investor's level of wealth). In the investment arena the process of solving such a problem is often termed optimization. Procedures for efficiently determining optimal strategies are frequently called optimization algorithms. Not surprisingly, computer programs that use such procedures are generally described as optimizers. The sections that follow deal with classes of optimization problems frequently encountered by Analysts and methods that can be employed to solve such problems.

The Standard Asset Allocation Problem


We focus on the allocation of an Investor's assets among several asset classes to as to maximize the utility of the resulting portfolio of assets for the Investor, taking into account the Investor's risk tolerance and relevant constraints on asset holdings. Many Analysts approach such problems using one-period estimates of asset risks, correlations and expected returns, assuming that the Investor's utility is a function of the expected return and standard deviation of return of the selected portfolio. More precisely, the Investor's utility is represented as a linear function of the mean and variance of the portfolio of assets: u = ep - vp/rt where:
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u = the utility of the portfolio for the Investor ep = the expected return of the portfolio vp = the variance of the portfolio return rt = the Investor's risk tolerance Here, rt represents the investor's marginal rate of substitution of variance for expected value. Moreover, u, the measure of portfolio utility, can be interpreted as a risk-adjusted expected return, since it is computed by subtracting a risk penalty (vp/rt) from the expected return (ep). The expected return of a portfolio will, of course, depend on its composition and on the expected returns of its components. A portfolio is represented by a vector of holdings, expressed as proportionate values. Let x be an {n*1} vector of such proportions and e be an {n*1} vector of asset expected returns. Then the expected return on portfolio x will be: ep = x'*e The variance of a portfolio's return will depend on its composition and on the covariances among the various asset classes. Let C be an {n*n} matrix of such covariances. Then the variance of return for portfolio x will be: vp = x'*C*x The goal is to find the best portfolio -- here, the one with the maximum possibility utility. The decision variables are the asset holdings -- that is, the elements of vector x. As these are varied, the utility of the associated portfolio will change. We wish to vary them until the maximum possible utility is attained. However, there are typically constraints on the allowable combinations. In the standard problem the x values represent proportionate holdings of assets. In such a case only values of x that sum to 1.0 may be considered. We thus must obey a full-investment constraint: sum(x) = 1 To generalize slightly in anticipation of more complex problems, we will require that: sum(x) = k where k is a constant. Often there will be further constraints on asset holdings. In many situations short sales are precluded, hence only non-negative values of the x's are allowed. Upper limits may also apply. The standard problem includes both types of bounds. Let lb be a {n*1} vector of lower bounds and ub an {n*1} vector of upper bounds. Then we require that each value of x(i) must be below or at its upper bound ub(i) and above or equal to its lower bound lb(i). In vector terms: x <= ub x >= lb More succinctly: lb <= x <= ub Cases involving only lower bounds can be treated by assigning values of plus infinity to upper bounds, while those involving only upper bounds can be treated by assigning values of minus infinity to lower bounds. If there are no bounds, both procedures can be invoked. This makes the standard problem formulation more general than one might initially assume.
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We will refer to this as the "standard asset allocation problem". To summarize, the goal is to: Select: x to maximize: u = ep - vp/rt where: ep = x'*e vp = x'*C*x subject to: sum(x) = k lb <= x <= ub Note that this involves the maximization of a quadratic function of the decision variables, subject to a set of linear constraints, some of which are inequalities. A problem with such characteristics is termed a quadratic programming (QP) problem. It may be solved with a general quadratic programming algorithm or with a procedure designed to deal only with problems that have similar structures. Here we introduce an algorithm that can solve the standard asset allocation problem in a simple and intuitive way. While somewhat limited in its range of application, it is easy to program and illustrates key economic principles that apply to a very broad range of optimization problems in Macro-investment Analysis.

A Three-Asset Example
To illustrate the steps in optimization procedures, we use a simple example involving three assets -- cash, bonds and stocks. The standard deviations and correlations among their returns are similar to those of real returns on diversified index mutual funds during the period from 1980 through 1995. Expected returns are similar to mean real returns over that period. All monthly values are annualized. It is important to note that the period in question involved very high average returns. Unbiased estimates of future expected returns would in all likelihood be considerably lower. It is convenient to include all the key asset-related information in one block. Here are the inputs for our example formatted for use in the optimization worksheet provided for solving such problems: MIN 0.00 0.00 0.00 INIT 1.00 0.00 0.00 MAX 1.00 1.00 1.00 ExpRet 2.80 6.30 10.80 StdDev 1.00 7.40 15.40 c:cash 1.00 0.40 0.15 c:bonds c:stocks 0.40 0.15 1.00 0.35 0.35 1.00

cash bonds stocks

The first column shows the lower bounds (all zero in this case) and the third column the upper bounds (all 1.00). The second column indicates the initial portfolio. In this case all of its assets are invested in cash. The fourth and fifth columns show the expected returns and standard deviations of the assets, respectively, stated in terms of percent return per year (for example, stock is expected to return 10.80% per year). The final columns provide estimates of the correlations among the asset classes. In matrix terms, the problem inputs are: e =
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The Gradient Method

2.80 6.30 10.80 sd = 1.00 7.40 15.40 cc = 1.00 0.40 0.15 lbd = 0.00 0.00 0.00 ubd = 1.00 1.00 1.00 x0 = 1.00 0.00 0.00 For computational purposes we need the covariance matrix C: C = (sd*sd').*cc C = 1.000 2.960 2.310 2.960 54.760 39.886 2.310 39.886 237.160 0.40 1.00 0.35 0.15 0.35 1.00

Two other inputs are needed. The first is k, the required sum of the values in the x vector. Here we compute it from the initial portfolio, so that the sum of the x values is required to be the same as currently : k = sum(x0) k = 1 The other input is the Investor's risk tolerance. In this case we assume that it is 50 -- a value representing a moderate attitude towards risk-taking. rt = 50

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The Gradient Method

The Utility Hill


Although our example involves three decision variables (cash, bonds and stocks), the full-investment constraint restricts portfolios to combinations that sum to one. Thus we can characterize the problem as one of choosing, say, proportions to be invested in bonds and stocks, with any remaining amount invested in cash. This makes it possible to graph the relationship between two of the decision variables and the measure of merit. The resulting surface will have some of the attributes of a hill. However, only a portion of this "utility hill"is feasible. We must restrict our search to coordinates in which the sum of the amounts invested in bonds and stocks is 1.0 or less. The diagram below shows the feasible portion of the utility hill over which we can conduct our exploration.

Note that the highest feasible point involves somewhat more investment in stocks than in bonds, and no investment in cash. Note also that it provides the Investor with considerably more utility (over 6.0%) than the initial all-cash portfolio shown at the bottom of the hill, which provides less than 3.0% in utility. We have called this surface a utility hill for a reason. It resembles at least a portion of a hill or mountain. In a sense, our job is to climb to the highest feasible point on the hill. We will do this in stages. We start with a feasible portfolio. Then we find the feasible direction in which we can move upward at the greatest rate. More specifically, we select the direction that will result in the greatest increase in altitude (utility) per step (change in portfolio holdings) -- that is, the steepest gradient. Having selecting a direction, we climb until we either reach a peak or a boundary that we cannot cross. Then we determine the feasible direction of steepest ascent again and repeat the process. When no feasible direction leads upward, we stop. Given the nature of the terrain in a standard problem, this procedure will place us on the highest allowable point -- that is, provide the portfolio
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The Gradient Method

with the greatest possible utility.

Asset Marginal Utility


Consider the effect of a small change in the holding of one asset on the portfolio's utility. Recall that: u = ep - vp / rt Let mu(i) be the marginal utility of asset i -- the derivative of u with respect to x(i): mu(i) = d u / d (x(i) This will be related to the marginal expected return of asset i: dep/dx(i) and its marginal risk: dvp/dx(i) as follows: mu(i) = dep/dx(i) - (1/rt)*dvp/dx(i) But we know that: dep/dx(i) = e(i) and dvp/dx(i) = the i'th row of 2*C*x where C is the asset covariance matrix. Given this, we can compute mu, the vector containing the marginal utilities of all the assets directly: mu = e - (1/rt)*2*C*x where x is the current portfolio. For the example we begin with the current portfolio (x) equal to x0. The resulting marginal utilities are: mu = 2.7600 6.1816 10.7076

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The Gradient Method

Thus utility will change at a rate of 10.7076% per unit change in the amount invested in asset 3, as long as the change in the latter is small. The rate of change will be 6.1816% for asset 2 and 2.7600% for asset 1.

The Optimal Feasible Swap


Marginal utilities provide important information about a portfolio -- information that can be used to improve it --to alter its composition so as to increase its utility for the Investor in question. In this case all the marginal utilities are positive, indicating that more of any asset would increase utility. It would be lovely if we could increase the proportions invested in all three assets or, better, yet, only the best of the three. But such is not feasible. The only changes that can be considered are those that meet the constraint that the sum of the proportions equal k. Since this is already the case for the current portfolio, we must restrict our choices to changes in which the sum of the amounts by which we increase one or more assets equals the sum of the amounts by which we decrease one or more of the others. In this case the most attractive asset to increase is the third (stocks). Happily, it can be increased, since the current amount (0.00) is below the upper bound (1.00). The least attractive asset to increase is the first (cash). But it is also the most attractive asset to decrease. This suggests a two-asset swap in which asset 3 is increased and asset 1 decreased. Such a swap would increase utility at the rate of 10.7076-2.7600 or 7.9476% per unit amount of the swap, as long as the change in the latter is small. Fortunately, this particular swap is feasible, since (1) the asset to be increased (stock) is currently below its upper bound and (2) the current value of the asset to be decreased (cash) is 1.00, well above its lower bound of 0.00. We conclude that if a small two-asset swap is to be undertaken, the best possibility involves a decrease in the amount of cash, with an equivalent increase in the amount invested in stocks. If the current portfolio is actually held, this requires the sale of cash securities, with the proceeds used to buy stocks. In the more likely event that the calculations are being made to determine an optimal portfolio to be held, the "buys" and "sells" would be hypothetical. For simplicity, however, we use the terms "sell", "buy" and "swap" to describe both cases. In a problem of this type, a swap is only feasible if the asset to be decreased is above its lower bound and the asset to be increased is below its upper bound. Moreover, if the current portfolio satisfies the constraint that sum of the holdings equals k, so will any portfolio resulting from such a swap, as long as the magnitude of the swap is not too large. Since (by definition) there are no additional constraints in a standard problem, these conditions are both necessary and sufficient for a swap to be feasible. These observations lead to the rules for finding the optimal feasible two-security swap: For all securities i for which x(i)>lb(i), find the one with the smallest value of mu(i). Let this asset be isell and its marginal utility mu(isell) For all securities i for which x(i)<ub(i), find the one with the largest value of mu(i). Let this asset be ibuy and its marginal utility mu(ibuy) The optimal two-security swap is then to sell isell and buy ibuy This will increase utility at the rate: mu(ibuy)-mu(isell) Clearly, if mu(ibuy)-mu(isell) is positive, the portfolio's utility can be increased. Moreover, no other small change can increase it by a larger amount. Why? Because (1) any other set of purchases will prove inferior to the purchase of ibuy, since
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The Gradient Method

ibuy's marginal utility is greater than that of any other potential feasible purchase or set of purchases and (2) any other set of sales will prove inferior to the sale since isell's marginal utility is smaller than that of any other potential feasible sale or set of sales. The optimal two-security swap is thus the optimal swap in a standard problem. Special cases require slightly more general rules. If two or more assets have the same marginal utility, the choice of isell or ibuy may not be unique and an arbitrary choice may be made. If all securities are at their lower bounds or at their upper bounds, no improvement is possible. This is also the case if the mu(ibuy) equals mu(isell) -- a condition that proves central for both optimization and an understanding of equilibrium in financial markets.

The Optimal Feasible Amount to Swap


The optimal feasible swap will increase utility at the greatest possible rate per unit swapped. But the rate of increase will change as the size of the swap increases. At some point, utility will reach its peak, then decline. Moreover, the feasible amount of a swap will be limited by the upper bound on the asset being purchased and by the lower bound on the asset being sold. All these factors need to be taken into account in order to find the optimal feasible size for any desired swap For generality, we represent a swap by a vector s of changes in asset holdings, where the sum of the elements is zero. In our example, the optimal feasible swap is: s = -1 0 1 Now, let a represent the amount swapped, so that the net effect is to change the portfolio by an amount equal to s*a. For example, if a = 0.10: s*a = -0.10 0.00 0.10 Let cx denote this set of changes: cx = s*a Then if such changes are made to portfolio x, the result will be a new portfolio xx, given by: xx = x + cx or xx = x + s*a Now, consider the utilities of portfolios x and xx:

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The Gradient Method

u(x) = x'*e - (1/rt)* x'*C*x u(xx) = (x' + cx')*e - (1/rt)*(x'+cx')*C*(x+cx) We are interested in the change in utility cu=u(xx)-u(x). Expanding the second formula and subtracting the first gives: cu = cx'*e - (1/rt) ( 2*x'*C*cx + cx'*C*cx); Substituting s*a for cx and simplifying gives: cu = [s'*e]*a - (1/rt) * ( [ 2*x'*C*s]*a + [s'*C*s]*(a^2)) Rearranging terms to express cu as a function of the amount of the swap, we obtain: cu = [ s'*e - (1/rt)*2*s'*C*x]*a - [(s'*C*s)/rt]*(a^2) or cu = k0*a - k1*(a^2) where: k0 = s'*(e - (1/rt)*2*C*x) k1 = (s'*C*s)/rt In our example: k0 = 7.9476 k1 = 4.6708 The figure below plots cu as a function of a for this case.

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The Gradient Method

Note that the change in utility increases at a decreasing rate. This is not surprising, since the function is quadratic with a negative quadratic term (-k1). This is a characteristic of all changes in portfolio composition. Given the nature of covariance matrices the s'*C*s will be positive for any set of changes represented by vector s. As long as the investor's risk tolerance is positive, k1 will be also, so that -k1 will be negative. We thus conclude that: Portfolio revision is subject to decreasing returns to scale. The greater the magnitude of a revision, the smaller will be the rate of further increase in portfolio utility -- that is, utility will increase at a decreasing rate. Note that k0, the first term in this expression, is equal to the net marginal utility of the swap. This is not surprising, since the marginal utility measures the effect on utility of an infinitesimal change in holdings. In this case, the maximum possible change in utility is obtained by swapping a large amount of the portfolio. The actual amount may be calculated directly. We seek the value of a at which cu is maximized. Since cu must have a positive slope at the origin and the slope must decrease with a, we need only set the derivative equal to zero: dcu/da = k0 - 2*k1*a = 0 or a = k0 / ( 2*k1 ) In this case: a = 7.9476 / (2 * 4.6708) = 0.8508 Thus the optimal amount to swap is 0.8508. Of course, this calculation does not take into account the upper and lower bounds on the holdings. To remain feasible, we cannot buy an amount of ibuy that will make x(ibuy) exceed ub(ibuy). Nor can we sell an amount of isell that will make x(isell) fall below lb(isell). The optimal feasible amount to swap (aopt) is thus:
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The Gradient Method

a = min( [ k0 / (2*k1), ub(ibuy) - x(ibuy), x(isell) - lb(isell) ] ) In our case: a = 0.8508 cu = k0*a - k1*(a^2) = 3.3808 So the optimal amount of the swap will add 3.3808 to the utility of the portfolio.

An Algorithm for the Standard Problem


We now have all the ingredients needed to solve a standard problem. Starting with any feasible portfolio, we can find the optimal feasible swap and the optimal amount of that swap. After making a swap in the appropriate amount we have a new (and improved) feasible portfolio. But this may also be improved, using the same technique. By repeating the process until no further improvement is possible, we reach the goal of maximizing utility without violating the stated constraints. The central part of the algorithm uses a loop that continues until a terminal condition is fulfilled. This can be written somewhat inelegantly in pseudo-MATLAB as: while 1==1 [ do computations ] if [ finished ] return end; end; To begin, of course, an initial feasible portfolio is required. Assuming that x0 meets this requirement, we precede the loop with: % set initial mix and number of assets x = x0; n = length(x); This also sets n as the number of assets for later use. Inside the loop, the first computations are those that compute the marginal utilities and find the best asset to buy and the best to sell. For expository purposes we do this in a somewhat inefficient manner, as follows:

% compute marginal utilities mu = e - (1/rt)*2*C*x; % find best assets to buy and sell ibuy = 0; mubuy = -1E200;
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The Gradient Method

isell = 0; musell = 1E200; for i = 1:n if x(i) < ub(i) % possible buy if mu(i) > mubuy mubuy = mu(i); ibuy = i; end; end; if x(i) > lb(i) % possible sell if mu(i) < musell musell = mu(i); isell = i; end; end; end;

This results in a large negative value of mubuy if no assets may be bought and a large positive value of musell if no assets may be sold. Otherwise, mubuy and musell are the marginal utilities of ibuy and isell, respectively, the best assets to buy and sell. At this point it is time to check to see if the procedure should be terminated. If the net rate of change in marginal utility associated with the optimal feasible swap is zero or negative, no more improvement is possible. Given the nature of computed values, it is desirable to stop when this amount is less than some minimum threshold. For example: % terminate if change in mu is less than threshold value if (mubuy - musell) <= 0.0001 return end In the optimization worksheet this constant is termed the marginal utility cutoff. If speed is more important than accuracy, it should be set to a relatively large value (for example, .001). If accuracy is more important than speed, it should be set to a relatively small value (e.g. 0.00001). Note the procedure for termination also covers cases in which no assets remain to be purchased and/or sold, since we have set the values of musell and mubuy to be very large and very small, respectively, in such cases. A bit devious, but effective. If the termination condition has not been met, it is time to make a swap. First, we set up the vector describing the optimal swap: % set up swap vector s = zeros(n,1); s(ibuy) = 1; s(isell) = -1; Then we compute the optimal amount to swap without considering the effects of asset bounds: % compute optimal amount of swap without regard to asset bounds k0 = s'*(e - (1/rt)*2*C*x); k1 = (s'*C*s)/rt; a = k0/(2*k1);
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This may or may not be feasible. If necessary, the amount to be swapped is reduced to avoid violating the upper bound of the asset to be bought or the lower bound of the asset to be sold: % reduce amount if required to keep ibuy from exceeding its upper bound if a > (ub(ibuy) - x(ibuy)) a = ub(ibuy) - x(ibuy); end; % reduce amount if required to keep isell from falling below its lower bound if a > (x(isell) - lb(isell)) a = x(isell) - lb(isell); end; To avoid the possibility of an infinite loop, it is wise to check for a zero amount and terminate if such is encountered: % terminate if amount is zero if a == 0 return; end Finally (!) it is time to revise the portfolio to improve it as much as possible and be in a position to repeat the process all over again: % change mix x = x + ( s*a) ; Here is the entire algorithm set up as a MATLAB function that takes rt, e, C, lb, ub and x0 as inputs and returns the optimal portfolio x as an output. function x = gmqp(rt,e,C,lb,ub,x0); % determines solution to a standard optimization problem % usage: % x = gmqp(rt,e,C,lb,ub,x0); % rt = Investor risk tolerance % e = {n*1} vector of asset expected returns % C = {n*n} return covariance matrix % lb = {n*1} vector of asset lower bounds % ub = {n*1} vector of asset upper bounds % x0 = {n*1} vector of initial feasible asset mix % set initial mix and number of assets x = x0; n = length(x); while 1==1; % compute marginal utilities mu = e - (1/rt)*2*C*x; % find best assets to buy and sell ibuy = 0; mubuy = -1E200; isell = 0; musell = 1E200;

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% end;

for i = 1:n if x(i) < ub(i) % possible buy if mu(i) > mubuy mubuy = mu(i); ibuy = i; end; end; if x(i) > lb(i) % possible sell if mu(i) < musell musell = mu(i); isell = i; end; end; end; terminate if change in mu is less than threshold value if (mubuy - musell) <= 0.0001 return end set up swap vector s = zeros(n,1); s(ibuy) = 1; s(isell) = -1; compute optimal amount of swap without regard to asset bounds k0 = s'*(e - (1/rt)*2*C*x); k1 = (s'*C*s)/rt; a = k0 / (2*k1); reduce amount if required to keep ibuy from exceeding its upper bound if a > (ub(ibuy) - x(ibuy)) a = ub(ibuy) - x(ibuy); end; reduce amount if required to keep isell from falling below its lower bound if a > (x(isell) - lb(isell)) a = x(isell) - lb(isell); end; terminate if amount is zero if a == 0 return; end change mix x = x + ( s*a) ;

With this function in a directory in the MATLAB path under the name gmqp.m, you could obtain the solution to a standard problem by simply giving the following command at the command line or in a program: x = gmqp(rt,e,C,lb,ub,x0) For our problem: x = 0

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0.3996 0.6004 Thus the optimal asset mix (portfolio) contains no cash and has roughly 40% invested in bonds and 60% in stocks.

Function GQP
While function gmqp suffices for most standard problems, it cannot handle cases in which rt=0, which would result in attempts to divided portfolio variance by zero. However, economically meaningful problems arise in which the goal is to minimize variance, as would an Investor with zero tolerance for risk. Such cases can be handled by changing the units in which utility is measured. Instead of: u = ep - vp/rt We can use: uv = rt*ep - vp The more commonly-used version (u) divides portfolio variance by rt, the marginal rate of substitution of variance for expected return, to convert vp to an expected-return equivalent. The latter is then subtracted from portfolio expected return to give u, a measure of portfolio utility in expected return equivalent terms. The second measure (uv) multiplies portfolio expected return by rt, the marginal rate of substitution of variance for expected return, to convert ep to a variance equivalent. The portfolio variance is then subtracted to obtain a measure of portfolio utility stated in variance-equivalent terms. When rt=0, maximizing uv is equivalent to minimizing portfolio variance, as desired. When rt is greater than zero, maximizing uv will give the same mix (x) as will maximizing u. This alteration is incorporated in MATLAB function gqp, that can be used instead of gmqp. Function gqp has a number of additional features. It uses more efficient vector methods to find the optimal swap and the appropriate amount of that swap and is thus faster than gmqp. It also computes the expected return and variance of the portfolio and returns them as additional outputs if requested to do so. With function gqp in a directory in the MATLAB path under the name gqp.m, you could obtain the solution to a standard problem by simply giving the following command at the command line or in a program: [x,ep,vp] = qqp(rt,e,C,lb,ub,x0)

The Optimization Worksheet


For those without access to MATLAB, all is not lost. The optimization worksheet is a javascript implementation of the gradient algorithm.The format for inputs follows that given in the section above. In addition, the Investor's risk tolerance and the marginal utility cutoff must be specified. The outputs obtained from the worksheet using the inputs shown earlier for an Investor with a risk tolerance of 50 are:

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PORTFOLIOS: cash bonds stocks Initial 1.000 0.000 0.000 Optimal 0.000 0.400 0.600 Change -1.000 0.400 0.600

CHARACTERISTICS: Initial ExpRet 2.800 StdDev 1.000 Utility 2.780

Optimal 9.002 10.648 6.734

Change 6.202 9.648 3.954

Not surprisingly, the optimal portfolio composition is that obtained earlier (to three decimal places). Also shown are the expected returns, standard deviations and utilities of the intial and optimal portfolios as well as the changes in all the variables.

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Optimization Worksheet

Optimization Worksheet (see instructions)

INPUTS
cash bonds stocks MIN INIT MAX ExpRet StdDev c:cash c:bonds c:stocks 0.000 1.000 1.000 2.800 1.000 1.000 0.400 0.150 0.000 0.000 1.000 6.300 7.400 0.400 1.000 0.350 0.000 0.000 1.000 10.800 15.400 0.150 0.350 1.000

Risk Tolerance: 50 Marginal Utility Cutoff: 0.0001

PROCESS

MAKE RECORD

OUTPUT

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Optimization Worksheet

NOTES
Sample data based on monthly real returns, 1980 - 1995 (equally weighted)

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Instructions for Optimization Worksheet

Instructions for Optimization Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes. When finished, click any area outside the boxes on the form. You may copy inputs from other sources such as spreadsheets, word processing documents, and other worksheets in this series, then paste the results into the appropriate boxes on this form. To copy an area from an Excel spreadsheet, select it, then select Edit Copy. In the browser, select a position in the input box, then select Edit Paste. To copy an area from a box in the browser to an Excel spreadsheet, select the text in the browser and select Edit Copy. In the Excel spreadsheet, select a position, then select Edit Paste. This brings each row into the spreadsheet as text. To convert to a matrix, select the column in which the information is located (the left-most one shown), then select Data Text-to-columns. Choose Delimited and Spaces as delimiters and the information will appear in the requisite number of cells. When you save a page on your own disk (using the browser's File Save As command), only the original material in the form will be saved. There are two ways to save and retrieve worksheet information. You can copy the information you wish to save to some other document, such as a spreadsheet, word processing document or text file. You can also load the source (ws_***.htm) file in a word processor and edit it to include your inputs. You will find the default information in blocks marked TEXTAREA and in the VALUE attributes of INPUT tags. Simply replace the default values with your information, then save the page as a file on your disk under any desired name. When you change an input, the output area will generally be cleared to avoid having old outputs appear simultaneusly with new inputs. To produce new outputs, click the PROCESS button.

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Instructions for Optimization Worksheet

Inputs
The Inputs box should contain all the needed input information other than the investor's rsk tolerance. Each row provides the inputs for a single decision variable (for example, an asset class). The columns must be in the order indicated below. Each must be given a short heading, although these are not actually checked for content. The first three columns indicate the Minimum proportions that may be invested in the items, the Initial portions invested, and the Maximum proportions that may be invested. The initial proportions will usually sum to 1.0 although this is not necessary. Each initial proportion must lie within or at an end of the range given by the minimum and maximum allowed values. The optimizer will consider only portfolios that are feasible (with each proportion greater than or equal to its minimum value and less than or equal to its maximum value) and for which the proportions sum to the same value as the sum of the proportions in the initial portfolio. The next two columns provide the Expected Returns (ExpRet) and Standard Deviations (StdDev) for the decision variables. These are usually stated in terms of return per year (for example, 10.5 for 10.5% per year). The remaining columns provide the Correlation Coefficients for the variables. The order must be the same as that used for the rows in the table. The next input box provides the investor's Risk Tolerance. This indicates the marginal rate of substitution of variance for expected return in the investor's utility function. It is normally positive, but a zero value is allowed for the special case in which the objective is to find the feasible portfolio with the smallest possible standard deviation. The final input box provides the Marginal Utility Cutoff. This is used to terminate the algorithm. When the marginal utility of the best feasible swap falls below this amount, the program stops. The smaller this amount, the more precise the solution but the longer the time required to obtain it.

Algorithm
The worksheet uses the gradient quadratic programming method of Sharpe ["An Algorithm for Portfolio Improvement," , in Advances in Mathematical Programming and Financial Planning, K.D.Lawrence, J.B. Guerard, Jr., and Gary D. Reeves, Editors, JAI Press, Inc., 1987, pp. 155-170] to find the feasible portfolio with the maximum possible Utility: Up = ep - ((sdp^2)/t)

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Instructions for Optimization Worksheet

where: Up = the utility of the portfolio ep = the portfolio's expected return sdp = the portfolio's standard deviation of return t = the investor's risk tolerance

Output
All output is provided in a single box. Two tables are included. The first table shows the Initial Portfolio, the Optimal Portfolio and the Change (Optimal - Initial). The second table shows the characteristics of the Initial and Optimal Portfolio and the associated changes in the level of each one(Optimal - Initial). Unless the risk tolerance is zero, the third line shows the utility of the portfolios and the change therein.

Notes
You may enter any desired text in this box to describe the source of the input data, etc..

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function [x,mixe,mixsd] = qqp(rt,e,C,lbd,ubd,x0); % [x,mixe,mixsd] = qqp(rt,e,C,lbd,ubd,x0) % computes an optimal asset mix % Copyright William F. Sharpe % This version: April 13, 1995 % inputs: % rt: risk tolerance % e: expected return vector % C: covariance matrix % lbd: lower bound vector % ubd: upper bound vector % x0: initial feasible mix vector % % outputs: % x: optimal mix vector % mixe: x'*e % mixsd: sqrt(x'*C*x); % % maximizes: rt*(x'*e) - x'*C*x % subject to: sum(x) = sum(x0) % lbd <= x <= ubd % algorithm based on: % William F. Sharpe, "An Algorithm for Portfolio Improvement," % in Advances in Mathematical Programming and Financial Planning % K.D. Lawrence, J.B. Guerard, Jr., and Gary D. Reeves, Editors % JAI Press, Inc., 1987, pp. 155-170. % maximum number of iterations maxit = 500; % convert any row vectors to column vectors if size(e,2) >1; e=e'; end; if size(lbd,2)>1; lbd=lbd'; end; if size(ubd,2)>1; ubd=ubd'; end; if size(x0,2) >1; x0=x0'; end; % return if x0 is not feasible if (x0>=lbd) & (x0<=ubd) % ok else disp('******** ERROR: x0 is not feasible *****'); disp(' press any key to return'); return; end; % set minimum MU change to continue minMUchg = 0.0001; % initialize x = x0; n = size(C,1); % continue to improve portfolio until further improvement impossible % when done, return iterations = 0; while 1==1; % compute marginal utilities mu = rt*e - 2*C*x; % find best variable to add [MUadd,Aadd] = max(mu - 1E200*(x>=ubd));

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% find best variable to subtract [MUsub,Asub] = min(mu + 1E200*(x<=lbd)); % terminate and return if change in mu is less than minimum if (MUadd - MUsub) <= minMUchg % compute mix e and sd mixe = x'*e; mixsd = sqrt(x'*C*x); % terminate return end % set up delta vector d = zeros(n,1); d(Aadd) = 1; d(Asub) = -1; % compute step size k = zeros(3,1); % optimal unconstrained step size k(1) = ((rt*d'*e)-2*(x'*C*d))/(2*(d'*C*d)); % maximum step size based on upper bounds Slack = ubd - x; AUp = find(d>0); k(2) = min(Slack(AUp)./d(AUp)); % maximum step size based on lower bounds Slack = x-lbd; ADown = find(d<0); k(3) = min(Slack(ADown)./ (-d(ADown))); % minimum step size kmin = min(k); % terminate and return if minumum step size is zero if (kmin == 0) % compute mix e and sd mixe = x'*e; mixsd = sqrt(x'*C*x); % terminate return; end % count and terminate if maximum iterations exceeded iterations = iterations+1; if iterations > maxit % compute mix e and sd mixe = x'*e; mixsd = sqrt(x'*C*x); % terminate return; end % change mix x = x + ( kmin*d) ; end;

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Contents:
q q q q q q

Characteristics of Optimal Portfolios Optimal Portfolio Composition without Bounds on Holdings A Three-Asset Example Characteristics of Optimal Portfolios without Bounds on Holdings Additional Linear Equality Constraints Additional Linear Objectives

Characteristics of Optimal Portfolios


Assume that a standard asset allocation problem has been solved and an optimal portfolio obtained. Each asset will be in one of three states, depending on the amount invested relative to its required upper and lower bounds. We can term these "down", "in" and "up", as follows: down: in: up: l(i) = x(i) l(i) < x(i) < u(i) x(i) = u(i)

Since the portfolio is optimal, it must be the case that the marginal utilities of all the "in-variables" are the same. If this were not the case, it would be possible to improve utility by reallocating money from an in-variable to another with a higher marginal utility. Thus: for all in-variables: mu(i) = mup where mup is a constant. It must also be the case that the marginal utility of every down-variable is less than or equal to this amount. If this were not the case, it would be possible to increase the amount of money allocated to such a down-variable and reduce the amount allocated to an in-variable, thereby increasing utility. Thus: for all down-variables: mu(i) <= mup Finally, the marginal utility of every up-variable must be greater than or equal to that of every in-variable --otherwise utility could be increased by reducing the amount invested in an up-variable and increasing the amount invested in an in-variable. Thus: for all up-variables: mu(i) >= mup We will exploit the implications of all these characteristics when deriving the critical line method for solving general asset allocation problems. First, however, we will focus on cases in which upper and lower bounds on asset holdings are either absent or

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non-binding. In such instances it is possible to determine optimal portfolio composition analytically -- that is, without using iterative procedures such as those required in the gradient and critical line methods.

Optimal Portfolio Composition without Bounds on Holdings


If there are no bounds on portfolio holdings, one can use the gradient method to determine an optimal portfolio by setting all upper bounds to plus infinity and all lower bounds to minus infinity. In the resultant optimal portfolio, of course, all variables will be in (that is, between their bounds). As a result, all will have the same marginal utility. Thus we know that for the optimal portfolio in such a setting: mu(i) = mup : for all i

Now, recall the formula for calculating the marginal utilities of a set of assets: mu = e - (1/rt) * 2*C*x For asset i: mu(i) = e(i) - (1/rt) * [ 2*C(i,1)*x(1) + 2*C(i,2)*x(2) + ... + 2*C(i,n)*x(n) ] We seek the composition of the optimal portfolio (x(1), x(2), ... x(n)) and the common marginal utility of all the assets in that portfolio (mup). This requires that all the marginal utilities be the same, that is: e(i) - (1/rt) * [ 2*C(i,1)*x(1) + 2*C(i,2)*x(2) + ... + 2*C(i,n)*x(n) ] = mup for assets 1,2,...n. Note that each of these equations is linear and that there are n such equations. But there is one more requirement for a standard portfolio problem: sum(x) = k In the absence of liabilities, etc. this takes the familiar form: sum(x) = 1 This is a linear equation in the x-variables, so we now have n+1 linear equations in n+1 unknowns. Barring degeneracy, this can be solved by simple matrix inversion and the optimal portfolio obtained directly. It is useful to state the problem using a straightforward matrix equation. This will ease the task of providing a solution, facilitate extensions, and most importantly, make evident a number of characteristics of solutions to particular classes of problems. To begin, we rewrite the requirement for asset i as: 2*C(i,1)*x(1) + 2*C(i,2)*x(2) + ... + 2*C(i,n)*x(n) + tmup = rt*e(i) where:

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tmup = rt*mup We will treat tmup as an unknown, recognizing that mup can always be computed after the fact by dividing tmup by rt. In practice, the values of tmup and mup may be only of passing interest, since the primary goal is to determine the composition of the optimal portfolio. Note that all the unknowns are now on the left-hand side. Let y be an {(n+1)*1}element vector that includes all the variables. Here: y = [ x(1) x(2) ... x(n) tmup

To memorialize the fact that this vector contains the unknown x-variables, we name it y, which is one letter from x, a convention dating back to the computer in the film "2001" which was named HAL, one letter removed from IBM (although in the other direction).. Now, let D be an {(n+1)*(n+1)}element matrix that includes information about the asset covariances and the constraint that the sum of the holdings equals a constant: D = [ 2*C(1,1) 2*C(2,1) ..... 2*C(n,1) 1 2*C(1,2) ... 2*C(2,2) ... 2*C(n,2) ... 1 ... 2*C(1,n) 2*C(2,n) 2*C(n,n) 1 1 1 1 0 ]

Note that this matrix is formed by bordering two times the covariance with the coefficients from the left-hand side of the constraint, hence the name D (one letter after C). For the remainder of the equation we need two more vectors. The first contains the right-hand side for the full-investment constraint in row (n+1) and zeros elsewhere. At the risk of some temporary confusion we will call this k. For the case in which the sum of the x values must equal 1: k = [ 0 0 .. 0 1 ] Note that k contains the constant (hence "k") from the right-hand side of the constraint. The last vector contains the asset expected returns in the first n rows and zero in the n+1'st row: f = [ e(1) e(2) ... e(n) 0 ] Since this contains the expected returns (e), we use the next letter (f) for its name.

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We can now write a single matrix equation that contains all the conditions required for an optimal portfolio. It is both simple and elegant: D*y = k + rt*f Of course we seek the portfolio that makes this equation hold. Since vector y contains the portfolio, we need to solve for y. This is simply done by multiplying both sides of the equation by the inverse of D. The result is: y = inv(D)*k + rt*inv(D)*f For purposes of interpretation (and in some instances, implementation) it is useful to write this as: y = mvp + rt*z where: mvp = inv(D)*k and: z = inv(D)*f

A Three-Asset Example
To illustrate the use of the formulas for optimal portfolio composition without upper and lower bounds we return to the simple three-asset (cash, bonds and stocks) case used earlier. Expected real returns, risks and correlations are: e =[ 2.80 6.30 10.80 ] sd =[ 1.00 7.40 15.40 ] cc = [ 1.00 0.40 0.15 0.40 1.00 0.35 0.15 0.35 1.00 ]

The corresponding covariance matrix is: C = (sd*sd').*cc = 1.000 2.960 2.960 54.760 2.310 39.886

2.310 39.886 237.160 ]

We assume the Investor has a risk tolerance (rt) equal to 25 and require that the sum of the holdings equals 1. This gives the following matrices:
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D = [ 2*C ones(1,3) D =

ones(3,1) 0 ] 5.9200 109.5200 79.7720 1.0000 4.6200 79.7720 474.3200 1.0000 1.0000 1.0000 1.0000 0 ]

2.0000 5.9200 4.6200 1.0000

k = [ zeros(3,1) 1 ] k = [ 0 0 0 1 f = [ e 0 ] f = [ 2.80 6.30 10.80 0

We can now find the components of the solution (mvp and z) and the solution (y): mvp = inv(D)*k mvp = [ 1.0392 -0.0396 0.0004 -1.8458 z = inv(D)*f z = [ -0.0389 0.0257 0.0132 2.6648 y = mvp + rt*z y = [ 0.0671 0.6021 0.3308 64.7731 ] The first three elements of y contain the optimal portfolio holdings. In this case the best combination involves 6.71% in cash, 60.21% in bonds and 33.08% in stocks. Since every holding is positive, this would also be the optimal combination for an Investor unable to take short positions in assets. However, this need not always be the case. Consider, for example, an Investor with a risk tolerance of 50. For such an Investor:

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y = mvp + 50*z y = [ -0.9050 1.2439 0.6611 131.3920

Here the optimal investment involves 124.39% in bonds, 66.11% in stocks and borrowing (a negative cash position) an amount equal to 90.50% of the initial value in order to finance the holdings in bonds and stocks.

Characteristics of Optimal Portfolios without Bounds on Holdings


As we have shown, the solution to the problem of portfolio choice without bounds on holdings can be written as an equation involving three vectors (y, mvp, z) and a constant (rt): y = mvp + rt*z We turn now to the properties of vectors mvp and z, which tell us a great deal about optimal portfolio holdings.

The Minimum variance Portfolio


Consider an Investor who wishes to minimize risk, no matter how much expected return is sacrificed in the process. Such a person will have a risk tolerance of zero. The optimal portfolio will, in turn, be given by y = mvp + 0*z = mvp Thus mvp is the minimum variance portfolio (hence its name). In our simple example: mvp = [ 1.0392 -0.0396 0.0004 -1.8458

It is easy to verify the fact that this is indeed a portfolio, since the sum of the x-values (elements 1 through 3) equals 1.0. To see why mvp must be a portfolio in this sense, it is useful to consider the problem for which it is a solution. Start with the original problem formulation: D*y = k + rt*f In this case:

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D*y = k + 0*f or: D*y = k for which the solution is: y = inv(D)*k Recall the components of the matrices and vectors in this case:

2*C(1,1) 2*C(1,2) 2*C(1,3) 1 x(1) 0 2*C(2,1) 2*C(2,2) 2*C(2,3) 1 * x(2) = 0 2*C(3,1) 2*C(3,2) 2*C(3,3) 1 x(3) 0 1 1 1 0 tmup 1 The last row requires that: 1*x(1) + 1*x(2) + 1*x(3) + 0*tmup = 1 Hence the solution must be a portfolio, that is the sum of the holdings must equal 1. In this example, the minimum-variance portfolio involves borrowing an amount equal to 3.96% of the Investor's funds by issuing (shorting) bonds, then investing the proceeds plus all the Investor's original funds in a combination of cash and a minuscule amount of stocks. The portfolio proper is: x = y(1:3,1) and its variance (vp) is: vp = x'*C*x = 0.9229 giving a standard deviation of: sdp = sqrt(vp) = 0.9607 Note that this is less than the standard deviation of cash, which equals 1.0. Such is the power of diversification. In this example, cash is not riskless, since returns are in real (inflation-adjusted) terms. Had nominal returns been used, cash could have been considered riskless (if the holding period and the investment period for the cash asset were the same). Consider, for example a case in which the variance of cash and its covariance with every other asset is zero. Retaining the original assumptions for bond and stock risks and correlations:

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D =

0 0 0 1.0000

0 109.5200 79.7720 1.0000

0 79.7720 474.3200 1.0000

-1.0000 -1.0000 -1.0000 0

and mvp = inv(D)*k = 1 0 0 0

Not surprisingly, if there is a riskless asset, the minimum variance portfolio is invested exclusively in it.

The Optimal Swap


We turn next to vector z. Recall that the optimal portfolio for an Investor with a risk tolerance of rt is: y = mvp + rt*z Now consider two Investors. One, with risk tolerance of zero, should hold portfolio y0, given by: y0 = mvp + 0*z = mvp The other, with risk tolerance of 1.0, should hold portfolio y1, given by: y1 = mvp + 1*z = mvp + z The differences between their portfolios are contained in the vector: y1 - y0 = (mvp + z) - mvp = z

Thus z is a vector of differences in holdings between two portfolios. The sum of the asset holdings will thus equal zero. In our earlier terminology, it is a zero-investment strategy. Hence the name (z). In the original version of the three-asset example: z = -0.0389 0.0257 0.0132 -2.6648

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Thus an Investor with a risk tolerance of 1.0 should hold 3.89% less in cash, 2.57% more in bonds and 1.32% more in stocks than an investor with the same amount of money but no tolerance for risk at all. Not surprisingly, the sum of the asset proportions equals zero, as it must if y is to be a portfolio. Since the asset proportions in z sum to zero, it can be considered a recipe for a swap. One unit of the swap (for example, $1) calls for the holder to pay (1) an amount equal to the return on 0.0389 units ($0.0389) invested in cash and to receive an amount equal to the sum of (2) the return on 0.0257 ($0.0257) invested in bonds and (3) the return on 0.0132 ($0.0132) invested in stocks. Of course, z is not just any swap. It is the optimal swap. An Investor with a positive tolerance for risk should, in effect, begin with the minimum variance portfolio, then take an appropriately large position in the optimal swap. In dollar terms, the swap position should equal the investor's initial fund times rt, since: y = mvp + rt*z Thus an Investor with a risk tolerance of 50 should take twice as large a position in the optimal swap z as should an Investor with the same wealth and a risk tolerance of 25. One need not actually take a position in a swap contract to achieve the desired result. In most cases, the Investor would simply determine the optimal portfolio y and invest in it directly. However, recognition that this is equivalent to the results obtained by starting with mvp and then making a standard swap z in an appropriate magnitude proves useful in understanding differences among Investors' optimal portfolio holdings.

Two Fund Separation


The recipe for an optimal portfolio is clearly linear. In vector form: y = mvp + rt*z Row i will be of the form: y(i) = mvp(i) + rt*z(i) For the first n rows corresponding to the asset positions, so that x(i) = mvp(i) + rt*z(i) : for i= 1,..,n Now consider two portfolios, each optimal for a given risk tolerance. Let a represent the smaller of the two risk tolerances and b the larger. Then the portfolios are respectively: ya = mvp + a*z yb = mvp + b*z Assume that ya and yb represent portfolios offered by two mutual funds (mfa and mfb, respectively). How might an investor with a risk tolerance equal to rt use such funds optimally? The answer is simple: place a proportion xa of wealth in fund a and a proportion 1-xa in fund b, using the following formula to compute xa: xa = (b-rt)/(b-a) To see why this works, note that:
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y = xa*ya + (1-xa)*yb = xa*(mvp+a*z)+ (1-xa)*(mvp+b*z) = mvp + [xa*a+(1-xa)*b]*z But, given our recipe for choosing xa: [xa*a+(1-xa)*b] = rt So the two-fund portfolio is in fact the optimal portfolio for the Investor in question. No matter how many assets are used to form the two mutual funds, an Investor can achieve a completely optimal portfolio by allocating his or her funds between the two mutual funds, as long as each of the funds is optimal for a particular risk tolerance and the two funds are designed for different risk tolerances. As a practical matter, of course, an Investor would have to take a short position in one of the funds if his or her risk tolerance fell outside the range covered by the funds. For this reason, it might be useful to utilize (1) a fund designed for an extremely small level of risk tolerance and (2) one designed for a very large level of risk tolerance. If several mutual funds are available, an Investor could achieve an optimal portfolio by combining any two funds, as long as each is optimal for different level of risk tolerance and the proportions invested in the funds are chosen appropriately (that is, using the formula given above for xa). This result is of sufficient importance to deserve a relatively grand name. It is sometimes termed "Tobin's separation theorem", since its introduction in Tobin 1958, but we will call the present result the two-fund separation theorem to differentiate it from more complex results that arise in different settings. Why the name? Because in this situation it is possible to separate the investment decision into two stages. In the first stage, two optimal mutual funds are formed. In the second, investors allocate their assets between the two funds. Moreover, two well-constructed funds are sufficient to span the set of desirable investment alternatives for all investors. To be sure, these very strong results flow from very strong assumptions. Investors are assumed to agree on probabilistic forecasts (asset means, standard deviations and correlations) and to consider portfolio mean and variance to be sufficient statistics for selecting portfolios. Moreover, short positions are assumed to be feasible and costless, as are other transactions. Later we will consider the effects of dropping one or more of these assumptions. In the meantime, it is appropriate to pause to reflect on the simplicity and tranquillity of a world in which these conditions would hold.

Additional Linear Equality Constraints


It is a relatively simple matter to extend the analysis of the last few sections to cover cases with two or more linear equality constraints. Write the set of m such constraints as: A*x = b where A is an {m*n} matrix of "left-hand sides" and b is an {m*1) vector of "right-hand sides". For example, in addition to the standard full-investment constraint, assume (1) that it is desired to select a portfolio with an income yield equal to 5.5%, and (2) that the yields of cash, bonds and stocks are, respectively, 5%, 7% and 3%. Then: A = 1 1 1

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5 b = 1 5.5

Lagrange Multipliers
To formulate this problem so it can be solved efficiently, we need to utilize explicitly a mathematical procedure that we have employed implicitly already: the method of Lagrange multipliers. The goal is to maximize portfolio utility, stated in expected return equivalent terms: up = ep - vp/rt As before, we choose instead to maximize utility stated in variance-equivalent terms since the optimal portfolio will be the same. In this metric, the objective function is: vup = rt*ep - vp Of course, we are not free to choose any asset holdings we might desire. Instead, we must meet one or more linear equality constraints: A*x = b For a solution to be feasible (that is, satisfy these constraints), we require that: b - A*x = zeros(m,1) Now the trick. We form a Lagrangean function by appending each linear constraint times an associated Lagrange multiplier to the original objective function. With two linear constraints: L = rt*ep - vp + g1*[b(1)-A(1,:)*x] + g2*[b(2)-A(2,:)*x] For portfolios that satisfy the two linear constraints, each of the terms in the square brackets will equal zero and the Lagrangean function L will equal the original objective function! Thus maximizing L will give the same answer as maximizing the original objective function, as long as only feasible portfolios are considered. Since we wish to maximize L, the goal is to get to the top of a hill where the height is given by the value of L and the coordinates of the terrain are given by the values of the variables (the x values plus g1, g2 and any additional Lagrange multipliers. Since the terrain is smooth, it is flat at the top of this particular hill. Moreover, the top is the only place at which it is flat. Thus it is both necessary and sufficient for an optimal solution that the first derivatives of L with respect to each of the variables be set to zero. Note, however, that there are now n+m variables -- the n asset holdings (here, x1, x2 and x3) and the m Lagrange multipliers (here, g1 and g2). The derivatives with respect to the asset holdings are: rt*e(1) - 2*C(1,1)*x(1) - 2*C(1,2)*x(2) - 2*C(1,3)*x(3) - g1*A(1,1) - g2*A(2,1) rt*e(2) - 2*C(2,1)*x(1) - 2*C(2,2)*x(2) - 2*C(2,3)*x(3) - g1*A(1,2) - g2*A(2,2) rt*e(3) - 2*C(3,1)*x(1) - 2*C(3,2)*x(2) - 2*C(3,3)*x(3) - g1*A(1,3) - g2*A(2,3)

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Setting these to zero and rearranging gives equations: 2*C(1,1)*x(1) + 2*C(1,2)*x(2) + 2*C(1,3)*x(3) + g1*A(1,1) + g2*A(2,1) = 0 + rt*e(1) 2*C(2,1)*x(1) + 2*C(2,2)*x(2) + 2*C(2,3)*x(3) + g1*A(1,2) + g2*A(2,2) = 0 + rt*e(2) 2*C(3,1)*x(1) + 2*C(3,2)*x(2) + 2*C(3,3)*x(3) + g1*A(1,3) + g2*A(2,3) = 0 + rt*e(3) The derivatives with respect to the Lagrange multipliers are: b(1) - A(1,1)*x(1) - A(1,2)*x(2) - A(1,3)*x(3) b(2) - A(2,1)*x(1) - A(2,2)*x(2) - A(2,3)*x(3) Setting these to zero gives the original constraint equations: b(1) - A(1,1)*x(1) - A(1,2)*x(2) - A(1,3)*x(3) = 0 b(2) - A(2,1)*x(1) - A(2,2)*x(2) - A(2,3)*x(3) = 0 Rearranging: A(1,1)*x(1) + A(1,2)*x(2) + A(1,3)*x(3) = b(1) A(2,1)*x(1) + A(2,2)*x(2) + A(2,3)*x(3) = b(2) We now have five linear equations in five unknowns. They may be written succinctly (and somewhat familiarly) as: D*y = k + rt*f where: D = [ 2*C A A' zeros(m,m)

k = [ zeros(n,1) b f = [ e zeros(m,1) ]

Note that our previous example represents a special case of this formula, with m=1 and each of the coefficients in A and b equal to 1.0.

Economic Interpretation of Lagrange Multipliers


Recall the form of the Lagrangean function that has been maximized when the solution is obtained: L = rt*ep - vp + g1*[b(1)-A(1,:)*x] + g2*[b(2)-A(2,:)*x] Consider the derivative of this function relative to, say, b(1). It will be: d L/d b(1) = g1

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Since the Lagrangean function will equal the original objective function for all feasible portfolios, we can interpret this derivative as the change in utility per unit change in the right-hand side of constraint number 1. Of course, the objective function is in variance-equivalent terms. To state the derivative in the standard expected return equivalent terms (up) we must divide by rt. Thus: d up / d b(1) = g1 / rt And similarly for any additional constraints. In the case of the standard full investment constraint, the Lagrangean multiplier reflects the marginal utility in variance equivalent terms of additional money to invest (for example, allowing the sum of the asset holdings to equal 1.0001 instead of 1.0000). Dividing by the investor's risk tolerance gives the marginal utility of additional funds in expected return equivalent terms. The latter is, in effect, the marginal utility of the portfolio (mup). Correspondingly, the Lagrangean multiplier is rt times this. All of which explains why we assigned the multiplier the name tmup and the result obtained by dividing it by rt the name mup in our earlier example. The result is quite general. Each Lagrangean multiplier indicates the marginal utility in variance-equivalent terms of a small change in the right-hand side of the corresponding constraint. In the case of portfolio yield, the multiplier would indicate the added utility per unit of change in the required yield. To state this in expected return equivalent terms, the Lagrangean would be divided by the investor's risk tolerance. Lagrangean multipliers are often useful for evaluating the extent to which a given constraint limits achievement of an overall objective. The greater the multiplier (assuming that it is positive), the more costly the constraint. Of course, the values apply for only small changes, since the objective function is quadratic, but they are useful for evaluating the desirability of at least small changes in various constraints.

Optimal Portfolio Holdings with an Added Constraint


Finally, we are ready to solve the problem posed with a constraint on portfolio yield. Using the formulas derived above, we obtain: D = [ 2*C A = 2.0000 5.9200 4.6200 1.0000 5.0000 A' zeros(m,m) 5.9200 109.5200 79.7720 1.0000 7.0000

] 1.0000 1.0000 1.0000 0 0 5.0000 7.0000 3.0000 0 0

4.6200 79.7720 474.3200 1.0000 3.0000

k = [ zeros(n,1) b ] = 0 0 0 1.0000 5.5000 f = [ e zeros(m,1 ] =


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2.8000 6.3000 10.8000 0 0 mvp = inv(D)*k = 0.8889 0.1805 -0.0695 39.8923 -8.4836 z = inv(D)*f = -0.0324 0.0162 0.0162 0.8723 0.3643 For rt = 25: y = mvp + 25*z = 0.0782 0.5859 0.3359 61.6987 0.6249 To see the effect on portfolio utility (up) of a small change in the yield constraint, we divide the corresponding multiplier by risk tolerance to obtain muy, the marginal utility of the yield constraint: muy = 0.6249/25 = .0250 Requiring a higher yield would allow for a greater optimal portfolio utility, since this value is positive (had it been negative, a higher yield requirement would have lowered optimal portfolio utility). Note, however, that the value is not large -- optimal portfolio utility would increase at a rate of 0.0250 (2.5 basis points in expected return terms) per unit change (100 basis points) in yield. Of course, this is a rate of change for a small difference in required yield. To find the effect of a substantial change (e.g. from 5.50% to 6.50%) the optimization would have to be performed with both values and the difference in optimal utility calculated directly.

Additional Linear Objectives


Before concluding the examination of cases in which there are no bounds on holdings we treat one further possible complication that has important implications for both portfolio construction and understanding the possible workings of capital markets. In particular, we consider an investor whose utility function has three or more arguments -- one quadratic and the others linear in the
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decision variables. To illustrate we use an example in which an investor associates a disutility with income yield due to its unfavorable tax treatment relative to capital gains. Letting yp be the yield of the portfolio, utility is now: up = ep + uy*yp - vp/rt where uy (utility from yield) is a constant indicating the investor's attitude towards yield. For concreteness we assume a negative value equal to -0.2 for uy. Thus a dollar received in the form of income (yield) will be 80% (1-0.2) as desirable as a dollar received in the form of a capital gain. Having run out of obvious letters, we let q represent the vector of asset yields. In our example: q = [ 5 7 3 ] and yp = x'*q As before, we can convert the utility function to variance-equivalent terms by multiplying all terns by rt, giving: vup = rt*ep +(uy*rt)*yp - vp For our example with three assets and two constraints, the derivative of the Lagrangean function for asset i becomes: rt*e(i)+(uy*rt)*y(i)-2*C(i,1)*x(1)-2*C(i,2)*x(2)-2*C(i,3)*x(3)-g1*A(1,i)-g2*A(2,i) Setting this to zero and rearranging gives: 2*C(1,1)*x(1)+2*C(1,2)*x(2)+2*C(1,3)*x(3)+g1*A(1,1)+g2*A(2,1) = 0+rt*e(1)+(uy*rt)*y(i) Putting these n equations together with the m equations for the derivatives taken with respect to the Lagrangean multipliers associated with the constraints gives a system of (n+m) linear equations of the form: D*y = k + rt*f + (uy*rt)*r where D, y and f are defined as before and r = [ q zeros(m,1) ] Once again, the optimal portfolio can be determined simply by multiplying each term by the inverse of D.. Thus: y = inv(D)*k + rt*inv(D)*f + (uy*rt)*inv(D)*r Note that the first two terms on the right-hand side are unchanged from the earlier incarnation. Thus we may write: y = mvp + rt*z + (uy*rt)*zy The new vector is zy. Clearly, it is a swap, or zero-investment strategy. An investor who derives neither utility (positive uy) nor
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Optimal Portfolios without Bounds on Holdings

disutility (negative uy) from yield will be uninterested in this swap. An investor with a preference for yield will wish to take long positions in it, while an investor for whom yield provides disutility will wish to take short positions in it.

A-fund Separation
In the current example, optimal asset holdings are linear in two variables -- rt and (uy*rt). To keep the notation simple, let: ur = uy*rt Then: y = mvp + rt*z + ur*zy Now, assume that three mutual funds (a,b and c) have been formed. Fund a holds a portfolio that is optimal for an Investor with a risk tolerance of rta and a value of ur equal to ura. Fund b holds a portfolio that is optimal for an Investor with preferences given by rtb and urb, and fund c holds a portfolio optimal for an Investor with preferences rtc and urc. Thus: ya = mvp + rta*z + ura*zy yb = mvp + rtb*z + urb*zy yc = mvp + rtc*z + urc*zy Consider an Investor who places proportions xa, xb and xc of his or her wealth in the three mutual funds, with: xa + xb + xc = 1 The resulting portfolio will be: y = xa*ya + xb*yb + xc*yc Or: y = mvp + [xa*rta+xb*rtb+xc*rtc]*z + [xa*ura+xb*urb+xc*urc]*zy The goal is to make the first bracketed expression equal to the Investor's risk tolerance (rt) and the second equal to his or her value of ur while keeping the sum of the proportions allocated to the funds equal to 1. This is a system of three linear equations in three unknowns (xa, xb, and xc): xa*rta + xb*rtb + xc*rtc = rt xa*ura + xb*urb + xc*urc = ur xa + xb + xc = 1 Barring degeneracy due to lack of differences among the mutual funds, it can be easily solved, providing the appropriate combination of mutual funds for the Investor to achieve his or her objectives. We have thus shown that in this setting, three mutual funds can provide Investors with sufficient alternatives to achieve optimal portfolios. Each such mutual fund must be optimal for a particular combination of rt and uy, and the three funds must be designed for Investors with different degrees of both rt and ur. Thus three (different) funds suffice to span the space of optimal portfolios when there are three arguments in investor's utility functions (variance plus 2 linear terms). Examination of the procedures used to obtain this result (and the earlier two-fund theorem) show that the natural generalization of this result is in fact correct:. If there are
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A possible arguments in Investor's utility functions (variance plus A-1 linear terms), A different funds are sufficient to span the space of optimal portfolios. This may be called the A-fund separation theorem. A world in which Investors care about more than expected return and risk requires more investment products and more care when selecting a combination of mutual funds for a particular Investor. But the magnitude of the Investor's task is still small, requiring only consideration of A (here, 3) mutual funds rather than n assets (e.g. potentially thousands of securities). Of course, this assumes away nasty realities such as transactions costs and bounds on holdings. It also assumes that the managers of the selected mutual funds do their jobs correctly (that is, construct optimal portfolios) and that Investors or their advisors know the preferences for which each mutual fund is optimal. To the extent that the real world falls short on one or more of these fronts, adjustments will have to be made before giving practical investment advice.

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The Critical Line Method

The Critical Line Method

Contents:
q q q q q q q q q q q q

The General Asset Allocation Problem Adding Linear Inequalities Parametric and Non-Parametric General Asset Allocation Problems Yet Another Three-Asset Problem Finding the Portfolio with the Maximum Expected Return Finding an Optimal Portfolio Given the Status of Each Variable Computing the Derivatives of the Lagrangean Function with Respect to Bounded Variables Finding Optimal Portfolios for a Range of Risk Tolerances Finding the Next Value of rt at Which a Variable Must Change Status Corner Portfolios The Algorithm C Fund Separation

The General Asset Allocation Problem


The gradient method works well for solving the type of problem that we have termed the standard asset allocation problem: Select: x to maximize: u = ep - vp/rt where: ep = x'*e vp = x'*C*x subject to: sum(x) = k lb <= x <= ub If there are no bounds on holdings, cases with additional linear constraints can be solved directly, as we have shown in the previous sections. But thus far we have no procedure for solving cases in which there are both bounds on holdings and linear constraints in addition to the standard full-investment constraint. Fortunately, Markowitz developed a general procedure in Markowitz 1956 that can handle additional linear constraints and upper and lower bounds on holdings. Moreover, the approach provides a method for determining the entire set of efficient portfolios. And, (as if this were not enough) it also leads to conclusions about the properties of the efficient set and a new separation theorem.

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The Critical Line Method

Markowitz called his procedure the critical line method, as shall we.

Adding Linear Inequalities


Recall that the standard problem involves two sets of constraints. The first requires that the sum of the proportions invested equal a constant: sum(x) = k The second constraints require that the proportions remain within specified bounds: lb <= x <= ub As in the analysis of problems without bounds, we can generalize the first constraint to allow for any desired number of constraints as long as they are linear in the variables (x values). Given m such constraints. We require that: A*x = b where A is an {m*n} matrix with the left-hand side coefficients of the constraints, and b is an {m*1} vector of the right-hand sides of the constraints. As indicated earlier, a problem with only the full investment constraint is a special case in which m=1 and all the coefficients in A and b are equal to 1.0. Linear equality constraints may be of some interest in their own right, but in most practical cases they are only a means to an end. By combining a linear equality with bounds on a variable one can constrain a linear function of the asset holdings to be within desired bounds. To illustrate, consider a three-asset case in which it is desired to limit the amount invested in cash plus bonds to 40% of the overall portfolio. To do so, we introduce a new variable (number 4) to represent the sum of the amounts invested in assets 1 plus 2. To make this variable (X4) equal to the sum of X1 and X2, we add a second equation to the constraint set, giving: A = [ 1 1 b = [ 1 0 ] Note that in the first (full-investment) constraint, variable 4 has a coefficient of zero, since it is not an investment, per se. To restrict the amount invested in the sum of the first two asset classes to be less than 40% of the portfolio, we need only to assign the appropriate values for the bounds on variable 4. In this case: lb = [ 0 0 0 0 ] [ 1 1 1 1 1 0 0 -1

ub =

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1 0.4 ]

Parametric and Non-Parametric General Asset Allocation Problems


We are now ready to formally define two versions of the general asset allocation problem. The non-parametric general asset allocation problem has the form: Select: x to maximize: u = ep - vp/rt where: ep = x'*e vp = x'*C*x subject to: A*x = b lb <= x <= ub The parametric general asset allocation problem has the form: For all positive values of rt: Select: x to maximize: u = ep - vp/rt where: ep = x'*e vp = x'*C*x subject to: A*x = b lb <= x <= ub The solution to the parametric version will be a matrix of portfolios rather than a single portfolio. One might imagine that this would be huge -- containing, for example, a different portfolio for every possible level of risk tolerance. Not so. We will show that in fact, a remarkably parsimonious matrix of portfolios can be used to determine the solution to the non-parametric version of the problem for any desired magnitude of rt. This rather opaque statement will (hopefully) be clear as the analysis unfolds.

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The Critical Line Method

Yet Another Three-Asset Problem


To illustrate some of the key concepts that form the basis for the critical line method, we use a variation on the by-now familiar three-asset problem. The assets are cash, bonds and stocks, with expected returns, risks and correlations: e = 2.8000 6.3000 10.8000 sd = 1.0000 7.4000 15.4000 cc = 1.0000 0.4000 0.1500 0.4000 1.0000 0.3500 0.1500 0.3500 1.0000

To make the problem interesting, we assume that for some reason, it is required that at least 20% of the portfolio be invested in each of the assets and that no more than 50% of the portfolio be invested in any asset. Thus: lb = 0.2000 0.2000 0.2000 ub = 0.5000 0.5000 0.5000 Our goal is to find all the portfolios which are efficient. In effect, we wish to maximize ep-vp/rt for every non-negative value of rt.

Finding the Portfolio with the Maximum Expected Return


To start, we take a somewhat easier problem: Maximize e - vp/rt when rt = infinity Of course, this is equivalent to: Maximize ep
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where: ep = x'*e vp = x'*C*x subject to: A*x = b lb <= x <= ub This is a linear programming problem, since all the constraints are linear, some are inequalities, and the objective function is linear. Many algorithms exist for solving such problems. The MATLAB optimization toolbox contains a function called lp that can handle any such problem. Since it is designed to minimize a linear function f'*x, the signs of the expected returns must be reversed to achieve maximization of ep. Since the function can also handle somewhat more general problems, two additional arguments need to be included. For our purposes these can be written as functions of e and A. The maximum-expected return portfolio can then be found using the statement: xinf = lp(-e,A,b,lb,ub,ones(size(e)),size(A,1)); where the notation xinf serves to indicate that this is the composition of a portfolio that is optimal for an Investor with infinite risk tolerance. While problems with two or more linear equalities are best solved using general linear programming algorithms, cases such as the present one, in which the only equation is the full investment constraint can be solved more simply using the following algorithm: 1. set all variables at their lower bounds 2. rank the variables in order of decreasing e(i) 3. increase the amount invested in the highest-e(i) variable to the smaller of a. the lower bound plus the remaining funds b. the upper bound 4. repeat step 3 with the next highest e(i) variable until no funds remain In MATLAB: % given e, lb, ub, finds maxe-portfolio xinf where sum(xinf)=1 xinf = lb; [zz,ii] = sort(-e); amtleft = 1 - sum(xinf); ix = 1; while amtleft>0 i = ii(ix); chg = min((ub(i)-lb(i)),amtleft); xinf(i) = xinf(i) + chg; amtleft = amtleft-chg; ix = ix+1; end; In this case: xinf = 0.2000 0.3000 0.5000

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The Critical Line Method

Now, recall the classification of a variable's status in a solution: down: in: up: l(i) = x(i) l(i) < x(i) < u(i) x(i) = u(i)

In this case, cash is down (at its lower bound), bonds are in (the solution), and stocks are up (at the upper bound). It is convenient to represent the states of the variables in a vector (s) using the following conventions: i down : s(i) = -1 i in : s(i) = 0 i up : s(i) = 1 Here: s = -1 0 1

Finding an Optimal Portfolio Given the Status of Each Variable


We have found the optimal portfolio for an Investor with infinite risk tolerance. What about one with a risk tolerance of, say, 45? To find an answer we might guess that the status of each variable in such a case would be the same as in the solution for rt=infinity. There is no reason to believe that this is so (except a suspicion that the author may know it to be the case). But for now, assume that it is true. Given this information, could you easily determine the magnitudes of the variables? Yes indeed. Recall the solution equation for the case in which no bounds are binding: D*y = k + rt*f In this case: 2*C(1,1) 2*C(1,2) 2*C(1,3) 1 x(1) 0 e(1) 2*C(2,1) 2*C(2,2) 2*C(2,3) 1 * x(2) = 0 + rt* e(2) 2*C(3,1) 2*C(3,2) 2*C(3,3) 1 x(3) 0 e(3) 1 1 1 0 tmup 1 0 The first equation is derived by setting the derivative of the Lagrangean function with respect to the first variable equal to zero. The second equation is derived by doing so with respect to the second variable. And so on, for the first n equations. These firstorder condition equations remain appropriate for the variables that are in the solution, for their bounds are not binding and hence could have been omitted entirely (at least for the risk tolerance being examined). Note, however, that the corresponding equations will not generally hold for variables that are down or up. On the other hand, it is easy to write an equation for any such variable, since it must be at the corresponding bound. In the case at hand we need to replace the first equation with one that states:

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The Critical Line Method

x(1) = lb(1) and the third equation with one that states: x(3) = ub(3) This is easily done by modifying D, k and f to give: DD*y = kk + rt*ff where the new matrices and vectors are: 1 0 0 0 x(1) 0.20 0 2*C(2,1) 2*C(2,2) 2*C(2,3) 1 * x(2) = 0 + rt* e(2) 0 0 1 0 x(3) 0.50 0 1 1 1 0 tmup 1 0 We can now proceed to solve the system of equations. The solution is given by: y = inv(DD)*kk + rt*inv(DD)*ff Here: y = 0.2000 0.3000 0.5000 209.5740 If everything else is correct, the optimal portfolio is the same for someone with a risk tolerance of 45 as for someone who doesn't care at all about risk!

The Kuhn-Tucker Conditions


In all the asset allocation problems we have analyzed the goal is to maximize a Lagrangean function. In this case, it is: L = rt*ep - vp + g1*[b(1)-A(1,:)*x] The objective is to reach the highest point in a terrain in which altitude is measured by L. However, in this setting we may not be on a smooth terrain. The presence of inequality constraints may lead to places in which there is an abrupt change in slope or a move in one or more directions is infeasible (in a sense, there is a fence). Nonetheless, there are some characteristics of the optimal position that can be exploited when designing a solution algorithm. Consider dL/dx(i) in the x(i) direction when at the optimal point. If x(i) is an in-variable, this derivative (slope) must be zero or else we would not in fact be at the top of the feasible hill. Thus we have: dL/dx(i) = 0 : for all in variables

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Now consider dL/dx(i) at the optimal point for a down-variable. If this were positive, we could not be at the top of the feasible hill since an increase in x(i) would improve the solution. However, it could (and in most cases would) be negative, indicating that a further decrease would lead to a higher value of L, but such a decrease is not allowed. Thus: dL/dx(i) <=0 : for all down variables Finally, it must be the case that dL/dx(i) is zero or positive for all up variables. If such a slope were negative, it would pay to decrease the value of the variable, since by so doing one could reach a higher position. Thus: dL/dx(i) >= 0: for all up variables These three characteristics of an optimal solution are collectively known as the Kuhn-Tucker conditions. If they are not met, a portfolio is not optimal.

Computing the Derivatives of the Lagrangean Function with Respect to Bounded Variables
To make certain that all is well with a purported solution, it is a simple matter to compute the derivative of the Lagrangean with respect to each variable. In this case the Lagrangean is: L = rt*ep - vp + g1*[b(1)-A(1,:)*x] The derivative of L with respect to Xi is: dL/dx(i) = rt*e(i) - 2*C(i,:)*x -g1 and the full set of the derivatives with respect to the assets can be written in matrix form as: dL = rt*e - 2*C*x -g where g is the vector of Lagrange multipliers. Since vector y contains the asset holdings (x) plus the Lagrange multipliers (g), we may take advantage of the structures of vector f and matrix D to write: dL = rt*f - D*y where the first n elements of dL are the derivatives of L with respect to the asset holdings. For the case at hand: dL = -88.0600 0 14.4104 -1.0000 Note that all the Kuhn-Tucker conditions for an optimal solution have been met. The derivative is negative for the down variable
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The Critical Line Method

(cash), zero for the in variable (bonds),and positive for the up variable (stocks).

Finding Optimal Portfolios for a Range of Risk Tolerances


By good fortune and hard work we have found the solution to the portfolio problem when rt = 45. We have also verified that it is indeed the solution by checking the derivatives of the Lagrangean function to see that they satisfy the Kuhn-Tucker conditions for optimality. But what about a case in which rt = 44? If in fact all the variables have the same status as in the previous solution we can use the same formulas. The portfolio is given by: y = inv(DD)*kk + rt*inv(DD)*ff and the derivatives by: dL = rt*f - D*y For rt = 44 we obtain: y = 0.2000 0.3000 0.5000 203.2740 dL = -84.5600 0 9.9104 -1.0000 It worked! Each asset in vector y is within its allowable bounds and the derivatives satisfy the Kuhn-Tucker conditions. We could, if desired, go on like this, trying values for rt of 43, 42, 41, etc. until the procedure "did not work". There are two ways that a purported solution could fail. First, one or more of the variables in y could be outside the permissible bounds. Second, the required Kuhn-Tucker conditions for the derivatives could be violated. In the first instance the ostensible solution would be infeasible. In the second instance, it would be suboptimal. But we need not proceed by trial and error. Instead we can determine the value of rt at which one or both of these conditions will first be violated as the value of rt is decreased.

Finding the Next Value of rt at Which a Variable Must Change Status


To keep the notation reasonably simple, it is useful to rewrite: y = inv(DD)*kk + rt*inv(DD)*ff

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The Critical Line Method

as: y = ya + yb*rt where: ya = inv(DD)*kk yb = inv(DD)*ff In this case: ya = 0.2000 0.3000 0.5000 -73.9260 yb = 0 0 0 6.3000 Now, recall that: dL = rt*f - D*y Substituting the equation for y gives: dL = rt*f - D*(ya + yb*rt) Simplifying: dL = dla + dlb*rt where: dla = -D*ya dlb = f - D*yb In this case: dla = 69.4400 0.0000 -188.0896 -1.0000 dlb = -3.5000 0 4.5000
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0 Now, note that a variable may change status in one of four ways as rt falls. 1) An in variable may go up. This can only happen if yb(i) is negative. The critical value of rt (crt) is reached when y(i)=ub(i), that is, when: ub(i) = ya(i)+yb(i)*crt or: crt(i) = (ub(i) - ya(i))/yb(i) 2) An in variable may go down. This can only happen if yb(i) is positive. The critical value of rt is reached when y(i)=lb(i), that is, when: lb(i) = ya(i)+yb(i)*crt or: crt(i) = (lb(i) - ya(i))/yb(i) 3) A down variable may come in. This can only happen if dlb(i) is negative. The critical value of rt is reached when dL(i)=0, that is, when: 0 = dla(i)+dlb(i)*crt or: crt(i) = -dla(i)/dlb(i) 4) An up variable may come in. This can only happen if dlb(i) is positive. The critical value of rt is reached when dL(i)= 0, that is: 0 = dla(i)+dlb(i)*crt or: crt(i) = -dla(i)/dlb(i) Applying these rules to the case at hand gives the following critical values of rt for our three variables: crt = 19.8400 0 41.7977 The greatest value of crt is the next value at which a variable must change status. Letting nrt represent the next critical value of rt: nrt = max(crt); In MATLAB we can find both the next critical value of rt and the variable to change status in one expression: [ncp,ichg] = max(crt); where ichg is the variable for which crt is largest. In this case: ncp = 41.7977

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ichg = 3 So stocks (variable 3) are to change status. Since s(3)=1, they want to go from up (s=1) to in (s=0).

Corner Portfolios
Before proceeding further, it is important to draw some implications from our experience to date. Imagine that we know that for a range of risk tolerances from rta to rtb the same bounds are binding. In other words, within this range, as risk tolerance is changed each member (if any) of one set of variables will remain at its upper bound, each member (if any) of another set of variables will remain at its lower bound, and each of the other variables will move within its designated bounds. For this range of risk tolerances one could find the optimal set of portfolios by solving the standard set of linear equations using the same DD matrix and kk and ff vectors. Therefore, within this range every asset holding is a linear function of risk tolerance. This in turn implies that for any risk tolerance between rta and rtb, the optimal portfolio can be constructed by simply taking a weighted average of the portfolios that are optimal for rta and rtb, with the weights proportional to the difference between the desired risk tolerance and the endpoints of the range rta to rtb. This observation provides the motivation for assigning a name to each portfolio that is optimal for a risk tolerance at which a variable changes status. We call such a portfolio a corner portfolio because in a graph that plots holdings against risk tolerance, two or more variables "turn a corner". As we will see, corner portfolios play a central role in the critical line algorithm. They also are attractive candidates for mutual funds.

The Algorithm
We now have the ingredients to complete the algorithm for the parametric general asset allocation problem. Here it is in outline form: 1. Find the portfolio that gives the maximum expected return. 2. Determine the status of each variable in the max-e portfolio. 3. Record the composition of the portfolio 4. Compute DD, kk and ff given the current status of each variable. 5. Find the equations for the optimal holdings and the derivatives of the Langrangean function. 6. Determine the next critical value of rt and the variable to change status. 7. Determine the optimal portfolio for the next critical value of rt and record it and the associated value of rt 8. Repeat steps 4 through 8 until the last critical value of rt is zero or negative The end result will be a matrix of portfolios and a vector of the associated risk tolerances. With the exception of the first, each of the portfolios in the matrix will be a corner portfolio. Moreover, this information is all that is needed to determine the optimal portfolio for any degree of risk tolerance! Given an Investor's risk tolerance, the Analyst needs only to do a table lookup to find the two corner portfolios for risk tolerances on either side of the desired value, then perform a simple computation involving a weighted average of the compositions of the portfolios in question.

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The Critical Line Method

The figure below shows the composition of all optimal portfolios, given our inputs, for risk tolerances from 0 to 50 (the blue line represents Cash, the red line Stocks, and the green line Bonds).

The corner portfolios are evident in the figure. Their compositions are shown in the table below:

rt <= 13.73 15.10 21.02 22.30 22.94 >=41.80

% Cash 50.00 45.19 22.18 20.00 20.00 20.00

% Bonds 30.00 34.81 50.00 50.00 50.00 30.00

% Stocks 20.00 20.00 27.82 30.00 30.00 50.00

Note that over the range of risk tolerances from 22.30 to 22.94 the optimal composition remains the same. This is not a rounding error. Since the efficient frontier is piecewise quadratic, there is always the possibility that there is a kink at the point corresponding to a specific level of risk and return. In such a case indifference curves with different slopes (risk tolerances) can be tangent to the efficient frontier at the same point, giving the same optimal portfolio.

C- Fund Separation
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The Critical Line Method

A world with inequality constraints is more complex than one without them. In such a setting, it is rarely possible to obtain an optimal investment strategy by determining a single optimal combination of risky securities, then mixing it with borrowing or lending to suit the risk tolerance of a given Investor. However, all is not lost. It is still possible to construct a limited number of mutual funds, each holding a portfolio of risky securities that is optimal for a particular risk tolerance, then allocate the assets of each Investor between two of the resulting mutual funds. This of course cannot be done haphazardly. To minimize the number of mutual funds, each should hold a different corner portfolio from the optimization analysis. If there are C different such corner portfolios, the minimum number of mutual funds required to service all possible Investors will equal C. Each fund will be ideal (if the optimization inputs were correct) for an Investor with a specific risk tolerance. Given this set of funds, each Investor should allocate his or her money between the two funds with objectives (risk tolerances) closest to his or her own. In a world of inequality constraints, there may need to be as many funds as there are different corner portfolios in the efficient set of portfolios. Given C such funds, the investment decision can be separated into (1) the formation of C funds and (2) the choice of one or two among them for each Investor. We memorialize this process by calling it C-fund Separation. If additional linear attributes are important, more efficient funds will be required, and the Investor will typically have to choose a combination of A funds (where A is the total number of relevant attributes). But separation of the process into two phases (construction of a set of mutual funds and Investor choice among those funds) is still possible. The results associated with the critical line algorithm have important implications for practical people. We finish with a case in point. Assume that there are four efficient funds, advertised as conservative (C), moderate (M), aggressive (A) and very aggressive (V), differing only in levels of risk (that is, no additional attributes are relevant). An Investor with preferences lying between "moderate" and "aggressive" should allocate assets between funds M and A. While he or she might achieve the same amount of risk by choosing a combination of C and V, this would be inefficient, giving lower expected return.. A slightly better choice, although still an inefficient one, might involve investing in all four mutual funds. But the best choice of all involves only the two funds with objectives nearest those of the Investor in question. This suggests that the desire to diversify across many mutual funds, each of which is itself relatively diversified, may be counterproductive. It is entirely possible to have too many mutual funds!

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Factor Models

Factor Models
q q q

The Need for Factor Models Linear Factor Models Factor-based Expected Returns, Risks and Correlations

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The Need for Factor Models

The Need for Factor Models

Contents:
q q

The Number of Estimates Needed for Mean/Variance Analyses The Use of Historic Data

The Number of Estimates Needed for Mean/Variance Analyses


The problem with securities is that there are too many of them. This is also true for pools of securities such as mutual funds. Worldwide, there are hundreds of thousands of securities and tens of thousands of mutual funds. In the United States alone there are roughly ten thousand mutual funds. To perform a mean/variance analysis of portfolios that could contain any of them would require estimates for the future values of:
q q q

10,000 expected returns, 10,000 standard deviations, and 100,000,000 (10,000*10,000) correlation coefficients

To be sure, this overstates the magnitude of the problem. We know that 10,000 of the correlation coefficients will equal 1.0, since each fund will be perfectly correlated with itself. Moreover, for each entry below the main diagonal of the correlation matrix there is a corresponding entry above it (that is, cc(i,j)=cc(j,i)). Thus the number of potentially different correlation coefficients to be estimated will be only (!) (10,000*10,000 - 10,000)/2, or 49,995,000. More generally, with N different assets, we require:
q q q

N expected returns N standard deviations (N^2 - N)/2 correlation coefficients

for a grand total of (N^2 + 3*N)/2 different estimates.

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The Need for Factor Models

There are two consequences of the fact that problems involving large numbers of assets require a great many estimates. The first concerns the sheer computational requirements for optimization or even the determination of the risk and return of a given portfolio. Fortunately, ever-declining computer costs can ameliorate the pain caused on this front. But a second problem remains -- it is simply too difficult to estimate each of the required values explicitly.

The Use of Historic Data


At first glance it might seem that the estimation problem could also be solved simply by unleashing a sufficient amount of computer power. Why not obtain a set of historic returns for the N assets and compute historic mean returns, standard deviations of return and correlations among the returns? Even for large values of N this could be done in reasonable time and for reasonable cost, although storage of each of the resulting estimates would use up a considerable amount of computer space. Issues of cost and time aside, such an approach would not provide a good solution. A set of historic data provides only a sample of possible outcomes. The statistics we desire are those that describe the entire underlying "return-generating" process. But the statistics from a sample are likely to differ in potentially significant ways from those that are appropriate for tasks such as risk estimation and portfolio optimization. In statistician's terms, the numbers obtained from historic data are "subject to error". More simply put, they include noise. In some cases this may be reasonably benign. For example, if some values are overstated and others understated, a simple average of historic values may provide a quite accurate estimate of the expected value of the true process. This suggests that the use of historic data for estimating the expected returns and risks of pre-specified portfolios might be an acceptable practice. However, the use of optimization to find the best portfolio for a given investor will be fraught with hazard if historic data are used, since optimization programs look for unusual values, and such values are far more likely to include error than those that are not unusual. The same danger lurks when evaluating portfolios chosen in simpler ways, but with knowledge of the behavior of the assets over the historic period. In either case, the purported risks and returns for the portfolios will be biased toward favorable estimates (higher expected returns and/or lower risks), and the portfolios will almost certainly be inefficient in prospective terms. More precisely, portfolios that appear on the efficient frontier using unadjusted historic data will almost certainly plot below the true efficient frontier that could be constructed if the correct future risks, expected returns and correlations were known.. Unhappily, of course, we can never know the location of the true efficient frontier, since we can never know precisely the correct future risks, expected returns and correlations. The problem with using historic data when estimates are required for a large number of assets can be seen by comparing the required number of estimates with the data available for the estimation. Assume that returns are available for N assets for T periods (e.g. months). In all, N*T numbers are available in the empirical database. But we need to estimate (N^2 + 3*N)/2 different numbers (expected returns, standard deviations and correlation coefficients). Taking the ratio of the former to the latter gives the
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ratio of numbers available per number to be estimated. It is 2*T/(N+3). The table below shows the ratio of the numbers available to the numbers being estimated for selected values of N and T.

N 10 100 1,000 10 100 1,000 10 100 1,000 10,000

T 60 60 60 120 120 120 840 840 840 840

available/estimated 9.23 1.17 0.12 18.46 2.33 0.24 129.23 16.31 1.68 0.17

For the common cases in which monthly returns are used for estimation, each set of three rows corresponds to 5, 10 and 70 years (the latter being approximately the number of years in longer-term databases. Cases in which fewer numbers are available than are to be estimated are clearly beyond the pale. Yet such combinations can easily arise in practice. This is often encountered in scenario analyses, when judgmental forecasts of asset returns in a limited set of possible future situations are used as the foundation for portfolio construction. But it is not uncommon in empirical analyses of historic data. One might assume that the problem of insufficient data can be mitigated sufficiently by simply using more data. Unfortunately this usually requires going farther back in history, and the longer the historic period covered, the less likely is the maintained hypothesis that the underlying joint probability distribution generating the returns has been the same. While these dilemmas cannot totally be resolved, there are ways to mitigate the problem. Needed are procedures that can produce estimates of risks, returns and correlations closer to the desired future values than those obtained by simply using historic statistics. Two ingredients are required.
q

First, historic data must be "smoothed" to try to focus on underlying relationships that are more

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likely to be true in the future and to ignore deviations from those relationships that are more likely to be due to random noise or errors. The tools used most often to accomplish this are factor models -- the subject of this chapter. Second, good financial economic theory must be utilized to adjust estimates of risks, expected returns and correlations until they bear some reasonable relationship with one another. This involves the use of concepts and models associated with equilibrium in efficient markets -- a subject that is treated at length in a later chapter.

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Linear Factor Models

Linear Factor Models

Contents:
q q q q

A Generic Linear Factor Model Terminology Decomposing Returns Matrix Representation of Factor Models

A Generic Linear Factor Model


The Equation
A linear factor model relates the return on an asset (be it a stock, bond, mutual fund or something else) to the values of a limited number of factors, with the relationship described by a linear equation. In its most generic form, such a model can be written as: ri = bi1*f1 + bi2*f2 + .... + bim*fm + ei where: ri = the return on asset i bi1 = the change in the return on asset i per unit change in factor 1 f1 = the value of factor 1 bi2 = the change in the return on asset i per unit change in factor 2 f2 = the value of factor 2 ... = terms of the form bij*fj with j going from 3 to m-1 fm = the value of factor m bim = the change in the return on asset i per unit change in factor m m = the number of factors ei = the portion of the return on asset i not related to the m factors

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For emphasis, the equation is sometimes written so that variables that are assumed to be known before the fact are differentiated from those the value of which is generally not known until after the fact. For example: ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~ In this version, a tilde after a variable indicates that its value is not generally known in advance. The values of such stochastic variables are uncertain. Thus we do not know what the return on the asset (ri~ ) will be, since we do not know the values that the factors (f1~, f2~, .... ,fm~ ) will take on, nor do we know the amount of the asset's return that will come from other sources (ei~). On the other hand, we do know (or at least assume that we know) the sensitivities of the return on the asset to each of the factors ( bi1, bi2, ....,bim) -- these are deterministic (not subject to uncertainty). Somewhat differently put, they are parameters in the model. Purists will note that it is unusual to place tildes after stochastic variables rather than over them. The latter is indeed the convention in media that are not typographically challenged. Our approach is simply a pragmatic response to the limitations of standard browser formats.

The Key Assumption


The factor model equation may appear to make a significant statement about the relationship between an asset's return and the values of the enumerated factors, but this is not so. For example, one could choose any arbitrary set of bij 's and fj's, then simply define the residual as: ei~ = ri~ - [bi1*f1~ + bi2*f2~ + .... + bim*fm~] The factor equation would then hold precisely, but could have no economic content at all. To make the equation have meaning, two assumptions are made. One is relatively innocuous. The other is not. First, the residual return (ei~) is assumed to be uncorrelated with each of the factors: corr (ei~, fj~) = 0 : for every j from 1 to m This is not as restrictive as it may seem. Consider, for example, a case in which the residual return is correlated with factor 1. By adjusting the factor exposure (bi1) appropriately, the correlation of the residual with the factor can be made to equal zero. Moreover, this can be done for every factor. In fact,
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in simple settings using historic data, multiple regression procedures can be used to find a set of factor exposures (bij 's) that will give residual returns that are uncorrelated with each of the factors. Why? Because standard linear multiple regression methods select slope coefficients (here, the bij 's) that minimize the variance of the residual (here ei). But this will insure that the residual is uncorrelated with each of the independent variables (here, the fj's), since the removal of any such correlation by changing one or more bij's will reduce the variance of the residual. Thus the assumption that the residual is uncorrelated with each of the factors is convenient, but does not give the linear factor model much power. However, the second assumption does. The key assumption of a linear factor model is that the residual for one asset's return is uncorrelated with that of any other: corr (ei~,e j~) = 0 : for every i not equal to j, with i and j running from 1 to m This means that the only sources of correlations among asset total returns are those that arise from their exposures to the factors and the covariances among the factors. The residual component of an asset's return is assumed to be unrelated to that of any other asset, and hence totally specific to that asset. In other words, the risk associated with the residual return is idiosyncratic to the asset in question. This assumption makes a linear factor model powerful in the sense that it rules out many possible combinations of outcomes. But greater power comes at a cost. The more restrictive a model, the greater the chance that it may be inconsistent with reality. For this reason it is incumbent on the Analyst to try to capture the most important sources of correlations among asset returns by including a sufficient number of factors and attempting to focus on the most important ones. This being said, as in the construction of any model, parsimony is a virtue, since the goal is to include "signals" and avoid "noise".

Non-linear Relationships
We have termed the standard factor model linear which, strictly speaking, it is. However this is far less restrictive than might first seem. There are no restrictions on correlations among the enumerated factors, so it perfectly possible to include some that are correlated with others or are transforms of others. For example, assume that the desired relationship is a quadratic one in which ri is related to two factors, fa and fb as follows: ri = bi1*fa + bi2*fb + bi3*fa2 + bi4*(fa*fb) + ei To put this in our standard format, define:
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Linear Factor Models

f1 = f a f2 = f b f3 = fa2 f4 = fa*fb Then the relationship can be written as a linear function of these new variables: ri = bi1*f1 + bi2*f2 + bi3*f3 + bi4*f4 + ei In cases of this sort it may be difficult to estimate the values of the sensitivities (bij's) from historic data because the new factors are highly correlated with each other, but there is no reason why such a format cannot be employed if good estimates can be obtained. To avoid needless carping on the need to define factors to allow a linear format for the overall relationship, we henceforth will use the shorter term: factor models.

Expected Residual Returns


Thus far we have imposed no restrictions on the expected returns of the factors or on the asset's residual returns (ei's). In general, we will not do so. This allows the expected return of ei to be positive, negative, or zero for any asset. However, in some applications it is useful to divide the expected non-factor return into two components -- a known expected value and an unknown residual component with an expected value of zero. As typically written, the equation becomes: ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + (ai + ei~) where the expected value of ei~= 0. As the choice of letter suggests, the equation is often written with the ai term first: ri~ = ai + bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~ In some cases the first term is called the asset's alpha value, but at this point we use the more humble notation of "a".

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Linear Factor Models

Terminology
Factor models are used in many domains in the field of investments, so it should not be surprising that different factors are used and different terms employed to describe the key components. Factors (the fj's) may be::
q q q

q q

macro-economic variables returns on pre-specified portfolios, returns on zero-investment strategies (long and short positions of equal value) giving maximum exposure to a fundamental or macro-economic factors, returns on benchmark portfolios representing asset classes, or something else.

The bij coefficients may be called:


q q q q q q q

factor exposures, factor sensitivities, factor loadings, factor betas, asset exposures style or something else.

The ei term may be called:


q q q q q q

idiosyncratic return, security-specific return, non-factor return, residual return, selection return or something else.

Different problems require different factors and emphasize different economic relationships. The job of the Analyst is to either construct and apply an appropriate factor model for the task at hand or to at least understand the underlying structures and economic meanings of models constructed by others.

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Decomposing Returns
A factor model is especially useful when analyzing historic asset returns, since such a model allows the Analyst to separate components of the overall return of the asset. For such purposes it is useful to write the underlying model as: rit = bi1*f1t + bi2*f2t + .... + bim*fmt + eit where: rit = the return on asset i in period t bi1 = the change in the return on asset i per unit change in factor 1 f1t = the value of factor 1 in period t bi2 = the change in the return on asset i per unit change in factor 2 f2t = the value of factor 2 in period t ... = terms of the form bij*fj with j going from 3 to m-1 fm = the value of factor m bim = the change in the return on asset i per unit change in factor m m = the number of factors eit = the residual return on asset i in period t While the subscript t and the term period suggest the traditional application in which each period represents a different historic realization (for example, a different month in the past), the concepts can be used as well in an ex ante analyses, in which each period (t) represents a different possible scenario or realization that could occur in the next (future) period. To emphasize the context, we will sometimes use the subscript s (for scenario) instead of t (for time period). In the former case, there are S scenarios. In the latter, there are T time periods. Note that in this representation the bij terms are not given a t (period) or s (scenario) subscript. This is innocuous in the latter case, since every scenario involves the same future period. However, in the former case, the assumption is quite restrictive, since it indicates that the asset's exposures to the factors were the same in every period. In some cases involving ex post returns, different exposures will be estimated for different time periods, with bij values replaced with bijt values.

Matrix Representations of Factor Models


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Linear Factor Models

To simplify notation and to facilitate computation it is useful to switch from a subscripted notation to a matrix representation. As usual, we utilize Matlab conventions. We consider several cases in turn, focusing on decomposition of returns, be they over time or over scenarios. For simplicity we cast our examples in terms of historic returns over different time periods, but the interpretations can easily be adapted to cases involving different possible scenarios over a single future time period.

One asset, one realization


First consider the case in which there is one asset and one time period (looking backward) or scenario (looking forward).Let b be a {1*m) vector of the asset's factor exposures, let f be an {m*1} vector of actual factor values, r a scalar representing the asset's return and e a scalar representing its residual return. The factor model equation can then be written as: r = b*f + e For example, let the asset's exposures to the factors be: b = [ 0.1 0.3 0.6 ]

Assume that the realized values of the factors in a given year were: f = [ 4 7 20 ] If the total return on the asset (r) was 16.0 percent, then: e = r - b*f = 16.0 - 14.5 = 1.5 Thus, in the year in question, the asset's residual (non-factor related) return was 1.5%, while its factorrelated return was 14.5%.

One Asset, Multiple Realizations


Next, consider a case in which there are many historic periods (looking backward) or scenarios (looking
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forward). Let there be T such alternatives. For each one, there will be a return on the asset, so that the scalar r will be replaced by T values, which can be written as a {1*T} (row) vector. Similarly, for every alternative there will be a set of factor values, so that f will be replaced by a {m*T} matrix. This will give a residual return for each of the periods or cases, so that the scalar e will be replaced by a {1*T} vector. We assume that the asset's factor exposures will be the same in each case, so that b will remain a {1*m} vector. The relationships among these variables can then be written with the following succinct equation: r = b*F + e Given r, b and F, the residual returns can be found by performing the operation: e = r - b*F For example, assume that in the last two years the realized returns for the asset were: r = [ 16 4 ]

while the factor values were: F = [ 4 7 20 3 2 10

This implies that the factor-related returns were: b*F = [ 14.5 and the residual returns were: e = r - b*F = [ 1.5 -2.9 ] 6.9 ]

In each case the first column corresponds to the previous one-period example, which is a special case (with T=1) of this present version.

Multiple Assets, Multiple Realizations


An even more general case can subsume both of the prior ones as special cases. Assume that there are N
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assets and T realizations. Let: R = an {N*T} matrix, where R(i,t) is the return on asset i in realization t B = an {N*m} matrix, where B(i,j) is the exposure of asset i to factor j F = an {m*T} matrix, where F(j,t) is the value of factor j in realization t e = an {N*T} matrix, where e(i,t) is the residual return on asset i in realization t The factor model then becomes: R = B*F + E and the matrix of residual returns can be found by computing: E = R - B*F As an example, assume that we have four assets, with exposures to three factors given by: B =[ 0.1 0.2 0 0 0.3 0.8 0.7 0 0.6 0 0.3 1.0 ]

If the asset's returns in the two years were: R =[ 16 7 8 22 4 1 6 7

Then the residual returns were: E = [ 1.5 0.6 -2.9 2.0 -2.9 -1.2 1.6 -3.0 ]

Not surprisingly, the first security is the one used in the prior case.

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Note that three different dimensions are involved here (two periods, three factors, and four assets). The matrices, with row and column labels are as follows: Returns (R): period 1 16.0 7.0 8.0 22.0 period2 4.0 1.0 6.0 7.0

security security security security

1 2 3 4

Asset Exposures (B): factor 1 0.1 0.2 0.0 0.0 factor 2 0.3 0.8 0.7 0.0 factor 3 0.6 0.0 0.3 1.0

security security security security

1 2 3 4

Factor realizations (F): period 1 4.0 7.0 20.0 period2 3.0 2.0 10.0

factor 1 factor 2 factor 3

Factor-related Returns (B*F): period 1 14.5 6.4 10.9 20.0 period2 6.9 2.2 4.4 10.0

security security security security

1 2 3 4

Residual returns (E = R - B*F): period 1 1.5 0.6 -2.9 2.0 period2 -2.9 -1.2 1.6 -3.0

security security security security

1 2 3 4

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Linear Factor Models

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Factor-based Expected Returns, Risks and Correlations

Factor-based Expected Returns, Risks and Correlations

Contents:
q q q

Factor-based Asset Expected Returns Factor-based Asset Covariances and Variances Factor-based Portfolio Expected Returns and Risks

Factor-based Asset Expected Returns


What is the expected return for a single asset whose return is generated by a factor model? The answer conforms nicely with intuition -- each uncertain term in the factor model equation can simply be replaced with its expected value. Thus, if: ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~ It will be the case that: ev(ri) = bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm) + ev(ei) where ev(x) denotes the expected value of x To see why this is the case, recall that for a given possible future scenario s: ris = bi1*f1s + bi2*f2s + .... + bim*fms + eis Now, multiply each term by prs , the probability that the scenario will occur: prs*ris = prs*bi1*f1s + prs*bi2*f2s + .... + prs*bim*fms + prs*eis

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This equation will continue to hold (the left side value must equal the right side value) and there will be one such equation for each possible scenario. Next, add together the equations for all S possible scenarios. Letting sums( ) denote the sum for s=1...S, we have: sums(prs*ris) = sums(prs*bi1*f1s) + sums(prs*bi2*f2s) + .... + sums(prs*bim*fms) + sums(prs*eis) Collecting terms that have scenario subscripts gives: sums(prs*ris) = bi1*sums(prs*f1s) + bi2*sums(prs*f2s) + .... + bim*sums(prs*fms) + sums(prs*eis) By definition, the first sum is the asset's expected return, the next m sums are the expected returns of the factors, and the last term is the expected residual return. Thus: ev(ri) = bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm) + ev(ei) as asserted. If the expected residual return is represented by ai, the equation can be written as: ev(ri) = ai + bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm) or, in matrix terms: e(i) = b*ef + a(i) where: e(i)= r*pr' ef = F*pr' a(i) = e*pr' Here, pr represents a {1*S} vector of probabilities, r a {1*S} vector of asset returns, F a {M*S} matrix of factor values, and e a {1*S} vector of residual returns. As previously, b represents a {1*M} vector indicating the asset's sensitivities to the factors. The computed values are: e(i), a scalar representing the asset's expected return; ef, an {M*1} vector of factor expected values; and a(i), a scalar representing the asset's expected residual return.
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This rather tortuous proof suffices for other situations involving linear functions. The expected value of a variable that is a linear function of other variables will itself be a linear function of the expected values of the variables in question, using the same constants (here, bij values). The equation for an asset's expected return could be used to compute the expected return on each asset, one at a time. However, it is far more efficient to generalize it so that the entire vector of asset expected returns can be computed in one operation. This is straightforward. Let: e = an {N*1) vector of asset expected returns B = an {N*m} matrix of factor exposures, where B(i,j) is the exposure of asset i to factor j ef = an {m*1} vector of asset expected returns a = an {N*1} vector of the expected residual returns e = an {N*1) vector of asset expected returns Then: e = B*ef + a This is a Matlab expression which requires one operation to do the entire job. With respect to expected returns, it would appear that the use of a factor model has actually increased the number of required estimates. In this approach, for N assets the Analyst needs N estimates of a(i) plus estimates of the expected values of the M factors. While this is true, there are at least some cases in which it is reasonable to assume that each asset has the same expected residual return, or that each such expected residual return is related in a simple way to the asset's factor sensitivities. In such cases, the number of estimates required to specify asset expected returns may be considerably smaller than N. Even when this is not so, a small increase in the size of the task of estimating expected values is a reasonable price to pay for the substantial decreases in the magnitude the task of estimating risks, as the next section shows.

Factor-based Asset Covariances and Variances


To determine the relationship between factor characteristics and those of an asset it is useful to reexamine the nature of covariance. Put in future terms, the covariance of asset i with asset j is the
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expected value of the product of (1) the deviation of asset i's return from its mean and (2) the deviation of asset j's return from its mean: cov(ri,rj) = ev( (ri-ei)*(rj-ej)) From this is follows that if k is a constant: cov(ri,k*rj) = ev( (ri-ei)*(k*rj-k*ej)) = ev( (ri-ei)*k*(rj-ej)) = k*ev( (ri-ei)*(rj-ej)) = k*cov(ri,rj) In words: the covariance of a variable with a constant times another variable equals the constant times the covariance of the two variables. The definition of covariance also implies that if ri,rj, and rk are returns: cov(ri,rj+rk) = ev( (ri-ei)*((rj+rk) - (ej+ek)) = ev( (ri-ei)*((rj-ej)+(rk-ek)) = ev( (ri-ei)*((rjej)+ ev( (ri-ei)*((rk-ek)) = cov(ri,rj)+cov(ri,rk) In words: the covariance of a variable with the sum of two variables equals the sum of its covariances with the two variables. Clearly, a similar statement holds for the relationship between the covariance of a variable with the difference between two other variables. Now, consider the covariance between two assets (i and j), where the returns of each are determined by a factor model. To keep notation to a minimum, let there be two factors. The relationships are thus: ri~ = bi1*f1~ + bi2*f2~ + ei~ rj~ = bj1*f1~ + bj2*f2~ + ej~ The goal is to determine the covariance between ri~ and rj~. Substituting the right-hand sides of the equations, we have: cov(ri~,rj~) = cov( (bi1*f1~ + bi2*f2~ + ei~ ), (bj1*f1~ + bj2*f2~ + ej~)) Using the relationships derived earlier, the right-hand side of this equation can be re-written as the sum of nine covariances, since there are three terms in each component. However, some of these will equal zero. The maintained assumptions of the factor model are that each residual is uncorrelated with that of any other variable, and that each residual is uncorrelated with each of the factors. However, since a variable's residual return will be correlated with itself, the corresponding term should be included to
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cover the case in which i=j. Including only the terms that could be non-zero, and dropping the tildes gives: cov(ri,rj) = bi1*bj1*cov(f1,f1) + bi1*bj2*cov(f1,f2) + bi2*bj1*cov(f2,f1) + bi2*bj2*cov(f2,f2) + cov( ei,ej) This can be written far more succinctly using matrix notation: Cij = bi*CF*bj' + rvij where: Cij = the covariance between the returns on assets i and j bi = a {1*m} vector of asset i's exposures to the m factors CF = an {m*m} matrix of the factor covariances bj = a {1*m} vector of asset j's exposures to the m factors rvij = the covariance between the residuals on assets i and j Note that rvij will equal zero if i and j are different, but will equal the variance of the asset's residual if i=j. A small amount of reflection on this derivation will indicate that the matrix version of the formula is as applicable if there are more than two factors as it is if there are two. The formula can be used to compute the variance of an asset's return since var(ri) = Cii.Thus: var(ri) = bi*CF*bi' + rvii More impressively, the formula can be generalized to compute the entire covariance matrix for asset returns. As before, let: B = an {N*m} matrix of factor exposures, where B(i,j) is the exposure of asset i to factor j and

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rv = an {N*1} matrix, where rv(i) is the residual variance for asset i (that is, the variance of ei) Then in Matlab notation: C = B*CF*B' + diag(rv) where: diag(rv) = a matrix with the elements of rv on the main diagonal and zeros elsewhere. For problems involving many securities (N) and relatively few factors (m) the number of potentially different estimated variables (those on the right-hand side of the equation) can be very much smaller than the number of asset covariances (on the left-hand side of the equation). For each of the covariances matrices (C and CF) we count only the elements on and below the diagonal, since once those are known, the remainder can be filled in. Taking this into account, the numbers of values to be determined for each component are: C: (N2+N)/2 CF: (m2+m)/2 B: N*m rv: N The table below shows a few examples. N 100 m 3 C 5,050 500,500 CF 6 6 B 300 rv 100 CF+B+rv 406 4,006

1,000 3

3,000 1,000

9,000 15 40,504,500 120 135,000 9,000 144,120 7,000 60 24,503,500 1,830 420,000 7,000 428,830 The first two rows are included for illustrative purposes. The third is representative of a typical model used for U.S. mutual funds, with 15 broad asset class returns used for factors to explain the returns of the many thousand mutual funds in the country. The fourth row is representative of some commercial models that use a number of factors to explain the returns of the thousands of common stocks in the United States.
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As the table vividly illustrates, the number of potentially different asset covariances (in C) can be huge. While the number of estimates required if a factor model is used (shown in the last column) can be large, the use of such a model reduces a virtually intractable problem to one that can be manageable. Finally, we can compare the total number of estimates required with and without a factor model for each of the four cases. In addition to the estimates required for covariances, those needed for expected returns (e), factor expected returns (ef) and residual expected returns (a) need to be taken into account. The table below shows the results: without model 5,150 501,500 with model 509 5,009

N 100

m 3

C 5,050 500,500

e 100 1,000

CF 6 6 120

B 300 3,000

rv 100 1,000

ef 3 3 15 60

a 100 1,000

1,000 3

9,000 15 40,504,500 9,000

135,000 9,000

9,000 40,513,500 153,135 7,000 24,510,500 435,890

7,000 60 24,503,500 7,000 1,830 420,000 7,000

The conclusion is the same. A factor model is a necessity for the estimation of risks and returns if problems of any size are to be analyzed.

Factor-based Portfolio Expected Returns and Risks


All the work performed in the previous sections can be summarized with the two equations for asset expected returns (e) and covariances (C): e = B*ef + a C = B*CF*B' + diag(rv) It is now time to consider portfolios of assets. The custom is to represent a portfolio by an {N*1} vector x in which each element is the proportion (by value) invested in an asset and the sum of the x's equals 1. As usual, the portfolio's expected return is given by: ep = x'*e

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and its variance by: vp = x'*C*x One could use the factor model-based equations to compute e and C, then the equations for portfolio expected return and variance to compute the portfolio's characteristics. However, this would require the creation of a possibly very large asset covariance matrix (C). An far more attractive alternative combines the equations, simplifies, and then solves for ep and vp. First, take the equations for expected return. Combine: e = B*ef + a and ep = x'*e to get: e = x'*B*ef + x'*a Grouping terms slightly gives: ep = (x'*B)*ef + x'*a The parenthesized expression involves multiplying a {1*N}vector by a {N*m} matrix. The result is a {1*m} vector that we will call bp: bp = x'*B The terminology is not without a purpose, for each element of bp indicates the exposure of the portfolio to a factor. In somewhat casual notation: bpf = sumi (xi*bif) More succinctly: bp = a {1*m} vector of the portfolio's exposures to the m factors where each exposure is a weighted average of the asset exposures to the factor in questions, with proportionate portfolio holdings used as weights.
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The expected return of a portfolio can thus be obtained by multiplying each of its bpj values by the expected return of the associated factor and adding the weighted average of the asset residual expected returns, using the portions invested in the assets as weights: ep = bp*ef + x'*a A similar approach can be used for computing a portfolio's variance, with very rewarding reductions in computational requirements. Combine the equations for variance and covariance: C = B*CF*B' + diag(rv) and vp = x'*C*x to get: vp = x'* B*CF*B'*x' + x'*diag(rv)*x This rather menacing equation can be simplified by grouping: vp = (x'* B)*CF*(B'*x') + x'*diag(rv)*x and then replacing the first two parenthesized expressions with the equivalent vector of portfolio bpj values: vp = bp*CF*bp' + x'*diag(rv)*x A further simplification is possible. The net result of the computations in the final term is simply to multiply each residual variance by the square of the asset's proportionate holdings, then add the results. Far better to do this directly, that is: x'*diag(rv)*x = (x.^2)'*rv so that: vp = bp*CF*bp' + (x.^2)'*rv This set of transformations allows the computation of portfolio variance without ever computing the covariances of the component assets! Once bp has been calculated, the portfolio's variance can be
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determined with one set of operations involving an {m*m} covariance matrix (CF) and another requiring the computation of only N products of two terms. A result well worth the matrix algebra involved in the derivations.

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Macro-Investment Analysis

Style Analysis
q q

Asset allocation: Management style and performance measurement Setting the Record Straight on Style Analysis

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Asset Allocation: Management Style and Performance Measurement

ASSET ALLOCATION: MANAGEMENT STYLE AND PERFORMANCE MEASUREMENT


An Asset class factor model can help make order out of chaos William F. Sharpe*
Reprinted from the Journal of Portfolio Management, Winter 1992, pp. 7-19.
This copyrighted material has been reprinted with permission from The Journal of Portfolio Management. Copyright Institutional Investor, Inc., 488 Madison Avenue, New York, N.Y. 10022, a Capital Cities/ABC, Inc. Company. Phone (212) 224-3599.

It is widely agreed that asset allocation accounts for a large part of the variability in the return on a typical investor's portfolio. This is especially true if the overall portfolio is invested in multiple funds, each including a number of securities. Asset allocation is generally defined as the allocation of an investor's portfolio among a number of "major" asset classes. Clearly such a generalization cannot be made operational without defining such classes. Once a set of asset classes has been defined, it is important to determine the exposures of each component of an investor's overall portfolio to movements in their returns. Such information can be aggregated to determine the investor's overall effective asset mix. If it does not conform to the desired mix, appropriate alterations can then be made. Once a procedure for measuring exposures to variations in returns of major asset classes is in place, it is possible to determine how effectively individual fund managers have performed their functions and the extent (if any) to which value has been added through active management. Finally, the effectiveness of the investor's overall asset allocation can be compared with that of one or more benchmark asset mixes. An effective way to accomplish all these tasks is to use an asset class factor model. After describing the characteristics of such a model, we illustrate applications of a model with twelve asset classes to analyze the performance of a set of open-end mutual funds between 1985 and 1989.

ASSET CLASS FACTOR MODELS Factor models are common in investment analysis. Equation (1) is a generic representation:

Ri represents the return on asset i, Fi1represents the value of factor 1, Fi2 the value of factor 2, Fin the value of the n'th (last) factor and ei the "non-factor" component of the return on i. All these values are (potentially) unknown before-the-fact, as indicated by the tildes. The remaining values (bi1 through bin) represent the sensitivities of Ri to factors Fi1 through Fin.
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A key assumption makes a model of this sort more than simply an exercise in data description: The non-factor return for one asset (ei) is assumed to be uncorrelated with that of every other (e.g. ej). In effect, the factors are the only sources of correlation among returns. An asset class factor model can be considered a special case of the generic type. In such a model each factor represents the return on an asset class and the sensitivities (bij values) are required to sum to 1 (100%). In effect, the return on an asset i is represented as the return on a portfolio (shown by the sum of the terms in the bracketed expression) invested in the n asset classes plus a residual component (ei). For expository convenience, the sum of the terms in the brackets can be termed the return attributable to style and the residual component (ei) the return due to selection. Indeed, a key contribution of this approach is the separation of return into these two main components.

EVALUATING ASSET CLASS FACTOR MODELS The usefulness of an asset class factor model depends on the asset classes chosen for its implementation. While not strictly necessary, it is desirable that such asset classes be 1) mutually exclusive, 2) exhaustive and 3) have returns that "differ". Pragmatically, each should represent a market-capitalization weighted portfolio of securities; no security should be included in more than one asset class; as many securities as possible should be included in the chosen asset classe; and the asset class returns should either have low correlations with one another or, in cases in which correlations are high, different standard deviations. While the appropriate measure of the efficacy of any specific implementation depends on the uses to which the model is to be put, factor models are typically evaluated on the basis of their ability to explain the returns of the assets in question (i.e. the Ris). A useful metric is the proportion of variance "explained" by the selected asset classes. Using the traditional definition, for asset i:

The right-hand side of equation (2) equals 1 minus the proportion of variance "unexplained". The resulting R-squared value thus indicates the proportion of the variance of Ri "explained" by the n asset classes1. It is important to recognize that this measure indicates only the extent to which a specific model fits the data at hand. A better test of the usefulness of any implementation is its ability to explain performance out-of-sample. For this reason it is important to consider not only the ability of a model to explain a given set of data but also its parsimony. Other things equal (e.g. Rsquared values), the fewer the asset classes, the more likely is the model to represent continuing fundamental relationships with predictive content2. To evaluate the exposures of funds to changes in the returns of key asset classes, the appropriate measure is the collective ability of a set of such classes to explain the time-series variability in the returns on a typical fund (e.g. mutual fund or separately-managed institutional account). Note that this criterion differs from that often applied in evaluating factor models designed to describe specific portions of the overall capital market. For example, when constructing an equity factor model, one might consider the ability of the selected factors to explain the time-series variation in the returns of a typical stock. Most stock market models include factors representing returns on industry groups and/or economic sectors -- factors that account for much of the typical security's return. If most managers
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diversify across industries and economic sectors,however, inclusion of factors related to differences in industry and sector returns will add little if any explanatory power to a model designed to explain fund returns.

A TWELVE ASSET CLASS MODEL The model we use has twelve asset classes. The return of each is represented by a market capitalization weighted index of the returns on a large number of securities. For reasons that will become clear, it is important to note that each index represents a strategy that could be followed at low cost using an index fund. The composition of each index is specified in sufficient detail by its provider to enable an investor to track the returns with little error through a passive (index-like) investment strategy. Table 1 describes the twelve asset classes and the indices used for the associated return series. Most are widely used indexes that require no further description. The four less well-known are those employed to represent U.S. equity classes.

TABLE 1 Asset Classes Bills Cash-equivalents with less than 3 months to maturity Index: Salomon Brothers' 90-day Treasury bill index Intermediate-term Government Bonds Government bonds with less than 10 years to maturity Index: Lehman Brothers' Intermediate-term Government Bond Index Long-term Government Bonds Government bonds with more than 10 years to maturity Index: Lehman Brothers' Long-term Government Bond Index Corporate Bonds Corporate bonds with ratings of at least Baa by Moody's or BBB by Standard & Poor's Index: Lehman Brothers' Corporate Bond Index Mortgage-Related Securities Mortgage-backed and related securities Index: Lehman Brothers'Mortgage-Backed Securities Index Large-Capitalization Value Stocks Stocks in Standard and Poor's 500-stock index with high book-to-price ratios Index: Sharpe/BARRA Value Stock Index Large-Capitalization Growth Stocks Stocks in Standard and Poor's 500-stock index with low book-to-price ratios Index: Sharpe/BARRA Growth Stock Index
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Medium-Capitalization Stocks Stocks in the top 80% of capitalization in the U.S. equity universe after the exclusion of stocks in Standard and Poor's 500 stock index Index: Sharpe/BARRA Medium Capitalization Stock Index Small-Capitalization Stocks Stocks in the bottom 20% of capitalization in the U.S. equity universe after the exclusion of stocks in Standard and Poor's 500 stock index Index: Sharpe/BARRA Small Capitalization Stock Index Non-U.S. Bonds Bonds outside the U.S. and Canada Index: Salomon Brothers' Non-U.S. Government Bond Index European Stocks European and non-Japanese Pacific Basin stocks Index: FTA Euro-Pacific Ex Japan Index Japanese Stocks Japanese Stocks Index: FTA Japan Index

In effect, the institutional universe of U.S. equities has been divided into four mutually exclusve and exhaustive groups3. The first two represent a partition of the stocks in Standard and Poor's 500 stock index. Every six months the S&P500 stocks are ranked according to the ratio of the most recently published book value per share to a previous month-end price per share. A dividing line is drawn so that approximately half the total value of the 500 stocks is placed on either side. Stocks with high book-to-price ratios are placed in the "value" stock index; the remainder are in the "growth" stock index. A similar procedure is followed in constructing the medium capitalization and small capitalization stock indexes. NonS&P500 stocks are ranked on the basis of total outstanding market capitalization every six months, and a dividing line drawn so that approximately 80% of the total value is above the line and 20% below it. Most of the stocks in the first group are placed in the medium capitalization index and most of the remaining stocks in the small capitalization index. To avoid excessive turnover in the composition of these indexes of relatively illiquid stocks (and an associated high cost for index tracking), any stock that has recently "crossed over the line" a relatively small distance is allowed to remain in its former index4. Many of the differences in returns of U.S. equity mutual funds can be attributed to differences in their exposures to these four asset classes. In effect, there appear to be two key dimensions along which such funds differ. One may loosely be termed "value/growth"; the other "small/large". Figure 1 illustrates the composition of the four domestic equity asset classes. Each index can be considered a capitalization-weighted "center of gravity" of the securities in its associated class, as the dots in Figure 1 indicate. Note that any combination of the four indices with non-negative holdings can be represented by a point in the area defined by the index locations (in this case, a triangle)5. FIGURE 1

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COMPOSITION OF FOUR DOMESTIC EQUITY CLASSES

Much has been written about both the small-stock and the value/growth phenomena. While the terms "value" and "growth" reflect common usage in the investment profession, they serve only as convenient names for stocks that tend to be similar in several respects. As is well known, across securities there is significant positive correlation among: book/price, earnings/price, low earnings growth, dividend yield and low return on equity. Moreover, the industry compositions of the value and growth groups differ (e.g. companies with high research budgets tend to have low book values relative to their stock prices). Those concerned with these distinctions have focused most of their research on long-run average return differences; that is, they have asked whether small stocks or value stocks "do better than they should" in the long-run. Less attention has been paid to likely sources of short-run variability in returns among such groups. For present purposes it suffices that such variability is substantial. Figure 2 provides relevant evidence: The variability in returns across the four asset classes from year-to-year is far greater than would be encountered if groups with similar numbers of securities had been formed randomly. Fund exposures across these dimensions vary greatly. As a result, much of the variation in fund returns in any given period can be attributed to the combined effects of their exposures to these asset classes and the realized returns on those classes.

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DETERMINING FUND EXPOSURES The traditional view of asset allocation assumes that an investor allocates assets among (potentially many) funds, each of which holds (potentially many) securities. Ultimately one is interested in the investor's exposures to the key asset classes. These are a function of 1) the amounts of the investor's portfolio invested in the various funds and 2) the exposures of each such fund to the asset classes. The exposures of a fund to the various asset classes are, in turn, a function of 1) the amounts that the fund has invested in various securities and 2) the exposures of the securities to the asset classes. While it is possible to attempt to determine a fund's exposures from a detailed analysis of the securities held by the fund, a simpler approach typically provides more than enough information for purposes of asset allocation. Such a method uses only realized fund returns to infer the typical exposures of the fund to the asset classes. Since only easily obtained information is required, the approach may be considered "external", in comparison with methods that rely on information that may be available only from sources internal to the fund. Inspection of equation (1) immediately suggests a procedure that might be used in this connection. Given, say, sixty monthly returns on a fund, along with comparable returns for a selected set of asset classes, one could simply employ a multiple regression analysis with fund returns as the dependent variable and asset class returns as the independent variables. The resulting slope coefficients could then be intererpreted as the fund's historic exposures to the asset class returns. Table 2 provides an example for Trustees' Commingled U.S. Portfolio (an open-end mutual fund offered by the Vanguard Group). Monthly returns from January 1985 through Decenber 1989 are used for the dependent variable, with the corresponding returns for the twelve asset classes serving as independent variables. The column entitled "Unconstrained Regression" shows results obtained applying Equation (1). The first twelve rows show the resulting slope coefficients (bij values), expressed as percentages. The coefficient total is shown next, followed by the Rsquared value (also expressed as a percentage). A substantial portion (95.20%) of the monthly variance in the fund's returns is explained by this equation. The coefficients, however, do not sum to 100%. What is more important, several are vastly inconsistent with the fund's actual policy (to invest in common stocks with no short positions).

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Table 2 Regression and Quadratic Programming Results Trustees' Commingled Fund - U.S. Portfolio January 1985 through December 1989

Unconstrained Regression Bills Intermediate Bonds Long-term Bonds Corporate Bonds Mortgages Value Stocks Growth Stocks Medium Stocks Small Stocks Foreign Bonds European Stocks Japanese Stocks Total R-squared 14.69 -69.51 -2.54 16.57 5.19 109.52 -7.86 -41.83 45.65 -1.85 6.15 -1.46 72.71 95.20

Constrained Regression 42.65 -68.64 -2.38 15.29 4.58 110.35 -8.02 -43.62 47.17 -1.38 5.77 -1.79 100.00 95.16

Quadratic Programming 0 0 0 0 0 69.81 0 0 30.04 0 0.15 0 100.00 92.22

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The column in Table 2 titled "Constrained Regression" reports the results of a multiple regression analysis similar to the first, with one added constraint: The coefficients were required to sum to 100%. The reduction in R-squared was slight (from 95.20% to 95.16%), but the inconsistency between the coeffficients and the fund's investment policy remains. The last column in Table 2 reports the results of an analysis where each coefficient is constrained to lie between 0 and 100% and the sum is again required to be 100%. As in the previous cases, the objective of the analysis was to select a set of coefficients that minimizes the "unexplained" variation in returns (i.e., the variance of ei), subject to the stated constraints. An equivalently goal was to maximize the associated value of R-squared, subject to the stated constraints. For this analysis, the presence of inequality constraints ( 0<= bij<= 100% for each i ) required the use of a quadratic programming algorithm. The addition of constraints reflecting the fund's actual investment policy causes a slight reduction in the fit of the resulting equation to the data at hand (i.e., a decrease in R-squared to 92.22%). Now, however, the coefficients conform far more closely to the reality of the fund's investment style, making the resulting characterization more likely to provide meaningful results with out-of-sample data. As Table 2 shows, the analysis suggests that the fund traditionally invests so as to obtain returns similar to those achievable with a portfolio with roughly 70% invested in a market-representative portfolio of value stocks and 30% in a marketrepresentative portfolio of small stocks. During the period investigated, over 92% of the month-to-month variation in the return on the fund could be explained by the concurrent variation in the return on this particular mix of value and small stocks.

STYLE ANALYSIS The use of quadratic programming for the purpose of determining a fund's exposures to changes in the returns of major asset classes is termed style analysis (see Sharpe[1988]). The goal is to find the "best" set of asset class exposures (bij values) that totals to 100% and conforms with rudimentary information concerning the fund's policies (typically, no net short positions in any asset class; for funds known to employ short positions, other bounds may be invoked).. In this context, the best such set of exposures is the one for which the the variance of ei is the least. Rearranging Equation (1):

The term on the left can be interpreted as the difference between the return on the fund (the first term on the right) and that of a passive portfolio with the same style (shown by sum of the terms in the brackets). The goal of style analysis is to select the style (set of asset class exposures) that minimizes the variance of this difference. Such a difference can be termed the fund's "tracking error" and its variance the fund's "tracking variance". Note that the objective of such an analysis is not to minimize either the average value of this difference or the sum of the squared differences. Thus the method is not designed to find a style that "makes the fund look bad" (or good). Rather, the goal is to infer as much as possible about the fund's exposures to variations in the returns of the asset classes during the period studied. We have noted that a quadratic programming algorithm must be used for such an analysis. For an exact solution, one can implement Markowitz' critical line method1(see Markowitz [1987]). This study uses the simpler gradient method described in Sharpe [1987]. Although in principle the latter produces only an approximate solution, differences between the results

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obtained with the two methods prove to be of no practical importance in this application.

MUTUAL FUND STYLES Figure 3 provides a graphical summary of the results shown in the final column of Table 2. The bar chart indicates the estimated style of the fund, and the pie chart the associated R-squared value. In the latter the R-squared value is identified as attributable to the fund's style and the remainder (1 - R-squared) to selection.

It is important to note that the style identified in such an analysis is, in a sense, an average of potentially changing styles over the period covered. Month-to-month deviations of the fund's return from that of style itself can arise from selection of specific securities within one or more asset classes, rotation among asset classes, or both security selection and asset class rotation . For the sake of simplicity, we use the term selection to cover all such sources of tracking differences.
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It is sometimes helpful to examine the behavior of a manager's average exposures to asset classes over time. To do so, one can perform a series of style analyses, using a fixed number of months for each analysis through time. Figure 4 shows the results from such a study for Trustee's Commingled U.S. Fund.

The point at the far right of the diagram represents the style described when the sixty months ending in December 1989 are analyzed. This corresponds to the style shown in Figure 3. Every other point represents the results of an analysis using a different set of sixty monthly returns (note, however, that each such set has fifty-eight months in common with its predecessor). As Figure 4 shows, this fund's style appeared to remain quite constant throughout the period analyzed. Figures 5 and 6 show the results obtained when the same type of analysis was applied to the returns of Fidelity Magellan Fund -- a highly popular open-end common stock fund. As Figure 5 shows, its style differed considerably from that of Trustees' Commingled U.S. Fund, with emphasis on growth rather than value stocks and exposure to medium-capitalization stocks in addition to smaller ones. The pie chart in Figure 5 shows that the fund is considerably more diversified (and/or engaged in less rotation) than Trustees' Commingled U.S. Fund. During the period covered, over 97.3% of the monthly variation in Magellan returns could be attributed to the concurrent return on a passive portfolio with the style shown in the bar chart in Figure 5.

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Figure 6 suggests that the Magellan Fund progressively increased its emphasis on large growth stocks and decreased its exposure to small capitalization stocks during the 1980s. This is not surprising, as the fund grew to approximately $14 billion by the end of the period, making substantial investment in very small stocks increasingly difficult.

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MUTUAL FUND TYPES Figures 3 through 6 show results for two particular mutual funds. Here we provide a more representative view of the efficacy of the procedure, with style analysis performed for each of 395 funds using returns from January 1985 through December 1989. Averages are taken for both the styles and R-squared values of all funds classified as being of the same "type" by Jaye C. Jarrett & Company, Inc., the providers of the data used for this study. In all, seven such types are represented. The results are shown in Figures 7 through 13. Each figure should be interpreted as representative of the style (bar chart) and variance due to style (pie chart) of a "typical" fund of the type. A portfolio invested in all the funds of a particular type would typically have a much higher R-squared (percent of variance attributable to style) than is shown in the figure in question. Moreover, there is typically considerable variation in both style and R-squared values among the funds within each type group. Given these caveats, the analyses provide useful illustrations of some of the features of the style analysis method.
Utility Stock Fund

Figure 7 shows the results for a typical utility stock fund. Such funds (atypically) concentrate their holdings in one industry. As a result, style accounts for an unusally small part (although still 59.3%) of the variance in return. Although such funds hold common stocks, their returns behave more like a passive portfolio invested in both stocks and bonds. That is, utility revenues are "sticky" because to the regulatory process, causing shares of such companies to have features that are both stocklike and bond-like. The utility fundexample emphasizes the fact that style analysis provides measures that reflect how returns act, rather than a simplistic concept of what the portfolios include. Note, finally, all equity exposure is to value stocks, relflecting the high dividend yields typical of utility shares.

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Growth Equity Fund

Figure 8 portrays a typical growth equity fund. Here the most prominent exposure is, as expected, to growth stocks, although the typical fund of this type also responds to movements in the returns of other asset classes. Note the exposure to Bills, which probably results from the actual cash holdings that many such funds maintin to meet liquidity needs. Overall, the results illustrate the fact that few funds are "pure" in the sense of responding only to movements in returns of one asset class. The style analysis procedure can detect some of the subtleties that exist in practice, instead of classifying each fund by a single (pure) style. Finally, note that almost 90% of the monthly variation in return of the typical growth equity fund can be attributed to its style -- a result typical of common stock funds.

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Growth and Income Equity Fund

Figure 9 shows the characteristics of a typical growth and income equity fund. Here too, style accounts for approximately 90% of the monthly variation in returns. The effects of a liquidity reserve are probably at least partly responsible for the exposure to Bills, although choices of stocks with lower beta values than those in the asset class indexes could also play a role. Note the almost perfect balance between value and growth Stocks, relecting an "SP500-like" stance with respect to largecapitalization stocks. The exposures to small and medium stocks may reflect actual investment in such stocks and/or a preference for equal weighting rather than capitalization weighting within the large stock sector. In an important sense, the source of a set of exposures may not even need to be identified, as long as the exposures are representative of likely future results.

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Small Stock Fund

Figure 10 indicates that small stock funds do indeed buy small stocks (as defined by the asset class used for this study). However, they also appear to buy somewhat larger ones. Moreover, there tends to be an emphasis on growth rather than value. This may reflect the actual purchase of large-capitalization growth stocks by some funds. It may also indicate a preference for medium-capitalization stocks with growth characteristics. As Figure 1 suggests, a point lying to the right of the point rerpresentin the medium stock index can be represented by a combination of the large growth stock index, the small stock index and the medium stock index. As before, the goal is to represent the behavior of the fund, not its precise composition. Finally, note that the R-squared value is slightly lower (87.6%) than for the other diversified funds -- perhaps reflecting the lower liquidity of this sector of the equity market.

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Balanced Fund

Figure 11 shows that balanced funds are precisely that. While any single fund may diverge substantially from the style shown in the figure, collectively balanced funds provide results similar to those obtained by holding all U.S. asset classes and small amounts of foreign ones. As with other diversified funds, style accounts for roughly 90% of the monthly variation in the returns for the typical fund of this type.

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High-Quality Bond Fund

Figure 12 shows that the method works well for bond funds as well as for stock and balanced ones. The typical high-quality bond fund provides exposure to corporate bonds, government bonds and mortgage-related securities, with style accounting for slightly over 88% of monthly variance in return. In any given case, a mix of, e.g., intermediate government bonds and corporate bonds might reflect actual holdings or the average quality of the corporate bond portfolio. Thus a portfolio with a higher average quality than that reflected in the Corporate Bond Index typically acts more like a mixture of corporate bonds (defined by the index) and intermediate government bonds. Similarly, a portfolio of corporate bonds with a longer duration than that of the Corporate Bond index will "track" more closely with a mix of corporate bonds (defined by the index) and long-term Government bonds. As always behavior, not nomenclature, is relevant.

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Convertible Bond Fund

Figure 13 shows a case where an asset class not explicitly represented in a model can be represented well by the classes that are included. As shown, 88.8% of the monthly variation in returns of a typical convertible bond fund can be attributed to the concurrent variation in the returns of a mix of stocks, bills, and bonds. This is not too surprising. A convertible bond has characteristics of both bonds and stocks. Of course, as bond and stock markets diverge, the relative sensitivities of any given convertible bond to the two markets will change, giving such an instrument its distinctive non-linear characteristic. Interestingly, managers of convertible bond funds appear to have preferred habitats, causing them to buy and sell convertible bonds so as to maintain fairly consistent exposures to asset classes of the type utilized in this study.

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Fund Type Summary

As these examples show, a remarkable amount of information can be revealed from an analysis of the returns provided by the manager of an investment fund. This is especially gratifying since in the final analysis return is the product the investor buys from such a manager.

THE INVESTOR'S EFFECTIVE ASSET MIX Once the styles of an investor's funds have been estimated, it is a simple matter to determine the associated overall effective asset mix. Letting Wi represent the proportion of the investor's portfolio invested in fund i, overall portfolio return (Rp) will be:

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As both equations (1) and (4) are linear, substitution of the former in the latter will provide another linear equation:

or:

where the bpj values are the portfolio's exposures to the asset classes. As can be seen by comparing Equations (5) and (6), each bpj is simply a value-weighted average of the exposures of the component funds to the asset class in question, with the relative amounts invested in the funds used as weights. The resultant effective asset mix (specified by the values bp1, bp2, ...,bpn ) will account for a large portion of the month-tomonth variation in returns for the typical portfolio invested in many funds. Under the assumption that the residual ei terms are uncorrelated, diversification across funds will greatly reduce the variance of the final (non-factor) component and thus increase the portion of variance attributable to asset allocation. Even if some of the residuals are correlated, the use of multiple funds will typically lead to substantial reduction in selection risk. The effective asset mix represents the style of the investor's overall portfolio. For a multiple-managed portfolio, style is even more important than for an individual fund.

PERFORMANCE MEASUREMENT In a sense, a passive fund manager provide an investor with an investment style, while an active manager provides both style and selection. This statements can be used to define the terms "active" and "passive" management. Note that in this taxonomy, the precise implementation of an asset class factor model play a crucial role. This suggests that one may wish to select a set of asset classes so that only superior performance relative to a static mix of the chosen classes warrants the higher fees usually associated with "active" as opposed to "passive" management. This is the approach we take, focusing on a fund's selection return, defined as the difference between the fund's return and that of a passive mix with the same style. There are several desiderata associated with the selection of a benchmark for performance measurement. A benchmark portfolio should be 1) a viable alternative, 2) not easily beaten, 3) low in cost, and 4) identifiable before the fact. Style analysis provides a natural method for constructing benchmarks meeting these requirements. The return obtained by a fund in each month can be compared with the return on a mix of asset classes with the same estimated style, where the style is estimated prior to the month in question. Note that this differs from the use of the ei values obtained as byproducts of a style analysis, since the latter are in-sample, not out-of-sample values. To illustrate the approach for Trustees' Commingled U.S. and Fidelity's Magellan Funds, for each month t: 1. The fund's style is estimated, using returns from months t-60 through t-1.6

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2. The return on the resultant style is calculated for month t. 3. The difference between the fund's return in month t and that of the style benchmark determined in steps 1) and 2) is computed. This difference is defined as the fund's Selection Return for month t. Figure 14 shows the cumulative sum of the monthly selection returns from January 1986 through December 1989 for Trustees' Commingled U.S. Fund.7 In such a graph, increases result from positive selection returns and decreases from negative ones. .

Average Std Dev T(Avg)

-.06 % per month 1.69 % per month -0.25

The table below the graph in Figure 14 summarizes the results in a different manner. On average, the fund underperformed its style benchmarks by -0.06% (6 basis points) per month, with a standard deviation of 1.69% (169 basis points) per month. The t-statistic associated with the mean difference was, however, small in absolute value, suggesting that the average difference was not statistically significantly different from zero.8 Figure 15 emphasizes the advantages to be gained by analyzing performance the way we have described. It compares the
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return on Trustees' Commingled U.S. Fund with that of Standard & Poor's 500 stock index (commonly used to evaluate mutual fund performance). The fund's performance, so measured, was over three times as bad as that shown previously: the cumulative difference was -10% and the average difference -20 basis points per month. But such a comparison includes results due to both style and selection. During the period in question the fund's style underperformed that of the S&P500 (primarily because of its exposure to small stocks). Indeed, this accounts for approximately two-thirds of the fund's underperformance relative to the S&P500. An investor choosing Trustees' Commingled U.S. Fund could and should have known that its style favored value stocks and small stocks. The choice to expose some of the portfolio to these asset classes should be attributed to the investor. Results (good or bad) associated with such the choice of a style should be attributed to the investor, not to the manager of a fund following that style.

Average Std Dev T(Avg)

-.20 % per month 2.13 % per month -0.65

Figures 16 and 17 show the results of similar analyses for Fidelity Magellan Fund. As Figure 16 shows, the fund provided a positive but statistically insignificant outperformance when compared with the S&P500 over the period.
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But Figure 17 shows that such a comparison masked Magellan's truly outstanding selection performance. During this period, the fund outperformed its style benchmarks by a cumulative amount of over 25%. Outperformance averaged 57 basis points per month with a standard deviation of 105 basis points. The t-statistic of 3.76 shows that such differences were highly significant statistically. Two aspects account for the large t-value: the relatively large average return difference and the relatively small variation in the difference from month to month.9

Average Std Dev T(Avg)

0.18 % per month 1.48 % per month 0.84

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Average Std Dev T(Avg)

0.57% per month 1.05 % per month 3.76

MUTUAL FUND PERFORMANCE Fidelity Magellan's performance from 1985 through 1989 is far from typical. While only out-of-sample results can provide a definitive test of the collective performance of mutual funds, the average ei values obtained as a by-products from fund style analyses can provide at least some evidence on the matter. Figure 18 shows the distribution of the average tracking errors obtained from the style analyses of 636 stock, bond and balanced funds. Each value is the average ei value obtained from a style analysis using returns for one fund covering the period from January 1985 through December 1989. Note that the distribution is roughly normal, with a mean of -0.074 (-7.4 basis points per month). This is roughly consistent with the hypothesis that the average mutual fund cannot "beat the market" before costs, because such funds constitute a large (and presumably representative) part of the market. Annualized, the mean underperformance is approximately 0.89% per year -- an amount that, if anything, may be slightly less than the nontransaction costs incurred by a typical mutual fund.

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Average = -.074

MEASURING AN INVESTOR'S PERFORMANCE In the paradigm utilized in this article, an investor makes decisions that result in an effective asset mix and a set of selection returns. In a sense, the investor selects a set of (passive or active) managers and a specific allocation of funds among such managers. Given the managers' styles, this determines the investor's effective asset mix. The procedures described earlier can be applied directly to measure the efficacy with which the investor performs his or her functions. The performance of each month's effective asset mix can be compared with that of a predetermined benchmark asset mix to assess the value added or lost due to asset allocation decisions (advertent or inadvertent). The remainder of the investor's return is attributable to the joint effects of 1) the fund managers' selection returns, and 2) the investor's allocation of money among the managers. The investor selection return (Sp) is simply:

where the Si values are determined out-of-sample, using procedures such as those described earlier.

CONCLUSION
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An asset class factor model can help make order out of the chaos that often attends the investment process. It can provide a consistent view of investment decisions investors make to economize on information flows and exploit comparative advantages. The style analysis procedure described in this article allows such a model to be implemented economically. At the very least it can serve as a valuable supplement to other methods designed to help investors achieve their goals in costeffective ways.

This article is adapted from the O'Neil Abbot Distinguished Lecture given at the Darden School of the University of Virginia on October 2, 1990. The author thanks Robert O'Neil, Mark Eaker and the faculty of the Darden School for making the presentation possible. He also thanks Mark Friebel, Sharon Kitajima, Diana Lieberman, Anita Nanda, and Kathryn Sharpe, colleagues at William F. Sharpe Associates for their contributions.

When an equation such as (1) is fit by regression analysis, the same value will be obtained whether equation (2) is used or the proportion of variance explained is computed directly. This follows from the fact that the residual returns obtained from a regression analysis are guaranteed to be uncorrelated with each of the asset class returns. When quadratic programming is employed, it is possible that the residual returns will be correlated with the returns on one or more asset classes; hence the two procedures for computing R-squared may yield slightly different results. In practice such differences are typically insignificant. In the remainder of the paper equation (2) is utilized for all calculations.. If regression analysis is used to fit equation (1), conventional tests of statistical significance can also be invoked to evaluate the likely performance of the model out-of-sample. When quadratic programming is employed, the assumptions that lie behind such tests are violated, making true out-of-sample tests the only reliable means of evaluating the efficacy of the approach. More precisely, BARRA's all-U.S. universe.

3. 4.

That is, a security already placed in one class is not permitted to migrate to the other class unless it passes the capitalization requirement by 20% of the boundary value.
5. 6. 7.

More generally, the convex hull of the points. For a more operational procedure, returns for a period ending with month t-2 might be used.

No compounding is employed in Figure 14 (and the subsequent ones using similar portrayals). This makes it possible to compare vertical distances directly at any point in the figure. Because selection return represents the difference between the returns of two portfolios, compounding would not provide the difference in the cumulative values of the fund and the benchmark. This being said, it should be pointed out that since the logarithm of a monthly value relative will generally differ little from the corresponding monthly return, a graph in which compounded selection returns are shown on a logarithmic scale appears similar to one in which returns are summed and shown on an arithmetic scale, as in this article. The t-statistic is computed by dividing the average return difference by the standard error of the mean (here, the standard deviation of the return difference divided by the square root of 60).

8.

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9.

The t-statistic is closely related to the reward-to-variability Ratio (sometimes termed the Sharpe Ratio) for the "active" component of a fund's return, which is simply the mean value divided by the standard deviation.

REFERENCES Markowitz, Harry M. Mean-Variance Analyses in Portfolio Choice and Capital Markets. Oxford: Basil Blackwell, Inc. 1987. Sharpe, William F. "An Algorithm for Portfolio Improvement," in Kenneth D. Lawrence, John B. Guerard, Jr. and Gary D. Reeves, eds. Advances in Mathematical Programming and Financial Planning, Vol. 1, pp. 155-170. Greenwich: JAI Press, Inc., 1987. ---------. "Determining a Fund's Effective Asset Mix," Investment Management Review, December 1988, pp. 59-69.

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Sharpe Interview on Style Analysis

Setting the Record Straight on Style Analysis


A Newsmaker Interview by Barry Vinocur
Reprinted with permission from Dow-Jones Fee Advisor

Few subjects are more timelyor controversialthan mutual fund style analysis. And no person figures more centrally in any discussion of style analysis than Stanford University's William F. Sharpe.

Though best known for his work on the capital asset pricing modelfor which he along with Harry Markowitz and Merton Miller were awarded the Nobel Prize in Economics in 1990Sharpe is also credited with developing mutual fund style analysis. His 1988 paper, "Determining a Fund's Effective
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Asset Mix" is considered must reading for anyone with even a passing interest in style analysis. Unlike some of his technique's critics, however, Sharpe refuses to make style analysis into a "holy war." As he told us recently, style analysis generally, and returns-based style analysis (the technique Sharpe uses), specifically, is a very powerful and useful tool. However, Sharpe stresses he wouldn't suggest investing in a fund based solely on style analysis. "Before I'd invest in a fund I would want to have read the Morningstar material and whatever else I could find, including the prospectus." What role should "style analysis" play in the selection (and monitoring) of investment managers? How should you use style analysis? What are the technique's strengths and limitations? For the answers to those, as well as long list of other questions, we again went straight to the source (see Investment Advisor, October 1994, page 83) and spoke with Sharpe. FA: Most discussions of "style analysis" begin with someone mentioning the Brinson, Singer and Beebower study. As I recall, they analyzed the performance of 82 large, multiasset U.S. pension fund portfolios from 1977 to 1987. Simply stated, they found asset allocation decisions accounted for 91.5% of the portfolios' performance. Sharpe: What that study said is if you put enough securitiesin this case mutual funds or investment managers togetheryou're going to get something that's responsive to basic market factors. In other words, there isn't a lot that's going to impact the portfolio but what's going on in those basic factors. In my practice with pension fundsusing returns-base style analysis for every single manager in a very mechanistic way, asset allocation plays an even more central role than it did in the Brinson and Beebower study. Brinson's and Beebower's factors were just really stocks, bonds and cash. But when I break it down and bring in value and growth stocks, asset allocation accounts for 98% or more of the return. Those are really profound numbers. Of course,every now and then there may be one that's 97%. FA: A lot of people use the term factor analysis interchangeably with style analysis. You make a distinction between the two. Sharpe: Factor analysis is a bad term because factor analysis is a particular way of estimating a factor model. And it's a way that most people don't use in this domain. Factor analysis is just one way of estimating a factor model and it isn't the method I use. So, let's replace factor analysis with a factor model. What is a factor model? A factor model says the fund's return is related typically linearlyto the return on this factor and the return on that factor and the return on the other factor, etc. And there are a lot of those models. The kind we're talking about here and again everybody is talking about the same thing up to this pointis what I call an asset class factor model, where the factors are the returns on asset classes. FA: Sounds pretty tame so far. Why all the fireworks?
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Sharpe: All of these methods are methods of estimating or writing numbers down for a factor model. The two things you have to do in such a procedure is that you have to first figure out what the factors are and then you have to figure out how sensitive each fund is to each of the factors. And we're all doing that. Where you start parting company is the way you do that. As far as picking the asset classes, that's an art form and we all do it. Some of us use the same asset classes but different methods. Where the methods part company is once you have picked the asset classes figuring out how sensitive a fund is to moves in each of those asset classes. One method, which I call just plain style analysis but which people are calling to differentiate it returnsbased style analysis, looks at the way the fund's returns moved in the past with the returns of the asset classes and uses that along with some minimal prior informationsuch as the fund didn't hold any short positionsto estimate the fund's effective asset mix or style. All the style is is exposure. If I say your style is 60% growth and 40% value that means you'll move 0.6 times whatever happens to growth stocks plus 0.4 times whatever happens to value stocks. Reduced to its bare essentials that's returns-based style analysis. FA: The view from the opposing camp would be? Sharpe: Everybody has to have some kind of a model. The major part of the opposing camp says it's not a good idea to look at the bottom line numbers the way returns-based style analysis does. That camp says you should look under the hood and see what's in the portfolio. That's fine. But if you do that you have to have a way of estimating the exposure of everyuthing in the portfolio to the asset classes so you can add them up. So you're not absolved from having to estimate a factor model. You now have to estimate a factor model for every single security so that you can aggregate and get the portfolio exposure. You can do that the way BARRA does with very complex factor modelsin which each security can be exposed to many factors or you can do it much more simplistically by assuming that each security is exposed to one and only one factor. So, its sensitivity to growth is 1.0 and its exposure to value is zero and everything else is zero. That's a very simple kind of model at the security level and, of course, makes it easy to add up. There are two problems with that approach. One is that it's very hard to estimate at the security level if you're going to deal with any subtleties because there's so much noise in what happens to a particular security. Whereas with a portfolio a lot of that noise is canceled out and you get a better view of the aggregate. FA: And the other problem...?
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Sharpe Interview on Style Analysis

Sharpe: The other issue is that if you limit yourself to sort of a zero vs. one view of the world each security is in one and only one asset classyou may just throw out a lot of reality As a practical matter most of tile security-by-security models do not cut across asset classes in the large. So, for example, you typically don't capture the sensitivity of a utility stock to interest rates because you say it's a stock. Or you use a stock model and the stock model doesn't have interest rates in it. FA: What about the argument that returns-based style analysis is always backward looking? Sharpe: That's another issue. One which shouldn't cause you to choose between one method or the other. However you perform style analysisthat is whether you pursue returns-based style analysis or what I'd call portfolio-based or composition-based, style analysis, you have to decide whether you want to know what the sensitivity of the portfolio is as it exists this very day to the various asset classes. Or, do you want to have some notion of what it was on average over some historic period. For some questions you can answer one way and for other questions you can answer the other way. If what you're trying to do is benchmark a manager for the next five years presumably you want some sort of an estimate of where he'll be on average over the next five years and that may be better reflected in the five year historic average of where he was than where he is this very day. For example, he may have rotated opportunistically and may very likely rotate out tomorrow. On the other hand, if he has made a once and for all shifthe's found religion and he's decided that value stocks are it and he'll never own a growth stock again even though he used tothen, obviously, you're going to want yesterday's portfolio. FA: Is one method "better" than the other? Sharpe: If you look at the portfolios composition and you look at it every month for some poor style rotator you're going to track him really well. But that's not the way you want to benchmark him. Because a benchmark shouldn't rely on information that the manager gives you. Rather the benchmark should reflect how you would do if you didn't have the manager. So you have to ask what am I doing this for? By and large what you're doing it for is performance analysis. You're doing it to figure out what benchmark you want to set. You're doing it after the fact to see if the benchmark you set was a reasonable benchmark. So, decide what question you're asking. Then, you can figure out how you want to approach it and what measure you want to use? FA: Do you use both methods? Sharpe: No, because I don t believe in simple taxonomya stock is a stock is a stock. I think that's too crude. And I don't have detail rich models security-by-security data. So, if I wanted to use a composition-based method, I couldn't. But I don't feel any need to use it for what I do. FA: Are there circumstances in which people should prefer composition-based style analysis?
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Sharpe Interview on Style Analysis

Sharpe: It's only as good as the security model that you're using. You have to have a model at the security level if you're going to use that. Often times, people have a model that's so implicit they don't realize it is a model. The Morningstar model is you re in this box, that box or another box. But that's a model. It's a model in which each security gets assigned to one of nine boxesif you include bonds and stocks they actually have 18 boxes. Each security gets assigned a one for one box as exposure and a zero for the other 17. That's a model. It's a factor model. And they use it appropriately, I'm sure. Is it a good model? Is there a better model? That's an empirical issue. FA: It seems a limitation of that approach is that it doesn't leave room for shades of gray. A stock is either large cap growth or large cap value, or whatever. Sharpe: That's right. Plus, you can really get fooled if you follow that approach. Let's take a fund that I know well because I'm on the board of directors Smith Breeden Market Tracking Fund. On the surface. it looks as if the fund has a lot of bonds. But there's this "funny" little swap in there. "But, hey, it's only worth three percent. And when the fund bought it, it was worth nothing." You might conclude it's a bond fund. That wouldn't be correct, however. FA: Morningstar's Don Phillips says he isn't worried about you, but about the popularizers of the technique who refer to "style analysis" with such catchy phrases as x-raying a portfolio. Sharpe: There are powerful commercial forces at work here. And almost everybody who has a commercial interest in one or the other technique is going to overstate the merits of his technique and underestimate the merits of the opposing technique. In a world of infinite resources, I'd say do it all. You cannot help but be better off with more information rather than less. But there's a huge disparity in the cost. Composition-based analysis is just a lot more costly. What often gets lost, however: is that the composition-based, or portfolio-based, methods are only as good as their security models. Every security has to be assigned a sensitivity to the asset class. It's basically a noise issue. So much impacts the price of a security that it's very hard to tell whether a security is reacting to the growth stocks or the value stocks or something else. However, if you put 20 securities in a portfolio that noise tends to average out and you get a much clearer view of the portfolio's sensitivity to the factors. FA: Which technique is better as an early-warning sign of a shift in style by a portfolio manager? Sharpe:Returns-based analysis using historic returns clearly is going to take a while to pick up major changes. There's no question about that. So, if there's a major change, you'll see it a lot quicker if you re looking at the portfolio.

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Sharpe Interview on Style Analysis

The next issue is whether its a permanent change. To determine that today, you'll have to talk to that portfolio manager. But in cases in which you're in touch with the manager and you have the resources and it's important enough, yes look at the portfolio. But even then, I might well prefer rather than using a very crude securities model to take that portfolioand I've done that a couple of timesand compute the portfolio's historic returns as it now exists. That may give you a better view of what that portfolio really is. FA: When you do returns-based style analysis you use monthly returns. Is there a case to be made for looking at returns daily or weekly? Sharpe: The problem with daily retunns is you're getting more and more noise. There's a problem here with noise and the more noise you get the poorer your estimates are. I use monthly data because it's what's most readily available and it works so well with most of the kinds of managers and funds that I look at. But I have talked to people who have had good luck with weekly data. FA: Critics of returns-based analysis love to tell stories about how Bill Sharpe analyzes a portfolio and says it contains this or that and then when you lift the hood, 'lo and behold, there aren't any bonds, or whatever. Sharpe: What you're talking ahout here is predominantly risk. It's not so much a matter of how the manager did on average over the seven years but how he did in months when there was a disparity in returns. If you have a security that says on it stock right up there at the top in nice Gothic lettering but it seems to go down whenever bonds go down, there's good reason to suspect there's something about the economics of the company or the way the instrument is written that makes it sensitive to interest rates. And if you happen to not want any more sensitivity to interest rates in terms of the risk you're taking, you better not buy that security. FA: What are the limitations of returns-based style analysis Sharpe: If you run into people with very concentrated portfolios. its very difficult to figure out what the core is. Say it's a sector fund, which won't work very well at all except utilities which happen to be fairly homogeneous and the analysis picks up the interest-rate sensitivity. But, if you have a chemical fund or something of that sort, you're going to get so much noise that if something good happens to that sector in a month when U.S. stocks are flat and Japanese stocks soar, the analysis is going to say you have a portfolio with some Japanese stocks in it. You can get that kind of spurious behavior. But, in practice, it's amazing how little of it you see. FA: How do you see "style analysis" changing the role of financial advisors? Sharpe: It has already had a pretty big impact on traditional institutional consulting. Traditional
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Sharpe Interview on Style Analysis

consultants charge a lot of money for saying: " I know those guys down at this or that finm, they manage bonds. And they manage long bonds and they do it well." Well, you don't have to pay a consultant $250,000 per year to do that for you. What we're talking about is figuring out which investment products mutual funds and such will implement a particularly good asset allocation for the client. To do that, the financial advisor has to talk to the client and educate the client understand the client to figure out what asset allocation makes sense, including changes through time. Then the advisor has to implement it. What this technique does is give you a very efficient tool to help you in that process. It's not the only tool. And if you have other tools, you should use them. But this is a very efficient tool for performance analysis and reporting. So. I see this technique as increasing the efficiency and lowering the cost of an important part of what afinancial advisor does. But it's by no means the only thing an advisor does. FA: What role should "style analysis" play in choosing managers or retaining managers? Sharpe: I would never suggest investing in a mutual fund based solely on style analysis. Before I'd invest in a fund I would want to have read the Morningstar material and whatever else I could find. including the prospectus. I would never say that style analysis is enough. Maybe it's enough to help you pick some funds that you want to look at more carefully. But once you look at style analysis and you decide that a fund is interesting to you, then you go further. FA: How should financial advisors make use of this technique? Sharpe : What I tell my students is that you work, to begin with, on the asset allocation. Then you have to figure out a suite of investment products that give you that allocation and then if you're so inclined will hopefully add some value through active management. To do that you have to know which product gives you exposure to which asset classes and how much. You have to estimate it as best you can. The simple way of saying "hey he's a value manager or a growth manager" is a little bit too crude. Even if he's a value manager maybe he's a value manager with cash or without cash. You need to know that. You need to have some sort of system that adds it all up. FA: Product vendors like to mention your name, though I have to say that no one I have run into comes right out and says: "Sharpe endorses our product." But you have already acknowledged that there are powerful commercial forces at work in this arena. So, whose product do you use? Sharpe : I have been very careful. I have spoken at the BARRA conference, the Ibbotson conference and the Zephyr conference. I'm an equal opportunity speaker and those are the three major vendors at this
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Sharpe Interview on Style Analysis

point as I see it. I have no financial stake in any of them. They all give me software and/or databases for my research for which I am very grateful. For all of my regular work, however, I use various pieces of my own software . FA: Some folks, including Morningstar's Don Philips, say they're concerned that "style analysis" may be misused. Sharpe: It's amazing how people can misuse even the simplest tool. On the other hand, that shouldn't be taken as an argument against using a technique that has a great deal of value. FA: Thanks, Bill.

Dow-Jones Fee Advisor


Editorial Director and Publisher BARRY VINOCUR (908) 389-8700 ext. 114 CompuServe 75054,1777 Internet: bvinocur@ix.netcom.com America Online: BVinocur

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Macro-Investment Analysis

Equilibrium
q

Equilibrium -- preliminary

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Equilibrium (preliminary)

Equilibrium (preliminary)
Note: This page provides formulas and some implications associated with mean-variance equilibrium. It is highly preliminary and may contain errors. In time, any errors will be corrected and the explanations expanded, especially those concerning the economics of the results and their practical implications.

The Optimality Condition with No Bounds


As before, we use the three-asset example for simplicity. correlations (cc): cash 1.00 0.40 0.15 bonds 0.40 1.00 0.35 stocks 0.15 0.35 1.00

cash bonds stocks

standard deviations (sd): sd 1.00 7.40 15.40

cash bonds stocks covariances (C):

cash bonds stocks

cash 1.000 2.960 2.310

bonds 2.960 54.760 39.886

stocks 2.310 39.886 237.160

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Equilibrium (preliminary)

expected returns (e): e 2.80 6.30 10.80

cash bonds stocks

Assume that portfolio x is optimal for risk tolerance t. Moreover, assume that each position in x is within any relevant bounds (that is, that no bounds are binding). For example, here the optimal portfolio (x) for a risk tolerance (t) of 25 is: portfolio (x): x 0.0671 0.6021 0.3308

cash bonds stocks

We know from the conditions for optimality that for this portfolio, the marginal utility of each asset must be the same. Let z represent this common marginal utility.. For reasons that will become clear, we express utility and marginal utility in variance-equivalent terms: u = t*ep - vp mu(i) = t* dep/dx(i) - dvp/dx(i) We know that: mu(i) = t*e(i) - 2*C(i,:)*x But optimality requires that this equal z. Hence for each asset i: t*e(i) - 2*C(i,:)*x = z Moreover, for portfolio x to be a portfolio, the sum of its components must equal 1: sum(x) = 1 or: x'*ones(n,1) = 1
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where n is the number of assets We can combine all these conditions in one matrix equation, which will prove useful in a number of contexts. First, we write all n of the first order conditions as: t*e - 2*C*x = z*ones(n,1) and re-arrange to give: 2*C*x + ones(n,1)*z = t*e To this we will add the full investment constraint: x'*ones(n,1) = 1 Define an {(n+1)*1} vector that includes the portfolio composition (x(1), x(2), ... x(n)) and z: xx = [x ; z] This allows us to "stack" all the conditions to give: CC*xx = kk + t*ee where: CC = [ 2*C ones(n,1) ; ones(1,n) 0] kk = [zeros(n,1); 1] ee = [e ; 0] In our case: CC: 2.0000 5.9200 4.6200 1.0000 5.9200 109.5200 79.7720 1.0000 4.6200 79.7720 474.3200 1.0000 1.0000 1.0000 1.0000 0

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Equilibrium (preliminary)

kk: 0 0 0 1 ee: 2.80 6.30 10.80 0

Finding an optimal portfolio with no bounds


It is straightforward to find an optimal portfolio if no upper and lower bounds are present or if any such bounds can be assumed to not be binding. Recall the conditions for optimality: CC*xx = kk + t*ee Multiplying both sides by the inverse of CC gives: inv(CC)*CC*xx = inv(CC)*kk + t*inv(CC)*ee or: xx = inv(CC)*kk + t*inv(CC)*ee Now, let: zp = inv(CC)*kk and rtswap = inv(CC)*ee

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Equilibrium (preliminary)

Then: xx = zp + t*rtswap In our example: zp: zp 1.0392 -0.0396 0.0004 -1.8458

cash bonds stocks z rtswap:

cash bonds stocks z

rtswap -0.0389 0.0257 0.0132 2.6648

Note that the asset positions in zp sum to 1.0. This must be the case since the final element in kk is 1.0 and the final row in CC has ones in every asset position. The effect is to require that the sum of the resulting holdings equals 1.0. Thus zp will always represent a true portfolio -- that is, holdings that sum to 1.0. In contrast, note that the asset positions in rtswap sum to 0.0. This must be the case since the final element in ee is 0.0. Since the final row in CC contains ones in every asset position, the effect is to require that the sum of the resulting holdings equals 0.0. Thus rtswap will always represent a zeroinvestment strategy, or swap. Consider now the optimal portfolio for an investor with zero tolerance for risk: xx = zp + 0*rtswap Thus zp is the optimal portfolio for an investor with no tolerance for risk. It must therefore be the minimum-variance portfolio. Now consider the investor with a risk tolerance of 25. The optimum portfolio is: xx = zp + 25*rtswap
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Equilibrium (preliminary)

or: 0.0671 0.6021 0.3308 64.7731 1.0392 -0.0396 0.0004 -1.8458 -0.9721 0.6418 0.3303 66.6189

In effect, the investor takes 25 units of the rtswap. This, added to the initial portfolio, gives net holdings with relatively little cash, a substantial bond position and a smaller but still significant stock position.

Two-fund separation
Returning to the equation for an optimal portfolio: xx = zp + t*rtswap It is clear that every investor can be accommodated if there are two instruments in the world: a portfolio (zp) and a swap (rtswap). Moreover, the magnitude of the latter that an investor should take is proportional to his or her risk tolerance. Optimal holdings are thus linear functions of risk tolerance. In fact, all investors can be accommodated by any two optimal portfolios. For example, consider xxa and xxb, which are optimal for risk tolerances of ta and tb, respectively: xxa = zp + ta*rtswap xxb = zp + tb*rtswap Now, consider an investor with risk tolerance t. Assume that she invests pa in portfolio xxa and pb (=1pa) in portfolio xxb. The resulting portfolio xx will be: xx = pa*xxa + (1-pa)*xxb = zp + (pa*ta + (1-pa)*tb) * rtswap This will in fact be optimal if: t = pa*ta + (1-pa)*tb or:

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Equilibrium (preliminary)

pa = (t - tb) / (ta - tb) As long as short positions are allowed (as is assumed here), any investor can choose any mix of portfolios xxa and xxb and be assured of optimality. Moreover, this will be the case as long as xxa and xxb are optimal for some levels of risk tolerance (i.e. are on the efficient frontier). This relationship is termed the two-fund separation theorem since it allows the choice problem to be separated into (1) the selection of two efficient funds and (2) the selection of the appropriate combination of such funds for each investor.

Expected Return and Beta Values


The first-order conditions for the optimality of portfolio x for an investor with risk tolerance i requires that the following hold for every asset i: t*e(i) - 2*C(i,:)*x = z The second term is equivalent to the covariance of asset i with portfolio x. We may thus write: t*e(i) - 2*Cix = z Re-arranging: e(i) = z/t + 2*Cix/t Note that this means that the values of e(i) will plot on a straight line in a graph in which e(i) is plotted on the vertical axis and Cix is plotted on the horizontal axis. Moreover, the vertical intercept will equal z/t and the slope will equal 2/t (and the latter will be positive, so the line will be upward-sloping). Thus the higher the covariance with the optimal portfolio, the higher will be the expected return. Since this is true for every asset i, it must also be true for every combination of assets, including portfolio x. Thus: ex = z/t + 2*Cxx/t But Cxx is the variance of x (Vx), so: ex = z/t + 2*Vx/t

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We may combine this with the equation for a single asset to obtain: ( e(i) - z/t ) / ( ex - z/t) = ( 2*Cix/t ) / ( 2*Vx/t) Simplifying gives: e(i) = z/t + ( ex - z/t ) * (Cix / Vx) From regression theory, we can interpret Cix/Vx (the scaled covariance of asset i with the optimal portfolio x) as the beta value of i relative to x. Thus: e(i) = z/t + ( ex - z/t) * Bix This implies that there is a linear relationship between asset expected returns and their beta values with respect to the optimal portfolio. Note that this is a direct implication of the assumption that x is an optimal portfolio (and the lack of binding upper or lower bound constraints).

The Market Portfolio and the Security Market Line


Now consider a world in which all investors solve the problem formulated here but differ in both risk tolerance and wealth. Let there be m investors, with w(j) the relative wealth of investor j. Let ww be the {m*1} vector of these relative wealths (summing to 1.0). Similarly, let t(j) be investor j's risk tolerance and tt the {m*1} vector of all such risk tolerances. For our example let there be 2 investors (Dick and Jane) with: tt: tt 10 25

Dick Jane ww:

Dick Jane

ww 0.30 0.70

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Equilibrium (preliminary)

We may represent all the optimal portfolios in an {n*m} matrix XX in which the j'th column contains the optimal portfolio for investor j. Here: XX = zp*ones(1,m) + rtswap*tt' Dick 0.6504 0.2171 0.1326 24.8018 Jane 0.0671 0.6021 0.3308 64.7731

cash bonds stocks z

Now consider xxm, the wealth-weighted average of the investors' portfolios: xxm = XX*ww This can be termed the market portfolio, since it contains all assets, in market-weighted proportions. Here: xm 0.2421 0.4866 0.2713 52.7817

Cash Bonds Stocks z

Note that the last two equations can be combined to give: xxm = zp*ones(1,m)*ww + rtswap*tt'*ww Rearranging: xxm = zp*[ones(1,m)*ww] + rtswap*[tt'*ww] The first expression in square brackets equals 1.0. And the second expression is simply a wealthweighted average of the investors' risk tolerances. Define the latter as: tm = tt'*ww Then: xm = zp + tm*rtswap

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Equilibrium (preliminary)

This indicates that the market portfolio is optimal for an investor with a risk tolerance equal to the wealthweighted average investor risk tolerance (perhaps better termed the "societal risk tolerance"). Given this optimality it immediately follows that: e(i) = z/tm + (em - z/tm) * Bim where z is the value of z for an investor with risk tolerance tm. If there is a riskless asset, z/tm will equal its return. We thus obtain the formula for the original CAPM: e(i) = rf + (em - rf) * Bim In the absence of a riskless asset, z/tm can be interpreted as the expected return on a zero-beta asset. Note that the slope of the resulting Security Market Line will equal the market risk premium and will generally be positive. It is useful to compare an Investor's optimal strategy with that of an Investor who is average in every respect (here, t = tm). We know that the latter will hold the market portfolio. Thus: xm = zp + tm*rtswap x = zp + t*rtswap x - xm = (t - tm) * rtswap or: x = xm + (t - tm) * rtswap Thus an Investor's optimal portfolio will differ from the market portfolio by rtswap times the difference between the Investor's risk tolerance and that of the market (society). We can think of rtswap as the "tilt" away from the market per unit of difference between the investor's risk tolerance and that of the market. In this view, the two vectors that provide two-fund separation are the market portfolio and the swap given by vector rtswap.

Reverse Optimization
Recall the conditions for optimality of a portfolio x for an investor with risk tolerance t if no bounds are relevant. For each asset i:
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t*e(i) - 2*C(i,:)*x = z Now, assume that the values of all covariances are known and that x can be assumed to be optimal for some investor, but that the risk tolerance of that investor is not known. Moreover, assume that the expected returns of two of the assets has been predicted, but the others have not. In our example, assume that the expected real return on Cash (asset 1) is 3.0% and the expected real return on Stocks (asset 3) is 8.0%. Then: t*e(1) - 2*C(1,:)*x = z t*e(3) - 2*C(3,:)*x = z where t and z are unknown variables and all other values are specified. This is a system of two linear equations with two unknowns and hence can be solved simply. For example: t*e(1) - 2*C(1,:)*x = t*e(3) - 2*C(3,:)*x or: t = ( 2*(C(1,:) - C(3,:))*x ) / ( e(1) - e(3)) In this case: t = 40.0038 Substituting in the first of the two equations: z = t*e(1) - 2*C(1,:)*x Here z = 114.7844 We now know the values of t and z for which portfolio x is optimal. But from the conditions of optimality we also know what all the remaining asset expected returns must be. Recall that: t*e(i) - 2*C(i,:)*x = z
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or: e(i) = ( z + 2*C(i,:)*x ) / t In this case there is only one remaining expected return, that of Bonds (asset 2). Its expected return will be: e(2) = ( z + 2*C(2,:)*x ) / t Here: e(2) = 5.1873 We are thus able to infer the vector of expected returns from the assumptions that (1) covariances are known, (2) an efficient portfolio is known, and (3) two expected returns are known. This process is is sometimes termed reverse optimization. Given the difficulty associated with predicting expected returns, it can be a powerful tool to insure that optimizations give sensible answers. If, for example, the market portfolio is used in this procedure, the results will be those implied by the capital asset pricing model. The reverse optimization worksheet uses this approach. Inputs may be pasted in directly from the output of the weighted covariance worksheet. The output of the reverse optimization worksheet may, in turn, be pasted directly into the optimization worksheet.

Additional Sources of Utility


Thus far we have assumed that Investor utility functions included only expected return and variance, that is: u = ep - vp / t But at least some Investors may care about other attributes of a portfolio. Of particular interest are attributes for which the portfolio attribute is a linear combination of the attributes of individual assets. For our example, assume that the liquidity of each asset can be specified and that a portfolio's liquidity is a value-weighted average of the liquidities of the individual assets. For example, assume that the asset expected returns are:

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Equilibrium (preliminary)

Cash Bonds Stocks

e 3.00 5.00 8.00

and the liquidity measures (denoted a for "attribute") are: a 1.00 0.50 0.20

Cash Bonds Stocks

Then the liquidity of portfolio x will be: ap = x'*a As with e, we can make a new vector with these attributes plus a zero: aa = [a ; 0] An Investor's utility will be assumed to depend on three characteristics of the portfolio. In particular, let at be an Investor's liquidity preference -- his or her marginal rate of substitution of variance for liquidity. The more an Investor prefers to have liquidity, the greater the amount of added variance he or she will accept to obtain added liquidity. Thus for an Investor unconcerned with liquidity, at=0. For one very concerned with liquidity, at will be large, and so on. We can now write the Investor's utility function as: u = t*ep + at*ap - vp The first-order conditions for portfolio optimality then become: mu(i) = t*e(i) + at*a(i) - 2*C(i,:)*x = z Combining all these first-order conditions gives: t*e + at*a - 2*C*x = z*ones(n,1) Re-arranging: (for all i)

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2*C*x + ones(n,1)*z = t*e + at*a Finally, adding the full investment constraint gives: CC*xx = kk + at*aa + t*ee where: CC = [ 2*C ones(n,1) ; ones(1,n) 0] kk = [zeros(n,1); 1] aa = [a; 0] ee = [e ; 0] To find the optimal portfolio for an Investor with liquidity preference at and risk tolerance t, we can simply solve: xx = inv(CC)*kk + at*inv(CC)*aa + t*inv(CC)*ee or: xx = zp + at*atswap + t*rtswap where zp and rtswap are as defined earlier, and: atswap = inv(CC)*aa Here: atswap 0.0053 -0.0043 -0.0011 1.0195

Cash Bonds Stocks z

We call this vector a swap because the asset positions must sum to zero due to the zero in the last position of aa. Moreover, the amount of adjustment in the overall portfolio should equal this vector times the Investor's liquidity preference. Hence the name atswap (here - liquidity preference swap). Note that the more an Investor prefers liquidity, the larger the cash position and the smaller the bond and stock
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Equilibrium (preliminary)

positions. In this case, zp is now the optimal portfolio for an Investor with zero risk tolerance and zero liquidity preference. Let att be the vector of Investor liquidity preferences. Here: at 0.00 0.20

Dick Jane

By summing over all Investors as before we have: xm = zp + atm*atswap + tm*rtswap where atm is the weighted average liquidity preference: atm = ww'*att Here: atm = 0.1400 In this case the optimal portfolios for the investors are: XX = zp*ones(1,m) + atswap*att' + rtswap*tt' or: Dick 0.6504 0.2171 0.1326 24.8018 Jane 0.0682 0.6013 0.3305 64.9770

Cash Bonds Stocks z and: xm = XX*ww or:

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Equilibrium (preliminary)

Cash Bonds Stocks z

xm 0.2428 0.4860 0.2711 52.9244

As before, it is useful to compare an Investor's optimal strategy with that of an Investor who is average in every respect (here, t = tm and at = atm). We know that the latter will hold the market portfolio. Thus: xm = zp + atm*atswap + tm*rtswap x = zp + at*atswap + t*rtswap x - xm = (at-atm)*atswap + (t-tm)*rtswap or: x = xm + (at-atm)*atswap + (t-tm)*rtswap Thus an Investor's optimal portfolio will differ from the market portfolio by atswap times the difference between the Investor's liquidity preference and that of the market (society). plus rtswap times the difference between the Investor's risk tolerance and that of the market (society) As before, we can think of rtswap as the "tilt" away from the market per unit of difference between the investor's risk tolerance and that of the market. And here, atswap is the "tilt" away from the market per unit of difference between the Investor's liquidity preference and that of the market. Note that in this case, three funds (and/or swaps) will be required to span the space of optimal portfolios (thus -- three-fund separation). One alternative would be to employ these three vectors: the market portfolio, the swap given by atswap, and the swap given by rtswap.

Liability Hedging
Finally, consider Investors who are concerned not with asset risk and return but with the risk and return of the difference between asset return and that of some liability (for example, pension obligations). For example, let the Investor's utility function depend on the expected surplus and standard deviation of surplus, where surplus is defined as: s = ra - h*rl

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Equilibrium (preliminary)

where ra is the return on assets, rl is the return on liabilities, and h is a constant. The expected surplus es will be: es = ea - h*erl where ea is the expected return on the assets and erl is the expected return on the liabilities. The variance of the surplus vs will be: vs = va - 2*h*cal + (h^2)*vl where va is the variance of the asset return, cal is the covariance of the asset and liability returns, and vl is the variance of the liability return. In variance-equivalent terms, the utility function can be written as: u = t*ex - vs or: u = t*(ea - h*erl) - (va - 2*h*cal + (h^2)*vl) But some of these terms will not be affected by the decision variables in the optimization (that is, the allocation of the fund among the assets). In particular, erl and vl are characteristics of the liability return distribution that cannot be changed via asset allocation. Hence we can simplify the problem to one of maximizing: u = t*ea - va - 2*h*cal The first two terms in this objective function are precisely the same as in the general asset allocation problem. Only the third differs. Consider the covariance of the asset returns with the liability. This will be a weighted average of the covariances of the individual assets with the liability, with the relative portfolio values as weights: cal = cl'*x where cl is an {n*1}vector of the covariances of the assets with the liability. But note that this makes the third term a linear function of the portfolio weights. Re-writing:

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Equilibrium (preliminary)

u = t*ea - [h*2*cl']*x - va But this is equivalent to the general formulation with a linear attribute, so all the conclusions reached earlier can be applied to this case. In particular, (1) one additional fund or swap will be needed to provide all possible optimal portfolios, (2) the market portfolio will be optimal for an Investor with the market average desire to hedge (here, h), and (3) a given Investor should tilt away from the market portfolio based, among other things, on the difference between his or her desire to hedge and that of the weighted average Investor.

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Macro-Investment Analysis

Performance Measurement
q q q

Mutual Fund Performance Measurement The Sharpe Ratio Morningstar's Risk-adjusted Ratings

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Mutual Fund Performance Measures

Mutual Fund Performance Measures, Factor Models, and Fund Style and Selection

William F. Sharpe www-sharpe.stanford.edu www-leland.stanford.edu/~wfsharpe

Mutual Fund Performance Measures

Use statistics from:


q

historic frequency distribution many periods Example: combination of mean and standard deviation for past 36 months

To predict statistics for:


q

future probability distribution one period Example: combination of mean and standard deviation for next month

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Mutual Fund Performance Measures

Decisions

One Fund One Fund plus borrowing or lending One fund from a given asset class or category A portfolio of potentially many funds

Portfolio Theory

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Mutual Fund Performance Measures

Hierarchic Taxonomic Procedures

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Mutual Fund Performance Measures

Statistics: M

Ex Ante:
q q q

Expected Return Expected geometric return etc.

Ex Post:
q q q q

Arithmetic average return Geometric average return Compounded total return over period etc.

Statistics: S

Ex Ante:
q q q q

Standard Deviation of Return Variance of Return Expected loss etc.

Ex Post:
q

Standard deviation of return

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Mutual Fund Performance Measures


q q q

Variance of Return Average loss etc.

Performance Measures

Return M Utility-based M-k*S Scale-independent M/S

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Mutual Fund Performance Measures

Variables

Total Return Fund Return Excess Return Fund Return - Return on a risk-free instrument Differential Return Fund Return - Return on an appropriate benchmark portfolio

Absolute and Relative Measures

Absolute Use statistics as computed for all funds Relative


q q q

Each fund assigned to a peer group Performance of funds ranked within each peer group Comparisons based on: Differences Ratios
r r

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Mutual Fund Performance Measures


r r

Rankings Stars 5 stars: top 10% 4 stars: next 22.5% etc.


s s s

Frequently-used Measures

Relative
Total Differential Excess Return Return Return Return Utility-based Scaleindependent Lipper Morningstar (form) Morningstar (subst.) Micropal

Absolute
Total Return Return Utility-based Scaleindependent Sharpe ratio selection Sharpe ratio Excess Return Differential Return selection mean (alpha)

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Mutual Fund Performance Measures

Scale-independent Measures

Variable = Return on A minus return on B Strategy requires zero investment


q q

long position in A short position in B

Change in value can be doubled by doubling sizes of positions For scale k:


q

Mk = k* M1 SDk = k* SD1 Mk / SDk = M1 / SD1

Therefore, ratio is scale-independent

Scale-independent Measures with Positive Expected Returns

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Mutual Fund Performance Measures

Scale-independent Measures with Negative Average Returns

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Mutual Fund Performance Measures

Inappropriateness of Total Return M/S Measures

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Mutual Fund Performance Measures

Morningstar Peer Groups

Peer Groups
q

Asset classes Categories


r

Asset Classes
q q q q

Domestic equity International equity Taxable bond Municipal bond

Domestic equity categories


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Mutual Fund Performance Measures


q q q q

Diversified (9) Specialty (9) Hybrid Convertible

Morningstar Diversified Equity Categories

Based on portfolio composition


q q

price/earnings, price/book market capitalization

Averaged over past three years Style Boxes


Large Value Large Blend Large Growth Medium Growth

Medium Value Small Value

Medium Blend

Small Blend Small Growth

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Mutual Fund Performance Measures

Morningstar Ratings

Stars:
q q

Rank within asset class (e.g. equity) 3-year, 5 year, 10 year and weighted average of 3,5, and 10 year Net of load charges

Category Ratings:
q q q

Rank within asset category (e.g. Large Growth equity) 3-year Load charges not taken into account

Percentages:
1 2 (worst) 10% 3 4 5 (best)

22.5% 35% 22.5% 10%

Morningstar Statistics, 3-year Ratings

M
q

Compounded return on fund - compounded return on Treasury bills

Loss

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Mutual Fund Performance Measures


q q

if fund return > Treasury bill return, loss = 0 if fund return < Treasury bill return, loss = - (fund return - bill return)

S
q q q

Average Monthly Loss sum ( monthly loss) takes all 36 months into account

Average Monthly Loss versus Standard Deviation of Monthly Returns, Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

Average Monthly loss versus function of Monthly Mean and Std. Deviation Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

Morningstar Risk-adjusted Rating

RARf = Mf / M - Sf / S M
_

if mean ( Mf ) >= compound return on Treasury bills, mean ( Mf )


r

if mean ( Mf ) < compound return on Treasury bills, compound return on Treasury bills
r

mean ( AMLf )

Morningstar Risk-adjusted Ratings as Utility-based Measures

RARf = Mf / M - Sf / S
=(
_

1/M ) * [ Mf - ( M / S ) * Sf ]
_

Rankings unaffected by initial constant ( 1/M ) Rankings depend on:


q

Mf - k * Sf

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Mutual Fund Performance Measures


q

where: _ _ k=M /S
r

A bi-linear VnM Utility Function with threshold = 4% and utility ratio = 2.5

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Mutual Fund Performance Measures

Optimal Leverage when Utility = Return - k*Risk

Optimal Leverage when Utility = Return - k*Risk2

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Mutual Fund Performance Measures

Indifference Curves and Iso-M/S lines: k = M / S

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Mutual Fund Performance Measures

Indifference Curves and Iso-M/S lines: k > M / S

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Mutual Fund Performance Measures

Sharpe Ratio Ranks versus Category Rankings, Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

Three-year Star Ratings and Mean-variance combinations, Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

An Asset Class Factor Model

R f = [ b1f F
~

+ b2f F

+ ... + bnf F

]+e
~

f
Fund return

Rf

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Mutual Fund Performance Measures

F 1 ,...,F n

Asset class returns

b1f ,..., bnf Fund asset class exposures (style) : sum =1 [ ... ]
~

Fund style return


~

ef

Fund selection return: e f i uncorrelated


~

with e f j

Benchmark Portfolios and Asset Exposures

R f = [ b1f F
~

+ b2f F

+ ... + bnf F

]+e
~

f
Fund return
~

Rf
~

F 1 ,...,F n b1f ,..., bnf [ ... ]


~

Asset class returns Benchmark portfolio composition Benchmark portfolio return Fund differential return

ef

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Mutual Fund Performance Measures

Methods for Selecting a Benchmark

Historic Average Composition Regression Style Analysis Projection MStar Category Actual Returns Actual Returns

Current MStar Style Retrospective Returns Retrospective Returns

Projected

FER Proposal

Taxonomic Factor Models

All conditions for a general asset class factor model hold plus For any given fund f

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Mutual Fund Performance Measures


q

One bif = 1 All other bif's = 0

Fund expected return = asset class expected return + fund alpha Fund Variance = asset class variance + fund selection variance

Overall Portfolio Return

R
~

p n

= [ b1p F
~

+ b2p F

+ ... + bnp

]+e

where: bjp = X1 b1j + X2 b2j + ... + Xn bnj


~ ~ ~ ~

e p = X1 e 1 + X2 e 2 + ... + Xn e m
~

[...] = (style) return on assets ( R A )

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Mutual Fund Performance Measures

e p = selection return

Selection Return Statistics

Ex post
~

mean ( e f )
~

Average selection return ( alpha ) Selection return variability

stddev ( e f )
Ex ante
~

expected ( e f ) Expected selection return ( alpha )


~

stddev ( e f )

Selection return risk

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Mutual Fund Performance Measures

Factor-model Based Analysis

Factor-model Based Analysis: Optimization Inputs

Asset Classes
q q q

Expected Returns Standard Deviations Correlations

Funds
q q q

Styles ( Benchmark portfolios) Expected selection returns (alphas) Selection risks

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Mutual Fund Performance Measures

Investor
q q

Risk tolerance: t other constraints, assets, liabilities, etc

Optimization with Unlimited Short Positions in Assets

Creating a hedge fund


q q

Long: fund Short: fund's benchmark asset mix

Zero investment required Return is scale-independent Asset allocation unaffected by scale of investment Select Xi to maximize: Xi expected (ei ) - ( Xi 2 Var ( ei ) ) / t

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Mutual Fund Performance Measures

Optimal Position in a Fund with Unlimited Short Positions in Assets

Xi = [ expected (ei ) / Var ( ei ) ) ] * ( t / 2 ) Amount of risk taken: Xi * stdev ( ei ) = [ expected (ei ) / stdev ( ei ) ] * ( t / 2 ) = [ selection Sharpe ratio ] * ( t / 2 ) Relative values independent of investor preferences

Choosing a Fund for an Asset Class Position with a Taxonomic Factor Model

Assume asset allocation is fixed Then: Ep = EA + X1 expected ( e1 ) + . . . + Xm expected ( em ) Vp = VA + X12 variance ( e1 ) + .... + Xm2 variance ( em ) Utility:
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Mutual Fund Performance Measures

[ EA - VA / t ] + [ X1 expected ( e1 ) - X12 variance ( e1 ) / t ] + ...+ [ Xm expected ( em ) - Xm2 variance ( em ) / t ]

The Optimal Fund for an Asset Class with a Taxonomic Factor Model

Xj is a given constant From the funds in the asset class, select the fund for which [ Xj expected ( ef ) - Xj2 variance ( ef ) / t ] is the largest Equivalently, select the fund with the largest value of: expected ( ef ) - ( Xj / t ) * variance ( ef ) A utility-based differential return measure with k a function of:
q

the amount to be invested in the asset class ( Xj ) the investor's risk tolerance (t)

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Mutual Fund Performance Measures

The Optimal Fund for a Small Portion of a Portfolio

The preferred fund for an investment of Xj in asset class j has maximum: z = expected ( ef ) - ( Xj / t ) * variance ( ef ) If Xj is small: ( Xj / t ) * variance ( ef ) is small z is approximately equal to expected ( ef ) = alpha Hence best fund is the one with the largest alpha relative to an appropriate benchmark

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Mutual Fund Performance Measures

Correlations of Percentiles within Categories

SR Sharpe Ratio Category Rating Star Rating

Cat.

Star

Alpha SSR

1.000 0.986 0.945 0.831 0.744 0.986 1.000 0.957 0.829 0.735 0.945 0.957 1.000 0.790 0.694

Selection Mean (Alpha) 0.831 0.829 0.790 1.000 0.940 Selection Sharpe Ratio 0.744 0.735 0.694 0.940 1.000

Style Analysis Alpha Ranks versus Category Rankings, Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

Style Analysis Selection Sharpe Ratios versus Category Rankings, Morningstar Diversified Equity Funds, 1994-1996

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Mutual Fund Performance Measures

Conclusions (1)

Hierarchic taxonomic approaches will generally be suboptimal


q

lower-level characteristics not taken into account when making decisions


r

asset category characteristics not taken into account when allocating among asset classes

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Mutual Fund Performance Measures

fund characteristics not taken into account when allocating among asset classes and categories

No universal single measure can provide a sufficient statistic for choosing


q

one fund in each category, or multiple funds in each category

Conclusions (2)

Need good estimates of:


q

future asset exposures


r

appropriate benchmark portfolio (fund style)

future fund selection risk future fund selection expected return

This information should be combined optimally with estimates of


q

future asset risks, expected returns and correlations investor risk tolerance and other characteristics

All useful predictors of future performance should be taken into account


q

include fund expense ratios, turnover, etc..

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Mutual Fund Performance Measures

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The Sharpe Ratio

The Sharpe Ratio


William F. Sharpe Stanford University
Reprinted fromThe Journal of Portfolio Management, Fall 1994
This copyrighted material has been reprinted with permission from The Journal of Portfolio Management. Copyright Institutional Investor, Inc., 488 Madison Avenue, New York, N.Y. 10022, a Capital Cities/ABC, Inc. Company. Phone (212) 224-3599.

. Over 25 years ago, in Sharpe [1966], I introduced a measure for the performance of mutual funds and proposed the term reward-to-variability ratio to describe it (the measure is also described in Sharpe [1975] ). While the measure has gained considerable popularity, the name has not. Other authors have termed the original version the Sharpe Index (Radcliff [1990, p. 286] and Haugen [1993, p. 315]), the Sharpe Measure (Bodie, Kane and Marcus [1993, p. 804], Elton and Gruber [1991, p. 652], and Reilly [1989, p.803]), or the Sharpe Ratio (Morningstar [1993, p. 24]). Generalized versions have also appeared under various names (see. for example, BARRA [1992, p. 21] and Capaul, Rowley and Sharpe [1993, p. 33]). Bowing to increasingly common usage, this article refers to both the original measure and more generalized versions as the Sharpe Ratio. My goal here is to go well beyond the discussion of the original measure in Sharpe [1966] and Sharpe [1975], providing more generality and covering a broader range of applications.

THE RATIO
Most performance measures are computed using historic data but justified on the basis of predicted relationships. Practical implementations use ex post results while theoretical discussions focus on ex ante values. Implicitly or explicitly, it is assumed that historic results have at least some predictive ability. For some applications, it suffices for future values of a measure to be related monotonically to past values -- that is, if fund X had a higher historic measure than fund Y, it is assumed that it will have a higher future measure. For other applications the relationship must be proportional - - that is, it is assumed that the future measure will equal some constant (typically less than 1.0) times the historic measure.

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The Sharpe Ratio

To avoid ambiguity, we define here both ex ante and ex post versions of the Sharpe Ratio, beginning with the former. With the exception of this section, however, we focus on the use of the ratio for making decisions, and hence are concerned with the ex ante version. The important issues associated with the relationships (if any) between historic Sharpe Ratios and unbiased forecasts of the ratio are left for other expositions. Throughout, we build on Markowitz' mean-variance paradigm, which assumes that the mean and standard deviation of the distribution of one-period return are sufficient statistics for evaluating the prospects of an investment portfolio. Clearly, comparisons based on the first two moments of a distribution do not take into account possible differences among portfolios in other moments or in distributions of outcomes across states of nature that may be associated with different levels of investor utility. When such considerations are especially important, return mean and variance may not suffice, requiring the use of additional or substitute measures. Such situations are, however, beyond the scope of this article. Our goal is simply to examine the situations in which two measures (mean and variance) can usefully be summarized with one (the Sharpe Ratio). The Ex Ante Sharpe Ratio Let Rf represent the return on fund F in the forthcoming period and RB the return on a benchmark portfolio or security. In the equations, the tildes over the variables indicate that the exact values may not be known in advance. Define d, the differential return, as:

Let d-bar be the expected value of d and sigmad be the predicted standard deviation of d. The ex ante Sharpe Ratio (S) is:

In this version, the ratio indicates the expected differential return per unit of risk associated with the differential return. The Ex Post Sharpe Ratio

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The Sharpe Ratio

Let RFt be the return on the fund in period t, RBt the return on the benchmark portfolio or security in period t, and Dt the differential return in period t:

Let D-bar be the average value of Dt over the historic period from t=1 through T:

and sigmaD be the standard deviation over the period 1:

The ex post, or historic Sharpe Ratio (Sh) is:

In this version, the ratio indicates the historic average differential return per unit of historic variability of the differential return. It is a simple matter to compute an ex post Sharpe Ratio using a spreadsheet program. The returns on a fund are listed in one column and those of the desired benchmark in the next column. The differences are computed in a third column. Standard functions are then utilized to compute the components of the ratio. For example, if the differential returns were in cells C1 through C60, a formula would provide the Sharpe Ratio using Microsoft's Excel spreadsheet program: AVERAGE(C1:C60)/STDEV(C1:C60)

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The Sharpe Ratio

The historic Sharpe Ratio is closely related to the t-statistic for measuring the statistical significance of the mean differential return. The t-statistic will equal the Sharpe Ratio times the square root of T (the number of returns used for the calculation). If historic Sharpe Ratios for a set of funds are computed using the same number of observations, the Sharpe Ratios will thus be proportional to the t-statistics of the means. Time Dependence The Sharpe Ratio is not independent of the time period over which it is measured. This is true for both ex ante and ex post measures. Consider the simplest possible case. The one-period mean and standard deviation of the differential return are, respectively, d-bar1 and sigmad1. Assume that the differential return over T periods is measured by simply summing the one-period differential returns and that the latter have zero serial correlation. Denote the mean and standard deviation of the resulting T-period return, respectively, d-barT and sigmadT. Under the assumed conditions:

and:

Letting S1 and ST denote the Sharpe Ratios for 1 and T periods, respectively, it follows that:

In practice, the situation is likely to be more complex. Multiperiod returns are usually computed taking compounding into account, which makes the relationship more complicated. Moreover, underlying differential returns may be serially correlated. Even if the underlying process does not involve serial correlation, a specific ex post sample may.
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It is common practice to "annualize" data that apply to periods other than one year, using equations (7) and (8). Doing so before computing a Sharpe Ratio can provide at least reasonably meaningful comparisons among strategies, even if predictions are initially stated in terms of different measurement periods. To maximize information content, it is usually desirable to measure risks and returns using fairly short (e.g. monthly) periods. For purposes of standardization it is then desirable to annualize the results. To provide perspective, consider investment in a broad stock market index, financed by borrowing. Typical estimates of the annual excess return on the stock market in a developed country might include a mean of 6% per year and a standard deviation of 15%. The resulting excess return Sharpe Ratio of "the stock market", stated in annual terms would then be 0.40. Correlations The ex ante Sharpe Ratio takes into account both the expected differential return and the associated risk, while the ex post version takes into account both the average differential return and the associated variability. Neither incorporates information about the correlation of a fund or strategy with other assets, liabilities, or previous realizations of its own return. For this reason, the ratio may need to be supplemented in certain applications. Such considerations are discussed in later sections. Related Measures The literature surrounding the Sharpe Ratio has, unfortunately, led to a certain amount of confusion. To provide clarification, two related measures are described here. The first uses a different term to cover cases that include the construct that we call the Sharpe Ratio. The second uses the same term to describe a different but related construct. Whether measured ex ante or ex post, it is essential that the Sharpe Ratio be computed using the mean and standard deviation of a differential return (or, more broadly, the return on what will be termed a zero investment strategy). Otherwise it loses its raison d'etre. Clearly, the Sharpe Ratio can be considered a special case of the more general construct of the ratio of the mean of any distribution to its standard deviation. In the investment arena, a number of authors associated with BARRA (a major supplier of analytic tools and databases) have used the term information ratio to describe such a general measure. In some publications , the ratio is defined to apply only to differential returns and is thus equivalent to the measure that we call the Sharpe Ratio (see, for example, Rudd and Clasing [1982, p. 513] and Grinold [1989, p. 31]). In others, it is also encompasses the ratio of the mean to the standard deviation of the distribution of the return on a single investment, such as a fund or a benchmark (see, for example, BARRA [1993, p. 22]). While such a "return information ratio" may be useful as a descriptive statistic, it
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lacks a number of the key properties of what might be termed a "differential return information ratio" and may in some instances lead to wrong decisions. For example, consider the choice of a strategy involving cash and one of two funds, X and Y. X has an expected return of 5% and a standard deviation of 10%. Y has an expected return of 8% and a standard deviation of 20%. The riskless rate of interest is 3%. According to the ratio of expected return to standard deviation, X (5/10, or 0.50) is superior to Y (8/20, or 0.40). According to the Sharpe Ratios using excess return, X (2/10, or 0.20) is inferior to Y (5/20, or 0.25). Now, consider an investor who wishes to attain a standard deviation of 10%. This can be achieved with fund X, which will provide an expected return of 5.0%. It can also be achieved with an investment of 50% of the investor's funds in Y and 50% in the riskless asset. The latter will provide an expected return of 5.5% -- clearly the superior alternative. Thus the Sharpe Ratio provides the correct answer (a strategy using Y is preferred to one using X), while the "return information ratio" provides the wrong one. In their seminal work, Treynor and Black [1973], defined the term "Sharpe Ratio" as the square of the measure that we describe. Others, such as Rudd and Clasing [1982, p. 518] and Grinold [1989, p. 31], also use such a definition. While interesting in certain contexts, this construct has the curious property that all values are positive -even those for which the mean differential return is negative. It thus obscures important information concerning performance. We prefer to follow more common practice and thus refer to the Treynor-Black measure as the Sharpe Ratio squared (SR2). 2: We focus here on the Sharpe Ratio, which takes into account both risk and return without reference to a market index. [Sharpe 1966, 1975] discusses both the Sharpe Ratio and measures based on market indices, such as Jensen's alpha and Treynor's average excess return to beta ratio.

Scale Independence
Originally, the benchmark for the Sharpe Ratio was taken to be a riskless security. In such a case the differential return is equal to the excess return of the fund over a one-period riskless rate of interest. Many of the descriptions of the ratio in Sharpe [1966, 1975] focus on this case . More recent applications have utilized benchmark portfolios designed to have a set of "factor loadings" or an "investment style" similar to that of the fund being evaluated. In such cases the differential return represents the difference between the return on the fund and the return that would have been obtained from a "similar" passive alternative. The difference between the two returns may be termed an "active return" or "selection return", depending on the underlying procedure utilized to select the benchmark.
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Treynor and Black [1973] cover the case in which the benchmark portfolio is, in effect, a combination of riskless securities and the "market portfolio". Rudd and Clasing [1982] describe the use of benchmarks based on factor loadings from a multifactor model. Sharpe [1992] uses a procedure termed style analysis to select a mix of asset class index funds that have a "style" similar to that of the fund. When such a mix is used as a benchmark, the differential return is termed the fund's selection return. The Sharpe Ratio of the selection return can then serve as a measure of the fund's performance over and above that due to its investment style. 3: Central to the usefulness of the Sharpe Ratio is the fact that a differential return represents the result of a zero-investment strategy. This can be defined as any strategy that involves a zero outlay of money in the present and returns either a positive, negative or zero amount in the future, depending on circumstances. A differential return clearly falls in this class, since it can be obtained by taking a long position in one asset (the fund) and a short position in another (the benchmark), with the funds from the latter used to finance the purchase of the former. In the original applications of the ratio, where the benchmark is taken to be a one- period riskless asset, the differential return represents the payoff from a unit investment in the fund, financed by borrowing. 4: More generally, the differential return corresponds to the payoff obtained from a unit investment in the fund, financed by a short position in the benchmark. For example, a fund's selection return can be considered to be the payoff from a unit investment in the fund, financed by short positions in a mix of asset class index funds with the same style. A differential return can be obtained explicitly by entering into an agreement in which a party and a counterparty agree to swap the return on the benchmark for the return on the fund and vice-versa. A forward contract provides a similar result. Arbitrage will insure that the return on such a contract will be very close to the excess return on the underlying asset for the period ending on the delivery date. 5: A similar relationship holds approximately for traded contracts such as stock index futures , which clearly represent zero-investment strategies. 6: To compute the return for a zero-investment strategy the payoff is divided by a notional value. For example, the dollar payoff for a swap is often set to equal the difference between the dollar return on an investment of $X in one asset and that on an investment of $X in another. The net difference can then be expressed as a proportion of $X, which serves as the notional value. Returns on futures positions are often computed in a similar manner, using the initial value of the underlying asset as a base. In effect, the same approach is utilized when the difference between two returns is computed. Since there is zero net investment in any such strategy, the percent return can be made as large or small as desired by simply changing the notional value used in such a computation. The scale of the return thus depends on the more- or-less arbitrary choice of the notional value utilized for its computation. 7: Changes in the notional value clearly affect the mean and the standard deviation of the distribution of
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return, but the changes are of the same magnitude, leaving the Sharpe Ratio unaffected. The ratio is thus scale independent. 8:

The Influence of a Zero Investment Strategy on Asset Risk and Return


Scale independence is more than a mathematical artifact. It is key to understanding why the Sharpe Ratio can provide an efficient summary statistic for a zero- investment strategy. To show this, we consider the case of an investor with a pre-existing portfolio who is considering the choice of a zero investment strategy to augment current investments. The Relative Position in a Zero Investment Strategy Assume that the investor has $A in assets and has placed this money in an investment portfolio with a return of RI. She is considering investment in a zero-investment strategy that will provide a return of d per unit of notional value. Denote the notional value chosen as V (e.g. investment of V in a fund financed by a short position of V in a benchmark). Define the relative position, p, as the ratio of the notional value to the investor's assets:

The end-of-period payoff will be:

Let RA denote the total return on the investor's initial assets. Then:

If R-barA denotes the expected return on assets and R- barI the expected return on the investment:

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Now, let sigmaA, sigmaI and sigmad denote the standard deviations of the returns on assets, the investment and the zero-investment strategy, respectively, and rhoId the correlation between the return on the investment and the return on the zero-investment strategy. Then:

or, rewriting slightly:

The Risk Position in a Zero Investment Strategy The parenthesized expression (p sigmad) is of particular interest. It indicates the risk of the position in the zero-investment strategy relative to the investor's overall assets. Let k denote this risk position

For many purposes it is desirable to consider k as the relevant decision variable. Doing so states the magnitude of a zero-investment strategy in terms of its risk relative to the investor's overall assets. In effect, one first determines k, the level of risk of the zero- investment strategy. Having answered this fundamental question, the relative (p) and absolute (V) amounts of notional value for the strategy can readily be determined, using equations (17) and (11). 9: Asset Risk and Expected Return It is straightforward to determine the manner in which asset risk and expected return are related to the risk position of the zero investment strategy, its correlation with the investment, and its Sharpe Ratio. Substituting k in equation (16) gives the relationship between 1) asset risk and 2) the risk position and the correlation of the strategy with the investment:

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To see the relationship between asset expected return and the characteristics of the zero investment strategy, note that the Sharpe Ratio is the ratio of d-bar to sigmad. It follows that

Substituting equation (19) in equation (14) gives:

or:

which shows that the expected return on assets is related directly to the product of the risk position times the Sharpe Ratio of the strategy. By selecting an appropriate scale, any zero investment strategy can be used to achieve a desired level (k) of relative risk. This level, plus the strategy's Sharpe Ratio, will determine asset expected return, as shown by equation (21). Asset risk, however, will depend on both the relative risk (k) and the correlation of the strategy with the other investment (rhoId ). In general, the Sharpe Ratio, which does not take that correlation into account, will not by itself provide sufficient information to determine a set of decisions that will produce an optimal combination of asset risk and return, given an investor's tolerance of risk.

Adding a Zero-Investment Strategy to an Existing Portfolio


Fortunately, there are important special cases in which the Sharpe Ratio will provide sufficient information for decisions on the optimal risk/return combination: one in which the pre-existing portfolio is riskless, the other in which it is risky. Adding a Strategy to a Riskless Portfolio Suppose first that an investor plans to allocate money between a riskless asset and a single risky fund (e.g. a "balanced" fund). This is, in effect, the case analyzed in Sharpe [1966,1975]. We assume that there is a pre-existing portfolio invested solely in a riskless security, to which is to be added a zero investment strategy involving a long position in a fund, financed by a short position in a

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riskless asset (i.e., borrowing). Letting Rc denote the return on such a "cash equivalent", equations (1) and (13) can be written as:

and

Since the investment is riskless, its standard deviation of return is zero, so both the first and second terms on the right-hand side of equation (18) become zero, giving:

The investor's total risk will thus be equal to that of the position taken in the zero investment strategy, which will in turn equal the risk of the position in the fund. Letting SF represent the Sharpe Ratio of fund F, equation (21) can be written:

It is clear from equations (24) and (25) that the investor should choose the desired level of risk (k), then obtain that level of risk by using the fund (F) with the greatest excess return Sharpe Ratio. Correlation does not play a role since the remaining holdings are riskless. This is illustrated in the Exhibit. Points X and Y represent two (mutually exclusive) strategies. The desired level of risk is given by k. It can be obtained with strategy X using a relative position of px (shown in the figure at point PxX) or with strategy Y using a relative position of pY (shown in the figure at point PyY). An appropriately-scaled version of strategy X clearly provides a higher mean return (shown at point MRx) than an appropriately-scaled version of strategy Y (shown at point MRy). Strategy X is hence to be preferred.

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The Exhibit shows that the mean return associated with any desired risk position will be greater if strategy X is adopted instead of strategy Y. But the slope of such a line is the Sharpe Ratio. Hence, as long as only the mean return and the risk position of the zero-investment strategy are relevant, the optimal solution involves maximization of the Sharpe Ratio of the zero-investment strategy. Consider, for example, a choice between fund XX, with a risk of 10% and an excess return Sharpe Ratio of 0.20 and fund YY with a risk of 20% and an excess return Sharpe Ratio of 0.25. Assume the investor has $100 to invest and desires a level of risk (here, k) equal to 15%. The optimal strategy involves investment of $100 in the riskless asset plus a zero-investment strategy based on fund YY. To make the risk of the latter equal to 15%, a relative position (p) of 0.75 should be taken. This, in turn, requires an investment of $75 in the fund, financed by $75 of borrowing (i.e. a short position in the riskless asset). The net position in the riskless asset will thus be $25 ($100 - $75), with $75 invested in Fund YY. In this case the investor's tasks include the selection of the fund with the greatest Sharpe Ratio and the allocation of wealth between this fund and borrowing or lending, as required to obtain the desired level of asset risk. Adding a Strategy to a Risky Portfolio Consider now the case in which a single fund is to be selected to complement a pre-existing group of
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risky investments. For example, an investor might have $100, with $80 already committed (e.g. to a group of bond and stock funds). The goal is to allocate the remaining $20 between a riskless asset ("cash") and a single risky fund (e.g. a "growth stock fund"), accepting the possibility that the amount allocated to cash might be positive, zero or negative, depending on the desired risk and the risk of the chosen fund. In this case the investment should be taken as the pre-existing investment plus a riskless asset (in the example, $80 in the initial investments plus $20 in cash equivalents). The return on this total portfolio will be RI. The zero- investment strategy will again involve a long position in a risky fund and a short position in the riskless asset. As stated earlier, in such a case it will not necessarily be optimal to select the fund with the largest possible Sharpe Ratio. While the ratio takes into account two key attributes of the predicted performance of a zero-investment strategy (its expected return and its risk), it does not include information about the correlation of its return with that of the investor's other holdings (rhoId). It is entirely possible that a fund with a smaller Sharpe Ratio could have a sufficiently smaller correlation with the investor's other assets that it would provide a higher expected return on assets for any given level of overall asset risk. However, if the alternative funds being analyzed have similar correlations with the investor's other assets, it will still be optimal to select the fund with the greatest Sharpe Ratio. To see this, note that with rhoId taken as given, equation (18) shows that there is a one-to-one correspondence between sigmaA and k. Thus, for any desired level of asset risk, the investor chooses the corresponding risk position k given by equation (18), regardless of the fund to be employed. But, as before, the expected return on assets will be:

which can be maximized by selecting the fund with the largest Sharpe Ratio. The practical implication is clear. When choosing one from among a group of funds of a particular type for inclusion in a larger set of holdings, the one with the largest predicted excess return Sharpe Ratio may reasonably be chosen, if it can be assumed that all the funds in the set have similar correlations with the other holdings. If this condition is not met, some account should be taken of the differential levels of such correlations. The Choice of a Set of Uncorrelated Strategies Suppose finally that an investor has a pre-existing set of investments and is considering taking positions in one or more zero-investment strategies, each of which is uncorrelated both with the existing
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investments and with each of the other such strategies. Such lack of correlation is generally assumed for residual returns from an assumed factor model and hence applies to strategies in which long and short positions are combined to obtain zero exposures to all underlying factors in such a model. In particular, this is assumed to hold for the "non-market returns" which are the residual returns in onefactor "market models" of the type employed in Treynor-Black [1973]. It is also assumed to hold for the "active returns" that constitute the residual returns in a model of the type used by BARRA (described, for example, in Grinold [1989]). Most germane, perhaps, for selecting funds, this is assumed to hold for the "selection returns" that constitute the residuals from the asset class factor model used in the style analysis procedure described in 10: Under the assumed conditions, the counterpart to equation (13) is:

where pi represents the relative position taken in strategy i and di represents its return. Letting sigmadi represent the risk of position i, asset risk is given by:

and expected asset return by:

Adding subscriptions to equations (21) and (18), and substituting the results gives:

and
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Now, assume that the investor's goal is to maximize a standard risk- adjusted expected return of the form:

where tau represents risk tolerance (the marginal rate of substitution of variance for expected return). Substituting equations (30) and (31) in (32) gives:

Since the terms involving the initial investment will be unaffected by the decisions (ki's) concerning the zero investment strategies, it suffices to maximize:

To do so, the partial derivative with respect to each decision variable (ki) should be set to zero:

The optimal risk position in strategy i is thus:

Hence the risk levels of the strategies should be proportional to their Sharpe Ratios. Strategies with zero predicted Sharpe Ratios should be ignored. Those with positive ratios should be "held long", and those with negative ratios "held short". If strategy X has a positive Sharpe Ratio that is twice as large as that of
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strategy Y, twice as much risk should be taken with X as with Y. The overall scale of all the positions should, in turn, be proportional to the investor's risk tolerance. An interesting application occurs when long and short positions can be taken (e.g. via financial futures) in the asset classes that underlie a style analysis model of the type described in Sharpe [1992]. In principle, funds should be selected based only on their selection returns, with the respective amounts of selection risk set in proportion to the funds' selection return Sharpe Ratios. The net exposures to asset classes required to implement this mixture of zero investment strategies can then be compared with the investor's desired passive asset mix to determine needed net positions.

Summary
The Sharpe Ratio is designed to measure the expected return per unit of risk for a zero investment strategy. The difference between the returns on two investment assets represents the results of such a strategy. The Sharpe Ratio does not cover cases in which only one investment return is involved. Clearly, any measure that attempts to summarize even an unbiased prediction of performance with a single number requires a substantial set of assumptions for justification. In practice, such assumptions are, at best, likely to hold only approximately. Certainly, the use of unadjusted historic (ex post) Sharpe Ratios as surrogates for unbiased predictions of ex ante ratios is subject to serious question. Despite such caveats, there is much to recommend a measure that at least takes into account both risk and expected return over any alternative that focuses only on the latter. For a number of investment decisions, ex ante Sharpe Ratios can provide important inputs. When choosing one from among a set of funds to provide representation in a particular market sector, it makes sense to favor the one with the greatest predicted Sharpe Ratio, as long as the correlations of the funds with other relevant asset classes are reasonably similar. When allocating funds among several such funds, it makes sense to allocate funds such that the selection (residual) risk levels are proportional to the predicted Sharpe Ratios for the selection (residual) returns. If some of the implied net positions are infeasible or involve excessive transactions costs, of course, the decision rules must be modified. Nonetheless, Sharpe Ratios may still provide useful guidance. Whatever the application, it is essential to remember that the Sharpe Ratio does not take correlations into account. When a choice may affect important correlations with other assets in an investor's portfolio, such information should be used to supplement comparisons based on Sharpe Ratios. All the same, the ratio of expected added return per unit of added risk provides a convenient summary of two important aspects of any strategy involving the difference between the return of a fund and that of a relevant benchmark. The Sharpe Ratio is designed to provide such a measure. Properly used, it can improve the process of managing investments.

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Endnotes
1. We use the formula for the standard deviation of a population, taking the observations as a sample. For applications in which the value of T is the same for all the funds being measured, the standard deviation of the historic data (in which the denominator is T rather than T-1) can generally be used instead, since the relative magnitudes of the resulting measures would be the same. 2. Treynor and Black showed that if resources are allocated optimally, the SR2 of a portfolio will equal the sum of the SR2 values for its components. This follows from the fact that the optimal holding of a component will be proportional to the ratio of its mean differential return to the square of the standard deviation of its differential return. Thus, for example, components with negative means should be held in negative amounts. In this context, the product of the mean return and the optimal holding will always be positive. For completeness, it should be noted that Treynor and Black used the term appraisal ratio to refer to what we term here the SR2 of a component and the term Sharpe Ratio to refer to the SR2 of the portfolio, although other authors have used the latter term for both the portfolio and its components. 3. This type of application is described in BARRA [1992, p. 21]. 4. In this context, maximization of the Sharpe Ratio is the normative equivalent to the separation theorem first put forth in Tobin [1958] in a positive context. 5. To see this, note that by borrowing money to purchase the underlying asset, one can obtain precisely the same asset at the delivery date. The ending value of such a strategy will be perfectly correlated with the value of the forward contract and neither will require any outlay. If the payoffs at the end of the period differ, one could take a long position in one combination (e.g. the forward contract or the asset/borrowing combination) and a short position in the other and obtain a guaranteed payment at the end of the period with no outlay at any other time. This is unlikely to be the case in a market populated by astute investors. In practice, transactions costs will limit the precision of the relationship. 6. Futures contracts are often not protected against changes in value due to (for example) dividend payments. They also generally require daily marking to market. For these reasons they differ from forward contracts with dividend protection, for which the arbitrage relationship will hold within the bounds of transactions costs. Futures contracts generally require that margin be posted. However, this is not an investment in the underlying asset. 7. Despite this drawback, once a notional value has been selected, the actual rate of return can be used for comparison purposes. 8. Indeed, a Sharpe Ratio can be computed without regard to notional value by simply using the mean and standard deviation of the distribution of the final payoff.

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9. To see the advantages of concentration on the risk position of a strategy, consider two funds. One (X) invests directly, the other (Y) borrows money at the riskless rate and invests in X, with a leverage ratio of 2 to 1. Let kx be the optimal position in fund X. Clearly the optimal position in fund Y will be half as large. However, the standard deviation of return on fund Y will be twice that of fund X. Thus the optimal risk position in Y will be the same as that in X. 10. In fact, the basic relationship on which this section builds was first obtained by Treynor and Black [1973].

References
BARRA Newsletter, September/October 1992, May/June 1993, BARRA, Berkeley, Ca. Bodie, Zvi, Alex Kane and Alan J. Marcus. Investments, 2d edition. Homewood, IL: Richard D. Irwin, 1993. Capaul, Carlo, Ian Rowley, and William F. Sharpe. "International Value and Growth Stock Returns," Financial Analysts Journal, January/February 1993, pp. 27-36. Elton, Edwin J., and Martin J. Gruber. Modern Portfolio Theory and Investment Analysis, 4th edition. New York: John Wiley & Sons, 1991. Grinold, Richard C. "The Fundamental Law of Active Management," Journal of Portfolio Management, Spring 1989, pp. 30-37. Haugen, Robert A. Modern Investment Theory, 3d edition. Englewood Cliffs, NJ: Prentice-Hall, 1993. "Morningstar Mutual Funds User's Guide." Chicago: Morningstar Inc., 1993. Radcliff, Robert C. Investment Concepts, Analysis, Strategy, 3d edition. New York: HarperCollins, 1990. Reilly, Frank K. Investment Analysis and Portfolio Management, 3d edition. Chicago: The Dryden Press, 1989. Rudd, Andrew, and Henry K. Clasing. Modern Portfolio Theory, The Principles of Investment Management. Homewood, IL: Dow-Jones Irwin, 1982. Sharpe, William F. "Mutual Fund Performance." Journal of Business, January 1966, pp. 119-138. -----. "Adjusting for Risk in Portfolio Performance Measurement." Journal of Portfolio Management, Winter 1975, pp. 29-34.
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-----. "Asset allocation: Management Style and Performance Measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. Tobin, James. "Liquidity Preference as Behavior Toward Risk." Review of Economic Studies, February 1958, pp. 65-86. Treynor, Jack L., and Fischer Black. "How to Use Security Analysis to Improve Portfolio Selection." Journal of Business, January 1973, pp. 66-85.

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Morningstar's Risk-adjusted Ratings

Morningstar's Risk-adjusted Ratings


William F. Sharpe* Stanford University January, 1998

Summary
The last decade has seen the rapid growth of investment via mutual funds across the globe. This has led to a demand for simple measures of the performance of such funds. In the United States, the most popular is the "risk-adjusted rating" (RAR) produced by Morningstar, Incorporated. This measure differs significantly from more traditional ones such as various forms of the Sharpe ratio. This paper investigates the properties of Morningstar's measure. We show that the RAR measure has characteristics similar to those of an expected utility function based on an underlying bilinear utility function. This is of some concern, since strict adherence to a goal of maximizing expected utility with such a function could lead to extreme investment strategies. Next, we show that in practice, Morningstar varies one of the parameters of this function in a manner that frequently leads to results similar to those that would be obtained with the more traditional excess return Sharpe Ratio. Finally, we argue that neither Morningstar's measure nor the excess return Sharpe Ratio is an efficient tool for choosing mutual funds within peer groups when constructing a multi-fund portfolio --the ostensible purpose for which Morningstar's rankings are produced.

Introduction
This paper analyzes the characteristics of the "risk-adjusted ratings" on which Morningstar, Incorporated bases its well-known "star ratings" and somewhat less well-known "category ratings", then compares these measures with more traditional mean/variance measures such as the excess return Sharpe ratio. It is common for a mutual fund family to proudly advertise that one of its funds or possibly several funds have "received 5 stars from Morningstar". One study1 found that as much as 90% of new money invested in stock funds in 1995 went to funds with 4-star or 5-star ratings. While this may or may not be the correct figure today, few if any advertisements announce that a fund has received 1 star. For better or worse, Morningstar's risk-adjusted measures greatly influence U.S. investor behavior. Since they differ significantly from traditional risk-adjusted performance measures such as various forms of the Sharpe ratio, it is important to understand their strengths and limitations.

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Ex Ante and Ex Post Performance Measurement


Mutual fund performance measures are typically based on one or more summary statistics of past performance. Measures that attempt to take risk into account incorporate both a measure of historic return and a measure of historic variability or loss. Since investment decisions only affect the future, the use of historic results involves an implicit assumption that the statistics derived from past performance have at least some predictive content for future performance. For example, a measure of average or cumulative return over some historic period may be assumed to provide information concerning expected return over some future period. Correspondingly, a measure of past variability or average magnitude of loss may be assumed to provide information about future risk or the likely loss over some future period. While measures of historic variability can be useful for predicting future levels of risk, there is ample evidence that measures of average or cumulative return are at best highly imperfect predictors of expected future return. We leave questions of predictability for other papers. Our goal is to examine the properties of Morningstar's and other measures under the heroic assumption that statistics from historic frequency distributions are reliable predictors of corresponding statistics from a probability distribution of future returns. In particular, we seek to relate alternative performance measures to likely investment decisions on the grounds that one should attempt to select a performance measure that aligns well with the decision to be undertaken, even if the relationship between the past and the future is subject to a great deal of noise. Ultimately, of course, the goal is to use all relevant information to make unbiased forecasts of expected returns, risks, and any other relevant characteristics of future fund performance, then use such estimates to determine an optimal combination of investments in appropriate funds. Our analysis of the Morningstar measures focuses on their key properties. The reader interested in empirical analyses of these and more traditional measures as well as the similarities and differences among them in practice will find a relatively extensive treatment in Sharpe [1997] . We begin with a description of the computations used by Morningstar.

Morningstar's Risk-adjusted Ratings


The Risk-adjusted Rating The Risk-adjusted Rating (RAR) for a fund is calculated by subtracting a measure of the fund's relative risk (RRisk) from a measure of its relative return (RRet): RARi = RReti - RRiski
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Relative Returns and Relative Risks Each of the relative measures for a fund is computed by dividing the corresponding measure for the fund by a denominator that is used for all the funds in a specified peer group. Letting g(i) represent the peer group to which fund i is assigned: RReti = Reti / BRetg(i) RRiski = Riski / BRiskg(i) where BRetg(i) and BRiskg(i) denote the bases used for the relative return and relative risk of all funds in the group in question. Star and Category Risk-adjusted Ratings Morningstar calculates RAR values taking load charges into account for purposes of determining its "star ratings". However, their newer "category ratings" omit load charges. The time periods utilized also differ. Four sets of star ratings are computed. The first three cover the last 3, 5 and 10 years, while the most popular (overall) measure is based on a combination of the 3,5 and 10-year results. In contrast, the category ratings cover only the last 3 years (36 months). For simplicity, we describe only the calculations for the RAR values used for the category ratings. Sharpe [1997] provides considerable detail about the broader set of measures as well as a host of empirical analyses of their similarities and differences. Return Morningstar's measure of a fund's return is the difference between the cumulative value obtained by investing $1 in the fund over the period and the cumulative value obtained by investing $1 in Treasury bills: Reti = VRi - VRb Thus if $1 invested in the fund would have grown to $1.50 in 36 months, assuming reinvestment of all distributions, while $1 invested in Treasury bills would, with reinvestment, have grown to $1.20: Reti = 1.50 - 1.20 = 0.30, or 30% The Relative Return Base

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Two steps are required to calculate the base to be used to calculate the relative returns for all the funds in a group. First, the returns for all the funds in the group are averaged. If the result is greater than the increase in value that would have been obtained with Treasury bills, the group average is used. Otherwise, the growth in value for Treasury bills is used. Thus: BRetg(i) = max ( mean i in g(i) [Reti], VRb - 1) Note that for the average value of Reti to be used, the funds must do at least twice as well as Treasury bills -- that is: mean i in g(i) (VRi - 1) >= 2*(VRb - 1) As we will show, the fact that BRetg(i) may have one of two distinct values makes it difficult to characterize the RAR measure in general terms. Risk To measure a fund's risk, Morningstar first computes the fund's excess return (ER) for each month by subtracting the return on a short-term Treasury bill from the fund's return. Next, all the positive monthly excess returns are converted to zeros. Finally, a simple mean is taken of the resulting "monthly losses" and the sign reversed to give a positive number2 Thus: Riski = - meant ( mint [ERit , 0] ) The result is defined as a measure of the fund's "average monthly loss". More strictly, it is a measure of opportunity loss, where the foregone opportunity is investment in Treasury bills, and months in which there was an opportunity gain are counted as periods of zero opportunity loss. The Relative Risk Base The base used to calculate the relative returns for all the funds in a group is simply the average of all the risk measures for the funds in that group: BRiskg(i) = meani in g(i) [Riski] Peer Groups For purposes of calculating RARs, each fund is assigned to one (and only one) peer group. For its star ratings, Morningstar uses four such groups: domestic equity, international equity, taxable bond, and municipal bond. For its category ratings, peer groups are defined more narrowly. In mid-1997, for example, there were 20 domestic equity categories, 9 international equity categories, 10 taxable bond
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categories, and 5 municipal bond categories. Stars and Category Ratings While Morningstar reports relative returns, relative risks and risk-adjusted ratings, most attention is focused on the "stars" and "category ratings" derived from the RAR values. To assign these measures, the RARs for all the funds in a peer group are ranked; funds falling in the top 10% of the resulting distribution are given 5 stars (or a category rating of 5), those in the next 22.5% get 4, those in the next 35% get 3, those in the next 22.5% get 2, and those in the bottom 10% get 1.

Mean-Variance Measures
Expected Utility Most academic treatments of risk and return are based on the mean-variance approach developed in Markowitz [1952]. Markowitz argued that the desirability of a probability distribution of portfolio returns should be summarized using the first two moments: the expected return and the standard deviation of return (or its square, the variance of return). The ex post counterparts are the arithmetic mean return, which we will denote Mi for fund i and the standard deviation of historic returns, which we will denote Si. For an investor who chooses only one mutual fund, the fund's return will equal his or her overall portfolio return. In this very special case, if the investor follows Markowitz' prescriptions, the expected utility of a portfolio invested solely in fund i can be written as: EUi = Mi - rk* (Si2) where rk is a measure of investor's k's risk-aversion -- that is, his or her marginal rate of substitution of mean return for variance of return. The goal of such an investor is to select the one fund for which this measure is the greatest, under the maintained assumption that historic returns are appropriate predictors of future returns. While this type of expected utility function is widely used for optimization analyses, it is rarely chosen for ex post performance measurement. In part this is due to the fact that it only applies strictly when all an investor's funds are to be allocated to one single risky investment. Even more limiting, however, is the fact that in principle no universal measure of this type can be used by all investors. Rather, each investor must evaluate performance using a measure designed for his or her degree of risk aversion (rk). The Excess Return Sharpe Ratio

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In an important contribution to investment theory, Tobin [1958] showed that combining a riskless investment with a risky one provides an opportunity set in which expected excess return is proportional to return standard deviation. This implies that an investor able to borrow or lend at a given rate and who is planning to hold only one mutual fund plus borrowing or lending should select the fund for which the ratio of expected excess return to standard deviation is the highest. This ratio is generally termed the Sharpe ratio, based on its introduction in Sharpe [1966]. As shown in Sharpe [1994], the key properties of the original measure apply more broadly to any "zero-investment strategy" such as that given by the difference between the returns on any two investments. To avoid confusion, we refer to the measure based on excess returns as the excess return Sharpe ratio (ERSR). Letting Rbt represent the return on a riskless security, the excess return Sharpe Ratio for fund i is: ERSRi = meant (Rit - Rbt) / stdevt (Rit - Rbt) Ex ante, Rb is a fixed constant, so that: ERSRi = (Mi - Rb) / Si Ex post, the more complete formula is typically employed to account for any variation in Rb. The goal of an investor able to borrow or lend at a fixed rate but planning to hold only one risky mutual fund is to select the fund with the greatest ex ante ERSRi since a strategy employing it with the appropriate amount of leverage can provide the greatest possible expected return for any desired level of risk As with other measures, of course, selection of a fund with the highest ex post excess return Sharpe ratio is only appropriate under the maintained assumption that the historic return distribution is a good predictor of the future probability distribution. Excess return Sharpe ratios are often used as measures of mutual fund performance, partly because they are less limited in applicability than mean variance expected utility measures. Importantly, under the assumptions on which the argument is based, the fund with the greatest Sharpe ratio is the best for any investor, regardless of his or her degree of risk aversion. In this sense, the measure is universal. Strictly, of course, the ratio is suitable only for cases in which an investor plans to invest funds in a single risky asset plus (possibly) borrowing or lending. Thus it is slightly more general (two investments rather than one), but still potentially inappropriate for a more typical portfolio involving multiple risky funds.

RAR as an Expected Utility Function


Expected Utility

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As shown, a fund's RAR is the difference between two relative measures: RARi = [ Reti / BRetg(i) ] - [ Riski / BRiskg(i) ] Rearranging slightly gives: RARi = (1 / BRetg(i) ) * [ Reti - ( BRetg(i) / BRiskg(i) ) Riski ] Note that both the first and second parenthesized expressions are the same for all the funds in a given group. Since the first term must be positive, both the rankings of funds within a group and the relative magnitudes of their ratings will be unaffected if this term is omitted. Denoting the second parenthesized expression as kg(i) gives a re-scaled RAR of the form: RRARi = Reti - kg(i) * Riski It is tempting to interpret this modified function as a measure of the expected utility of fund i for an investor with a risk aversion of kg(i), where risk aversion is a measure of the investor's marginal rate of substitution of Reti for Riski. Under this interpretation, kg(i) would represent the risk aversion of all investors who select funds in the group in question. We address the relevance of such an assumption later. For now we take RRAR as a measure of expected utility. Periodicity Sharpe ratios use standard statistics from a frequency distribution of differential returns. For example, the first two moments of the probability distribution of next month's excess return might be assumed to be similar to the same moments from the frequency distribution of the last 36 months' excess returns. Importantly, the same time period (e.g. monthly) is used for both statistics. Morningstar's risk measure has a similar character. Each monthly loss is given the same weight, with the average value presumably used as a surrogate for the expected value of next month's loss. However, the measure of return is the difference between two cumulative values taken over the complete historic period. The properties of such a statistic are complex, since it represents the difference between two value relatives, each of which can be considered to equal the result obtained by raising [1 plus the geometric mean return] to the T'th power, where T is the number of months in the overall period. Since the geometric mean of a series of returns is a function of both the arithmetic mean and the variance of the series, the resulting return measure includes aspects of both return and risk. Among other things, this makes the statistical properties of Morningstar's measure highly complex, seriously compromising the analyst's ability to estimate likely ranges of future performance, given historic results. This contrasts with the Sharpe ratio, which is a simple transform of the standard t-statistic for measuring the statistical significance of the difference between a realized mean value and zero and
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hence easily used in this manner. We explore further implications of Morningstar's calculation in greater detail below. For now, we consider a modification that would make the RAR measure internally consistent. In particular, we use as a measure of return the difference between the fund's arithmetic mean monthly return and the arithmetic mean return on Treasury bills; we also modify the procedure used to calculate the relative return base accordingly: MRARi = MReti - mkg(i) * Riski where : MReti = meant (Rit - Rbt) In this measure, mkg(i) is the marginal rate of substitution of mean monthly excess return for mean loss, given by: mkg(i) = MBRetg(i) / BRiskg(i) where: MBRetg(i) = max ( meani in g(i) [MReti], meant [Rbt] ) Except in extreme cases, the relative MRARi values for the funds within a peer group will be similar to those obtained using Morningstar's actual procedures (that is, the corresponding RRARi or RARi values). In the following analysis, we assume that MReti, BRetg(i) and kg(i) are computed using arithmetic monthly mean values. This allows us to obtain precise analytic results. Fortunately, the main qualitative conclusions apply as well to the more complex measures utilized by Morningstar. The Bilinear Utility Function Consider an investor with a Von Neuman-Morgenstern utility function of the form: U = a* (Ri - Rb) if Ri <= Rb, and U = (Ri - Rb) if Ri > Rb where Ri is the return on fund i, Rb is the return on treasury bills, and a is a constant greater than one.

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An example of such a function in which Rb=5% and a= 3 is shown in Figure 1. As can be seen, it is composed of two linear segments, with a greater slope to the left of Rb than to the right. Such a function exhibits risk-aversion in the large, since the loss in utility associated with a return below Rb is greater than the gain in utility associated with a return equally far above Rb. However, within return ranges that lie wholly above or wholly below Rb, the function is linear and thus reflects risk-neutrality.

Figure 1: A Bilinear Utility Function

A bilinear function of this sort captures one of the three salient features of the prospect theory of decisionmaking under uncertainty derived by Kahneman and Tversky [1979] from observation of choices made by subjects in experimental settings. An individual with such a function experiences loss-aversion, where loss is measured from a reference point determined by the current riskless rate of return Rb. More precisely, the function can be said to reflect opportunity loss aversion, with the value of the parameter a providing a measure of the degree of such aversion and the riskless rate acting as the reference point or alternative investment opportunity.

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Maximizing Expected Utility with a Bilinear Utility Function Now consider an investor with a bilinear utility function who wishes to determine the expected utility of a given mutual fund over a future period. To begin, we rewrite the formula for the utility function as: U = Ri - Rb + [(a - 1) *(Ri - Rb) if Ri <= Rb and 0 otherwise] The expected value of U will thus be: E(U) = E( Ri - Rb ) + (a - 1)* E ( Li) where: Li = Ri - Rb if Ri <= Rb, and Li = 0 if Ri > Rb Note that Li is exactly equal to Morningstar's monthly loss figure.. Let there be T possible future returns, each equally likely to be realized. Then the expected values are simply arithmetic means, and: E(U) = mean ( Ri - Rb ) + (a - 1)* mean( Li) Substituting historic excess returns for future returns gives a measure that would be precisely equal to Morningstar's RAR if the latter used arithmetic mean monthly excess returns for its return calculations. Since the differences due to this disparity are likely to be small, in form, Morningstar's RAR measure is highly similar, if not identical, to that that would be chosen by an investor who wishes to maximize a bilinear utility function but has decided to invest in only one mutual fund. Loss-aversion Compare the equation for expected utility with our modified version of Morningstar's RAR measure: MRARi = Reti - kg(i) * Riski Thus it is approximately true that:

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a = 1 + kg(i) Since kg(i) is positive, the investor will exhibit opportunity loss aversion, with the magnitude of aversion greater, the larger is kg(i). Optimal Investment Choice for an Investor with a Bilinear Utility Function While the bilinear utility function has at least one attractive property, on closer examination it can be shown to imply extreme investment choices under plausible circumstances, as we now show. Consider a strategy in which a proportion of an investor's wealth equal to x is placed in risky fund i and a proportion equal to (1-x) is placed in a riskless asset. The mean and variance of the strategy's excess return will be given by x*Mi and x*Si, respectively. Since both measures are linear in scale, their ratio is scale-independent. Thus the excess return Sharpe ratio for the strategy will equal that of the fund itself. Indeed, it is the fact that Sharpe ratios are scale-independent that makes them attractive as measures of performance. For such strategies, both of Morningstar's measures are also proportional to scale. Recall that: Reti = VRi - VRb Letting TRi and TRb represent the total compound return for fund i and bills, respectively, over the period covered: Reti = ( 1 + TRi ) - ( 1 + TRb ) = TRi - TRb For a strategy in which x is invested in fund i and (1-x) in Treasury bills: Retx = [ x*(1 + TRi ) + ( 1-x)*( 1 + TRb )] - (1 + TRb) = x*(TRi - TRb) = x*Reti A similar relationship holds for the average loss measure. In months for which Ri <= Rb: L = x*(Ri - Rb) while for months for which Ri > Rb: L = 0 = x*0 Hence for the strategy in which x is invested in fund i and (1-x) in Treasury bills:

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Riskx = x * Riski The fact that both Morningstar's measures are proportional to scale implies that by combining a risky fund with borrowing or lending, an investor can attain any point on a linear opportunity set in Retx-Riskx space. Faced with such a tradeoff, what choice will be made by an investor with a bilinear utility function? Figure 2 shows three possible outcomes. In each case, the opportunity set is shown by the red line. The green lines are representative iso-expected utility lines . All combinations of risk and return along any such line provide the same expected utility, with higher lines representing greater expected utility than lower lines. Each investor's objective is to find the feasible point (on the red line) with the highest expected utility (on the highest attainable green line). The three figures represent investors with different degrees of risk aversion. The investor in the left-hand panel is the most risk averse; the investor in the right-hand panel is the least risk averse;the investor in the middle panel has an intermediate degree of risk aversion.

Figure 2: Investment Choice for Three Investors with Bilinear Utility Functions

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Note that for two out of the three investors the optimal choice is an extreme one. The conservative investor invests solely in Treasury bills, while the aggressive investor puts as much as possible in the mutual fund, borrowing to the maximum allowable limit. Only for an investor with risk aversion precisely equal to the available risk-return tradeoff is any interior strategy optimal, and any such investor is totally indifferent to the degree of leverage involved. Such choices are clearly inconsistent with the observed behavior of the vast majority of investors, calling into serious question the assumption that investors have utility functions as simple as that of the bilinear form. The problem is mitigated slightly in settings in which many investment options are available and multiple funds may be selected. However, even in such cases, the efficient opportunity set is likely to be close to linear, leading to very similar results. Note that these objections apply as well to a function in which expected utility is a linear function of mean (Mi) and standard deviation (Si). The problem does not arise, however, using the Markowitz formulation in which expected utility is a linear function of mean and variance, since the implied isoexpected utility curves increase at an increasing rate in mean/standard deviation space. As shown in Figure 3, such preferences lead to interior investment choices, even when the efficient portion of the opportunity set is linear. Figure 3: Investment Choice for an Investor with a Mean-Variance Utility Function

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RAR as a Function of Mean and Variance


While Morningstar's RAR measure differs considerably from a utility function based on a fund's mean and variance of return, it is likely to be well approximated by a function of these more traditional measures. Morningstar Return as a function of mean and variance To begin, consider Reti. It is the difference between the value relative for the fund and that for Treasury bills. But the value relative over T periods will equal one plus the geometric mean return (G) to the T'th power. Thus Reti = ( 1 + Gi) T - (1 + Gb)T A close approximation for the geometric mean of a series is given by subtracting one-half the variance from the arithmetic mean. Thus: Reti = ( 1 + Mi - Si 2 / 2 ) T - (1 + Mb - Sb2 / 2)T
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As can be seen, Morningstar's return measure incorporates aspects of both mean return and risk (standard deviation of return), with Reti increasing in Mi and decreasing in Si. Given knowledge of Mi and Si, one can clearly obtain a good estimate of Reti. Morningstar Risk as a function of mean and variance The situation is not as clear-cut for Riski. In general it will depend on both the shape of the return distribution and its moments. Letting prx be the probability of state of the world x and ERix the excess return on fund i in state x, the expected loss (Riski) for fund i is defined as: Riski = - sumx [ prx*minx (ERix ,0) ] Consider now the situation in which the mean and variance of the distribution of excess returns are sufficient statistics to identify the entire distribution. This is the case, for example, if returns are normally distributed. Under this assumption: Riski = f [ Mi-Rb, Si ] since Mi-Rb is the mean of the excess return distribution and Si is its standard deviation (assuming that Rb is known). Using a relationship given in Triantis and Hodder [1990], it can be shown3 that for a normal distribution: Riski = f [ Mi-Rb, Si ] = Si * n(-z) - (Mi - Rb) * N(-z) where: z = ( Mi-Rb ) / Si Here, n(z) denotes the standard normal density function while N(z) denotes the standard cumulative normal. 3. Empirical evidence given in Sharpe [1997] indicates that monthly return distributions for diversified mutual funds may be sufficiently close to normal to make this approximation quite accurate Morningstar RAR as a function of mean and variance If both Riski and Reti are well approximated as functions of Mi and Si, then RARi will be also.

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Figure 4 shows the relationship between RAR and various combinations of e (expected annual excess return) and sd (standard deviation of annual excess return) using the approximations given above for a case in which the riskless rate of interest is 5% per year, the holding period is 3 years, and the peer group has an average excess return of 5% and a standard deviation of 15%. As can be seen, the relationship is monotonic and very close to linear in the region shown, which includes likely combinations for popular investment strategies. Figure 4: RAR as a Function of Expected Excess Return and Standard Deviation

The high degree of linearity of the relationship in Figure 4 can be seen more clearly in Figure 5, which shows a few of the associated iso-RAR curves. Clearly an investor who wishes to maximize RAR is likely to select an extreme solution unless the opportunity set is highly non-linear. Figure 5: Iso-RAR Curves

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Recall that a portfolio is said to be mean-variance efficient if it provides the maximum possible mean for a given level of variance and the minimum possible variance for a given level of mean. Equivalently, fund A is said to be inefficient if there exists another fund B with (1) the same expected return but less risk, (2) the same risk but more expected return, or (3) less risk and more expected return. With functions such as those shown in Figures 4 and 5, in each such case, fund B would also have a higher RAR value than fund A if the approximations held. Thus it would be appropriate to exclude from consideration portfolios that are inefficient using the mean-variance criterion even if the ultimate goal were to select a portfolio with the largest possible RAR value. These relationships imply that the key differences between Morningstar's measures and those used in more traditional mean-variance analyses concern (1) the use of a linear combination of a return measure and a risk measure, rather than a ratio of the two and/or (2) the use of risk per se rather than risk-squared in the linear measure. The use of a multi-period value relative and a measure of average loss is thus of secondary importance in terms of implications for fund selection. These results provide an illustration of our earlier assertion that Morningstar's actual RAR calculations give implications for investment choice very similar to those obtained using the simpler modified (MRAR) measure. Moreover, they suggest that if monthly returns are close to normally distributed, a choice based on a RAR measures will differ from one based on the use of a traditional mean-variance approach only in the selection of an extreme point on the mean-variance efficient frontier rather than an interior point on that same frontier. This is unfortunate since a preference for extreme risk-return combinations is inconsistent with investor behavior. In effect, the RAR measure assumes that an investor's marginal rate of substitution of expected return for risk is the same, no matter what the level of his or her portfolio's return or risk. This is inconsistent with observed behavior -- both in this context and
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in more general cases involving choices among competing alternatives.

RARs and Excess Return Sharpe Ratios


Clearly, there are conceptual difference between rankings of funds based on RAR values and excess return Sharpe Ratios. This can be seen in Figure 6, which shows selected iso-excess return Sharpe Ratio lines (iso-SR for short) in red and selected mean-variance approximations of iso-RAR curves in green. Figure 6: Iso-Excess Return Sharpe Ratio Lines and Approximate Iso-RAR Curves

To assess the likely magnitudes of such differences, consider a selected mutual fund, X and the iso-RAR and iso-SR lines on which it lies. Figure 7 shows a case in which fund X has an expected return of 10% and a standard deviation of 15%. Now consider the set of all funds that are better than X based on the RAR criterion. They will lie above the green line in Figure 7. Similarly, the set of all funds that are worse than X based the RAR criterion will lie below the green line. On the other hand, funds that are better than X based on the ERSR criterion will lie above the red line and those that are worse will lie below the red line. Figure 7: The Iso-SR and Iso-RAR Lines for a Single Fund

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Obviously, the sets of funds rated better or worse than X may be different, depending on the criterion used. However, the differences may be relatively few. Figure 8 shows the regions in which the criteria give different results. Any fund plotting in the blue area will have a higher RAR than fund X but a lower ERSR. Any fund plotting in the yellow area will have a lower RAR than fund X but a higher ERSR. However, for all funds that plot above both lines or below both lines, the criteria will lead to the same conclusion. In general, the closer the slopes of the two lines, the fewer will be the disparities in rankings between the two criteria. Figure 8: Regions in Which the SR and RAR Criteria Conflict

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Now, recall the procedures used to compute Morningstar's RAR measures. As we have shown, the slope of the iso-RAR curve is given by the ratio of the return base to the risk base. If the period used for the computation has been one in which the average return for the funds in the relevant peer group has been sufficiently high (greater than two times the return on Treasury bills), the return base will equal the mean excess return for the funds in the peer group. In every case the risk base is the mean risk for the funds in the peer group. Let a fund (A) have a mean excess return and standard deviation of return equal, respectively, to the corresponding average value for all the funds in its peer group. This implies that under such conditions, by construction, the mean-variance approximation to the iso-RAR line for fund X will be coincident with the iso-SR line for the fund. In such circumstances, the sets of funds that are better and worse than fund A will be the same, no matter which criterion is used. The same can be said about any fund that plots on fund A's iso-SR (and iso-RAR) line -- that is, any fund with the same ERSR as a fund with the average risk and return for the peer group. In practice, funds are likely to cluster reasonably closely around this line. Hence we might well expect that for peer groups with good average historic performance, rankings based on Morningstar's RAR measure might be relatively similar to those based on the more traditional excess return Sharpe Ratio. Figure 9, taken from Sharpe [1997], shows that this can indeed be the case. Each point represents the ranking of a one of 1,286 diversified equity funds within its category peer group, based on performance from 1994 through 1996. The correlation coefficient was 0.986, showing that despite substantial differences in computational procedures, Morningstar's approach and the simpler excess return Sharpe Ratio do indeed give similar results in times such as the 1994-1996 period of relatively high returns for U.S. equity funds.

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Figure 9: Rankings Based on Morningstar's Category RARs and Excess Return Sharpe Ratios

While these results are quite striking, it is important to note that they apply to a situation in which returns were high and Morningstar's procedure therefore utilized the mean returns of the peer groups for the return bases in the calculations. Since ex post returns are used for the performance measures, there can be situations in which the average return for a peer group is small or even negative. In such cases, Morningstar sets the return base at the level obtained by Treasury bills. This may well lead to a greater disparity in rankings based on the Morningstar and Sharpe Ratio measures. Figure 10 shows an extreme version of such a situation. Here, both funds X and Y have performed poorly. However, fund Y had a better (algebraically greater, or less negative) excess return Sharpe Ratio than fund X, as shown by the fact that it lies on a higher iso-SR (red) line. On the other hand, Morningstar's RAR measure assigns a better rating to fund X than to fund Y, since X provided a better average return and a lower risk, leading the fund to plot on a higher iso-RAR (green) line. Figure 10: Performance of Two Funds in Bad Times

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This example makes very clear the differences in the questions that the two measures attempt to answer. We have argued that the RAR measure is best seen as an attempt to determine the best single fund on the assumption that only one fund is to be held in the investor's portfolio. In this context, X was certainly better (here, less bad) than Y. Moreover, this would be true for any (positive) degree of investor riskaversion (slope of the iso-RAR lines). However, this is not the setting for which the excess return Sharpe Ratio was developed. It is intended for situations in which an investor can use borrowing or lending to achieve his or her desired level of risk. In this context, the excess return Sharpe Ratio gives the more appropriate answer. An investor who desired a level of risk of, say 10% would have held either fund X or a 50/50 combination of fund Y and lending at the riskless rate (here, 5%). The latter strategy, shown by point Y' in Figure 10, was clearly better than investment in fund X, as shown by its greater excess return Sharpe Ratio.

Multi-Fund Portfolios
Morningstar's measure is best suited to answer questions posed by an investor who places all his or her money in one fund. The excess return Sharpe Ratio is best suited to answer questions posed by an investor who allocates money between one fund and borrowing or lending. Neither type of investor
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should be interested in ranking funds within peer groups -- indeed such rankings conceal information about the relative magnitudes of the underlying variables that is crucial for such an investor. Why then does Morningstar present its risk-adjusted ratings in terms of rankings of funds within peer groups? The only plausible answer is that investors are assumed to have some other basis for allocating funds across peer groups and plan to use Morningstar's rankings as at least an important input when deciding which fund or funds to choose from each peer group. In such a situation, neither Morningstar's measure nor the excess return Sharpe Ratio is an appropriate performance measure. The reason is simple. When evaluating the desirability of a fund in a multi-fund portfolio, the relevant measure of risk is its contribution to the total risk of the portfolio. This will depend on the fund's total risk and, more importantly, in most cases, on its correlation with the funds in the remainder of the portfolio. Neither the Morningstar RAR measure nor the excess return Sharpe Ratio incorporates any information about such correlation. Excessive reliance on either measure in such a decision process could seriously diminish the effectiveness of the resulting multi-fund portfolio. There are some very special cases in which a different single measure of fund performance may be useful when constructing an optimal multi-fund portfolio. For example, Sharpe [1994] shows that the Selection Sharpe Ratio, based on the difference between a fund's return and that of an appropriate asset class benchmark, may be used if long and short positions in asset classes can be taken as needed. However, the preconditions for this special case may not be met in many cases, and even if they are, there can be significant differences between rankings based on excess return Sharpe Ratios and Selection Sharpe Ratios. Given the relationships between RARs and excess return Sharpe Ratios, rankings based on Selection Sharpe Ratios will also differ considerably from those based on RARs. In many if not most cases, the use of any procedure for ranking funds within peer groups, followed by selection of one or more funds from each of several peer groups based on such rankings, is likely to be suboptimal, and possibly highly suboptimal.

Conclusions
We have shown that Morningstar's RAR measure has a number of drawbacks. It is complex, with poor statistical qualities. More importantly, it fails to capture an important aspect of investor preferences -increasing aversion to risk -- and the resulting desire for portfolios that are neither the least or most risky available. Fortunately, the inherent disadvantages are mitigated to a considerable extent by Morningstar's practice of adjusting the risk-aversion implicit in the measure to equal the ratio of return to risk for each peer group over the specific period covered, although this adjustment is made only in part if the peer group performance has been modest or poor. While this procedure makes the measure even more time and sample-dependent, it has the advantage of aligning rankings rather well with those that would be obtained using the more familiar, less complex and statistically more straightforward excess return Sharpe Ratio.
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Given a choice between Morningstar's RAR measure and the excess return Sharpe Ratio, the evidence would seem to favor the latter. However, a more appropriate choice would involve either a different performance measure or none at all. If it is possible to costlessly separate fund selection from asset allocation by taking long and short positions in index funds representing "pure asset plays", funds may usefully be evaluated based on their projected Selection Sharpe Ratios. Such measures take into account only a fund's non-asset related expected return and risk. Typically, rankings based on selection Sharpe Ratios will differ considerably from those based on Morningstar's measures or excess return Sharpe Ratios. So of course will the resulting preferred portfolios. While it is tempting to conclude that investors constructing multi-fund portfolios should shift their focus from performance measures based on total or excess return to those based on differential or relative-tobenchmark return, such is not our ultimate counsel. The conditions under which the Selection Sharpe Ratio is appropriate are stringent and unlikely to hold for a typical investor. Rather than continue the search for the ideal universal performance measure it is preferable to return to basics. Markowitz taught us that portfolios should be constructed taking into account the best possible estimates of all relevant future risks and returns. This is as true for portfolios of mutual funds as it is for portfolios of individual securities. Asset allocation exercises, followed by selection of funds within peer groups based on simple rankings, are easy but may lead to inefficient overall portfolios. A better approach takes into account the complexity involved in such decisions. The key information an investor needs to evaluate a mutual fund includes (1) its likely future exposures to movements in major asset classes, (2) the likely added (or subtracted) return over and above a benchmark with similar exposures, and (3) the likely risk vis-a-vis that benchmark. Efforts should be devoted to obtaining the best possible estimates for future values of these key ingredients, then using them optimally to determine efficient portfolios.

Footnotes

*. The author would like to thank John Watson of Financial Engines, Inc. for suggestions and comments on an earlier draft. 1. Described in Damato1996 2. For the calculations used by Morningstar, it makes no difference whether the sign is reversed, due to the subsequent division by the risk base, which is an average of all the risk numbers. However, for ease of interpretation, we reverse the sign so that a smaller absolute value of risk will be considered more desirable than a larger absolute value (as with standard deviation). 3. Function f was obtained by integrating over negative values of the excess return, taking into account
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the relationship shown in equation (A1) in Triantis and Hodder [1990].

References

Damato, Karen "Morningstar Edges Toward One-Year Ratings," The Wall Street Journal, April 5, 1996, p. C1. Markowitz, Harry, "Portfolio Selection," Journal of Finance, March 1952, pp. 77-91 Sharpe, William F., "Mutual Fund Performance," Journal of Business, January 1966, pp. 119-138. Sharpe, William F., "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994. Sharpe, William F., Morningstar's Performance Measures, 1997 Kahneman, Daniel and Amos Tversky, "Prospect Theory: An Analysis of Decision Under Risk," Econometrica, XXXXVII (1979): pp. 263-291. Tobin, James, "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, February 1958, pp. 65-86. Triantis, Alexander J. and James E. Hodder, "Valuing Flexibility as a Complex Option," The Journal of Finance, Vol. XLV No. 2, June 1990, pp. 549-564.

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Morningstar's Performance Measures: Contents

Morningstar's Performance Measures Contents

Overview Computation Alternative Measures Fund Characteristics 3-year and Overall Ratings Sharpe Ratios Category Ratings Star Ratings Alphas and Selection Returns Peer-Group Comparisons

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Morningstar's Performance Measures: Overview

Morningstar's Performance Measures Overview

Morningstar's Performance Measures


In early 1997, Morningstar Incorporated's CD-ROM service included data on 7,782 mutual funds based in the United States. The number of such funds, already large, continues to grow at a rapid rate. Given this enormous range of choice, investors crave a simple method for separating good funds from average or bad funds. Several services purport to do so. However, Morningstar's is almost certainly the most widely used in the United States, with the majority of attention given to its "star" risk-adjusted performance measures. Evidence of the impact of the Morningstar ratings abounds. Fund manager advertisements frequently cite them. For example: "How did one company's mutual funds receive more four- and five-star ratings than 98% of the companies with funds rated by Morningstar? We earned them."1 "... Morningstar gave an impressive overall rating of four stars to the CREF Stock Account... The CREF Bond Market Account received an overall rating of five stars ... and the CREF Social Choice Account earned four stars..."2 The influence of these ratings is thought to be considerable. According to one report: "As billions of dollars flow into mutual funds, those ubiquitous Morningstar stars carry a lot of weight with investors. They mean big money for fund companies that can advertise top-of-the-heap "five star" results. indeed, almost 90% of the new money that flowed into stock funds last year went to funds with four-star and five-star ratings, according to Financial Research, of Chicago."3 While "the stars" are the most prominent performance measures produced by Morningstar, they are by no means the only ones. In fact, six different measures designed to take both risk and return into account can be found in Morningstar's services.
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It is clearly important that investors understand the procedures used by Morningstar to compute key performance measures, the theoretical and empirical characteristics of such measures and the relationships between them and alternative measures used in academic and professional studies. Such is the goal of this paper.

Historic Analysis versus Prediction


Morningstar presents its measures as summaries of historic results which may or may not provide useful predictions of future results. For example: "Many commentators insist on treating the star rating as a predictive measure or a shortterm trading signal. The rating, which is clearly labeled as a historical profile, does neither. (It would be just as ill-advised to treat an alpha or a Sharpe ratio with similarly blind faith).... the rating does not reflect Morningstar's opinion of a fund's future potential; it is simply a first-stage screen that summarizes how well each fund has historically balanced risk and return."4 While such cautionary statements are well-advised, the choice of an historic performance measure is likely to be made on the presumption that the measure in question will have some predictive value for some measure evaluated over a future period. Moreover, it is usually assumed that the performance measure that can best provide information about a given future measure is the historic value of that same measure. In practice neither of these assumptions may prove warranted. In this paper we consider several measures of performance. For each, we attempt to answer two questions: 1. In what investment context is the measure most suitable for summarizing forecasted performace? 2. How different are the historic results obtained with the measure from those obtained with other measures? More simply put: 1. For what decision is the measure best? 2. How different is it from the others? From a pragmatic viewpoint it is important to address both these issues. Theory may indicate that
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measure A is preferable to measure B for answering a particular investment question. However, if the results obtained by ranking funds on measure B are almost the same as thouse obtained by ranking them on measure A, use of the wrong measure may not prove especially harmful. We address only in passing the third piece of the puzzle -- the extent to which a given future performance measure can be predicted using currently available information, including previous realizations of the same or other performance measures. Other studies and our very tentative results suggest that a fund's expense and turnover are likely to better predict its future net performance than any single measure of its past performance. Nonetheless, historic performance may add predictive power when used in conjunction with information about a fund's expenses and turnover. In such instances a risk-adjusted measure of historic performance is likely to prove to be more valuable than one without such adjustment, even when the measure being predicted involves little or no adjustment for risk.

Footnotes
1. Smith Barney advertisement in the Wall Street Journal, May 3, 1996. 2. Academe This Week, provided by TIAA CREF on the World Wide Web, June 3, 1996. 3. Karen Damato, "Morningstar Edges Toward One-Year Ratings", The Wall Street Journal, April 5, 1996, p. C1. 4. Amy C, Arnott, in Morningstar Mutual Funds, December 6, 1996

Go to Table of Contents for this paper

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Morningstar Performance Measures: Computation

Morningstar's Performance Measures: Computation

Sources
The material in this section was initially prepared by the author based on Morningstar's descriptions and tested for accuracy with experiments using Morningstar's CD-ROM data to replicate selected results. An early draft of the material was reviewed by Morningstar and revised to correct errors. Subsequently, new material was added. I am grateful for the assistance provided by Paul Gozali, Don Phillips and Paul Torregrosa of Morningstar. Any errors, of course, remain mine.

The Measures
Morningstar provides a great deal of useful information in its print publications and in its Principia Plus CD-ROM data service. We focus here on six measures of performance that take into account both a measure of historic average or compound return and a measure of historic risk and/or benchmark performance. In order of increasing complexity, they are:
q q q q q q

Sharpe ratio alpha best-fit alpha category risk-adjusted rating (and category rating) 3-year risk-adjusted rating (and 3-year star rating) overall risk-adjusted rating (and overall star rating)

The first three measures are absolute and cardinal -- each fund receives a numeric rating that is not dependent on the performance of other funds. The other measures are relative and ultimately, ordinal. Each is built in three stages. In the first stage, a cardinal measure is determined for each member of a group. In the second stage these measures are converted to ordinal ranks, indicating relative positions within the group. In the final stage, the ranks are used to assign each fund a rating from 1 to 5, with 5 assigned to the best funds in the group and 1 to the worst.
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The first four measures summarize aspects of fund performance over the most recent three years, based on total returns without considering any load charges. The last two measures take load charges into account. The succeeding sections describe a number of subsidiary calculations that serve as components of the six measures of interest. To avoid ambiguity and to follow in the tradition of Morningstar's nomenclature, we prefix some of the measures with "ms". We also highlight the sections describing such measures in red.

Monthly Returns A primary ingredient in all the Morningstar calculations is the set of historic monthly rates of return for the funds. The rate of return for fund i month t is calculated as follows: Rit = (EVit + EVDit - EVi,t-1) / EVi,t-1 where: EVit = closing net asset value on the last trading day of month t EVDit = closing net asset value on the last trading day of month t of distributions taken as shares in month t EVi,t-1= closing net asset value on the last trading day of month t-1 In general, distributions are reinvested in the fund's shares at the closing net asset value on the "exdistribution day".

Monthly Excess Returns For many calculations, excess returns are utilized. The excess return for fund i in month t is the difference between the fund's return for the month and the return on a 90-day U.S. Treasury bill for that month: ERit = Rit - Bt

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where: ERit = the excess return on fund i in month t Bt = the return on a Treasury bill in month t While Morningstar does not provide the source of its Treasury bill returns, they are very similar to those of Salomon Brothers' monthly returns on 90-day Treasury bills, averaging slightly under 25 basis points (.25%) less per year over the period from 1987 through 1996. During this ten-year period the two series were also highly correlated, with a correlation coefficient of 0.981.

Average Monthly Returns One measure of performance over a period is a simple arithmetic average of a fund's monthly returns, calculated by summing the fund's returns for all the months, then dividing by the number of months: AMRi = ( 1 / T ) * sumt=1..T { Rit } where: AMRi = the arithmetic monthly average return on fund i during period T sumt=1..T { } denotes the sum of the expressions in the brackets with t = 1, 2,..,T T = the number of months in the period Both here and in subsequent equations we omit the time period covered (T) in order to simplify the notation. Most of the calculations cover the last three years, with T = 36.

Average Monthly Excess Returns For some purposes, statistics for a fund's excess returns are used. The average monthly excess return is computed in the same manner as the average monthly return, but using excess returns rather than total returns: AMERi = ( 1 / T ) * sumt=1..T { ERit }
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where: AMERi = the arithmetic monthly average excess return on fund i during period T

T-Period Value Relative A traditional measure of performance in the mutual fund industry is the cumulative value of $1 compounded over a specified number of periods. Morningstar uses such measures on both before-load and after-load fee bases. The value relative at the end of T periods not taking any load charges into account is: VRi = prodt=1,..T { 1 + Rit } where VRi = the T-period value relative for fund i prodt=1,..T { } denotes the product of the expressions in the brackets with t = 1, 2,..,T

Morningstar Mean Morningstar uses the term Mean for the annual rate of return that would provide the same T-period value relative as did the actual monthly returns for a fund over the T periods. If there are T months in the period, the number of years (y) will equal T/12. The desired value is then found by solving the equation: ( 1 + msMRi ) y = VRi where: msMRi = the Morningstar mean return for fund i y = T/12 = the number of years in the period

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Standard Deviation of Monthly Returns A statistic summarizing the historic variation of monthly returns during a period is the standard deviation. This is calculated by taking the square root of the average of the squares of the deviations of the returns from their average value: VMRi = ( 1 / T ) * sumt=1..T { ( Rit - AMRi ) 2 } SDMRi = sqrt { VMRi } where: VMRi = the variance of monthly returns for fund i during period T SDMRi = the standard deviation of monthly excess returns for fund i during period T sqrt { } denotes the square root of the expression in the brackets

Standard Deviation of Monthly Excess Returns To some purposes it is useful to measure the standard deviation of a fund's monthly excess returns, computed as: VMERi = ( 1 / T ) * sumt=1..T { ( ERit - AMERi ) 2 } SDMERi = sqrt { VMERi } where: VMERi = the variance of monthly excess returns for fund i during period T SDMERi = the standard deviation of monthly excess returns for fund i during period T

Morningstar Standard Deviation

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Morningstar's reported standard deviation of fund returns uses both the monthly standard deviation and monthly mean return to compute an annualized value, assuming compounding of the monthly returns and zero serial correlation. The formula is: msSDi = sqrt { [ SDMRi2 + ( 1 + AMRi ) 2 ] 12 - [ ( 1 + AMRi ) 2 ] 12 } where: msSDi = Morningstar standard deviation of fund i

Excess T-Period Value Relative For some calculations, Morningstar compares the cumulative value of $1 invested in a fund with the cumulative value of $1 invested in Treasury bills. The latter is: VRB = prodt=1,..T { 1 + Bt } where: VRB = the T-period value relative for Treasury bills The excess T-period Value Relative for fund i is then: EVRi = VRi - VRB where: EVRi = the excess value relative for fund i after T periods

Morningstar Mean Excess Return To compute a mean excess return, Morningstar finds the annual rate of return that, if compounded, would have produced a value equal to one plus the excess T-period value relative: ( 1 + msMERi ) y = 1 + EVRi

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where: msMERi = the Morningstar mean excess return for fund i y = T / 12 = the number of years in the period

Morningstar Standard Deviation of Excess Returns Morningstar computes an annualized standard deviation based on a fund's excess returns using a formula similar to that used for total returns: msSDERi = sqrt { [ SDMERi2 + ( 1 + AMERi ) 2 ] 12 - [ ( 1 + AMERi ) 2 ] 12 } where: msSDERi = Morningstar standard deviation of fund i's excess returns

Morningstar Sharpe Ratio To compute its version of the Sharpe Ratio for a fund, Morningstar divides its mean excess return measure by its standard deviation measure: msSRi = msMERi / msSDERi where msSRi = the Morningstar Sharpe ratio for fund i

Morningstar Asset Classes and Categories In early 1997, Morningstar assigned each fund in its database to a category. Each category was, in turn, assigned to one of four asset classes. The tables below show the categories included in each of the four asset classes at the time.

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Domestic Equity Large Value Large Blend Large Growth Medium Value Medium Blend Medium Growth Small Value Small Blend Small Growth Specialty - Precious Metals Specialty - Natural Resources Specialty - Technology Specialty - Utilities Specialty - Health Specialty - Financial Specialty - Real Estate Specialty Communication Specialty - Unaligned Domestic Hybrid Convertibles

International Equity Europe Latin America

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Diversified Emerging Markets Pacific Pacific ex-Japan Japan Foreign Stock World Stock International Hybrid

Taxable Bond Long-Term Government Intermediate-Term Government Short-Term Government Long-Term Bond Intermediate-Term Bond Short-Term Bond Ultrashort Bond High-Yield Bond Multisector Bond International Bond

Municipal Bond Muni National - LongTerm Muni National Intermediate Muni Single State - LongTerm
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Muni Single State Intermediate Muni Bond - Short-Term

Of particular interest are the first nine categories in the Domestic Equity asset class, termed diversified equity funds by Morningstar. Beginning in later 1996, each equity fund that was considered sufficiently diversified was assigned to one of these nine classes, with the choice of category "... based on an average of the portfolio's characteristics over the past three years".1 Generally, such assignments are likely to be related to the average historical style box classifications of the funds over the previous three years.(the style box classification of a fund at any given time is based on the average price-to-book value, average price-to-earnings ratio, and market-capitalization of its most recently reported equity holdings). However, Morningstar "... may occasionally move a fund to a different category than its historical statistics would indicate if the fund has made a dramatic shift in style."2 but in such a case will not calculate relative-to-category measures until the fund has been in the new category for 18 months. In general, the category to which a fund is assigned is likely to reflect its average position over the previous three years on both the value/growth (low to high average stock price-to-book and price-to-earnings) and large/small (large to small average stock market capitalization) spectrums.

Morningstar Beta To compute a second measure of performance, Morningstar performs a regression analysis comparing the monthly excess returns on a fund over the last 36 months with the excess returns on a standard index. For funds in the Domestic Equity and International Equity classes, the index utilized is Standard and Poor's 500 stock index. For funds in the Taxable Bond and Municipal Bond asset classes, the index used is Lehman Brother's Aggregate Bond Index. The regression equation may be written as: ERit = ai + msBetai * ERindex,t + eit where: ERit = the excess return on fund i in month t ERindex,t = the excess return on the index in month t

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ai = the regression intercept msBetai = the regression slope coefficient eit = fund i's residual return in month i As in any such regression analysis, the slope coefficient can be computed by dividing the covariance of the variables by the variance of the independent variable. Here: msBetai = cov ( ERi , ERindex ) / Var ( ERindex ) where: msBetai = Morningstar's beta for fund i As the notation indicates, this gives Morningstar's Beta coefficient for fund i.

Morningstar Alpha The intercept from the regression used to compute the Morningstar beta for a fund provides a measure of fund performance, since it represents the mean difference between the fund's excess return and that of a strategy using an index, levered up or down to have the same beta value relative to the underlying index. To produce its measure of alpha, Morningstar annualizes the regression intercept using compounding, so that: 1 + msAlphai = ( 1 + ai ) 12 where: msAlphai = Morningstar's alpha for fund i

Morningstar R-squared The explanatory power of the regression equation fit by Morningstar to compute alpha and beta values is measured by the R-squared value. This is equal to one minus the ratio of (1) the variance of the residuals from the equation to (2) the variance of the fund's excess returns:
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1 - msR2i = var ( ERi - Betai * ERindex ) / var ( ERi ) where: msR2i = Morningstar's R-squared for fund i

Morningstar Best-Fit Alpha In addition to the regression analysis used to produce its alpha measure, Morningstar regresses each fund's excess returns for the last 36 months on a number of other indices, one at a time. It then selects the index that produces the best fit (highest R-squared value) for each fund. The alpha value from this regression is reported as the fund's best-fit alpha. The procedure is identical to that used to compute the alpha value for the fund, with the best index used instead of the standard index for the fund's asset class. In some cases the two indices are the same and the best-fit alpha will equal the (regular) alpha. In other cases the indices differ, producing potentially different values of alpha. In early 1997, twenty-one indices (termed secondary, specialized benchmarks by Morningstar) were used in this analysis. Of these, 14 were used for stock funds and 13 for bond funds. The following table lists the indices and indicates which ones were tested for each of the two types of funds.

ID LB Agg LB Int LB L-T LB Govt LB Corp LB Mtg LB Muni FB HY S&P500

Stk Bds Index Y Y Y Y Y Y Y Y Y Y Y Y Lehman Brothers Aggregate Bond Index Lehman Brothers Intermediate-Term Treasury Index Lehman Brothers Long-term Treasury Index Lehman Brothers Government Bond Index Lehman Brothers Corporate Bond Index Lehman Brothers Mortgage-Backed Securities Index Lehman Brothers Municipal Bond Index First Boston High-Yield Bond Index Standard and Poor's 500 Index

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SP Mid400 Y Russ 2000 Wil 4500 SB World MSCI AllCtry MSCI EASEA MSCI Eur MSCI Pac MSCI PacxJp MSCI WdxUS JSE Gold Wil REIT Y Y Y Y Y Y Y Y Y Y Y Y Y Y

Standard and Poor's MidCap 400 Index Russell 2000 Index Wilshire 4500 Index Salomon Brothers Non-U.S. Dollar World Government Bond Index Morgan Stanley Capital International All Country Index MSCI Europe, Australia and South East Asia Index Morgan Stanley Capital International Europe Index Morgan Stanley Capital International Pacific Index Morgan Stanley Capital International Pacific ex Japan Index Morgan Stanley Capital International World ex U.S. Index JSE Gold Index Wilshire Real Estate Investment Trust Index

Morningstar also reports beta and R-squared results from the best-fit regression, giving three measures: msBFAlphai = Morningstar's best-fit alpha for fund i msBFBetai = Morningstar's best-fit beta for fund i msBFR2i = Morningstar's best-fit R-squared for fund i

Morningstar Category Return To provide a normalized measure of returns of funds within each category, Morningstar divides each fund's excess 36-month value relative by a base figure. For each category, the base is the larger of (1) the average excess 36-month value relative for the funds in the category or (2) the 36-month value relative
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for Treasury bills - 1: msCReti = EVRi / RetBasec(i) where: msCReti = Morningstar's category return for fund i RetBasec(i) = the return base for fund i's category and: RetBasec(i) = max { avgj in c { EVRj } , VRB - 1} where: avgj in c { } indicates the average of the term in the brackets for funds (j) in category c

Since the excess value relative equals the value relative minus the value relative for bills, the return base will equal the average excess value relative only if the average increase in value for the category exceeds two times the increase in value for Treasury bills: if avgj in c { VRj - 1 } > 2 * ( VRB - 1) RetBasec(i) = avgj in c { EVRj } else RetBasec(i) = VRB - 1 If the category returns are high enough for the first of the two formulas above to be utilized, the average of the category returns for the funds within a category will equal 1.0. Otherwise, it will be less than 1.0.

Average Monthly Loss

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Morningstar's measure of risk is based on the extent to which a fund's returns fell below those of Treasury bills. The first step in such calculations involves the calculation of a fund's loss in each month, defined as the smaller of its excess return and zero: Lit = min { ERit ,0 } where: Lit = fund i's loss in month t The Average Monthly Loss for fund i is its average loss over T periods: AMLi = sum ( Lit ) / T where: AMLi = fund i's average monthly loss over T periods

Morningstar Category Risk To compute a measure of relative risk for each fund in a category, Morningstar divides each fund's average monthly loss by the average of such values for all funds in the category: msCRiski = AMLi / RiskBasec(i) RiskBasec(i) = avgj in c { AMLj } where: msCRiski = Morningstar's category risk for fund i RiskBasec(i) = the risk base for fund i's category While the average monthly loss for a fund will typically be negative, so will the risk base for its category. Thus the Morningstar category risk values will all be positive and the values for the funds within a category will average to 1.0.

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Morningstar Performance Measures: Computation

Morningstar Category Rating Morningstar combines a fund's category return and category risk to compute a category risk-adjusted rating: msCRARi = msCReti - msCRiski where: msCRARi = Morningstar's category risk-adjusted rating These values are then ranked and converted to category rating percentiles, with the largest value assigned to the 100'th percentile and the lowest to the first percentile. Finally, category ratings are assigned, based on the percentile rankings of the funds within the category, as follows: From Percentile 0 10 32.5 67.5 90 To Percentile 10 32.5 67.5 90 100 Category Rating 1 2 3 4 5

Load-Adjusted T-period Value Relative For purposes of its"star" ratings, Morningstar uses returns that take into account any "maximum frontend load fees, applicable deferred loads, and applicable redemption fees". The goal is to compute the "cash-out" value at the end of T periods, assuming an initial outlay of $1. For example, if a fund requires a maximum front-end load fee equal to Li of the initial outlay, the load-adjusted T-period value relative will be: LAVRi = ( 1 - Li ) * VRi where:

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Morningstar Performance Measures: Computation

LAVRi = fund i's load-adjusted value relative for T periods For a no-load fund, Li = 0 and LAVRi = VRi

Morningstar Load-Adjusted Return Morningstar's load-adjusted return is the load-adjusted counterpart to the Morningstar mean return. It is the annual rate of return that would provide the same T-period load-adjusted value relative as did the fund. If there are T months in the period, the number of years (y) will equal T/12. The desired value is then found by solving the equation: ( 1 + msLARi ) y = LAVRi where: msLARi = the Morningstar load-adjusted return for fund i over T periods y = T/12 = the number of years in the period

Load-adjusted Excess T-Period Value Relative A fund's Load-adjusted excess T-period value relative is calculated by subtracting the ending value of $1 invested in Treasury bills over T periods from that obtained from the fund, after adjusting the latter for any load charges: LAEVRi = LAVRi - VRB where LAEVRi = the Load-adjusted excess value relative for fund i after T periods

Morningstar Return
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Morningstar Performance Measures: Computation

To normalize load-adjusted excess returns for a period, Morningstar divides each fund's Load-adjusted excess value relative by a base figure. This differs from the calculations used for category returns, however, since the base is determined by averaging the comparable values for all funds within the asset class in which the fund is placed: msReti = LAEVRi / ClassRetBaseAC(i) where: msReti = the Morningstar return for fund i ClassRetBaseAC(i) = the return base for fund i's asset class and: ClassRetBaseAC(i) = max { avgj in AC { LAEVRj } , VRB - 1} Here, the return base will equal the average load-adjusted excess value relative only if the average increase in value for the asset class exceeds two times the increase in value for Treasury bills: if avgj in AC { LAVRj - 1 } > 2 * ( VRB - 1) ClassRetBaseAC(i) = avgj in AC { LAEVRj } else ClassRetBaseAC(i) = VRB - 1

Morningstar Risk The Morningstar Risk of a fund is computed by taking the ratio of its average monthly loss during a period to the average of such values for all funds in its asset class: msRiski = AMLi / ClassRiskBaseAC(i) ClassRiskBaseAC(i) = avgj in AC { AMLj }

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Morningstar Performance Measures: Computation

where: msRiski = The Morningstar risk for fund i ClassRiskBasec(i) = the risk base for fund i's asset class

Morningstar Risk-adjusted Rating To compute a risk-adjusted rating for a fund, Morningstar subtracts the Morningstar risk value from the Morningstar return value: msRARi = msReti - msRiski where: msRARi = Morningstar's y Risk-adjusted rating

Morningstar Star Rating Where data are available, Morningstar computes risk-adjusted ratings for a fund using 3, 5 and 10-year periods (1 year values are computed as well, but of less interest here) . For any given period (say, 3 years), the risk-adjusted ratings for all funds within an asset class are ranked and converted to percentiles, then stars are assigned using the same cutoff points employed for category ratings: From Percentile 0 10 32.5 67.5 90 To Percentile 10 32.5 67.5 90 100

Stars 1 2 3 4 5

Of particular interest in this connection are the 3-year risk-adjusted ratings and the associated 3-year star ratings, since they are based on data from the same period used for the other performance measures and
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are available for the most funds.

Morningstar Overall Star Rating In addition to the star ratings for specific periods, Morningstar calculates an overall star rating for each fund for which there are at least 36 months of data. The first step involves the determination of a star rating for each of the time periods (3, 5 and 10 years) available for the fund in question. For each fund, a weighted average of the number of stars in each time period is then taken, with the weights depending on the months for which data are available, as follows: 3 year RAR 1.00 0.40 0.20 5 year RAR 0 0.60 0.30 10 year RAR 0 0 0.50

Months 36 to 59 60 to 119 120 or more

The rounded value of the result is then reported as the fund's overall star rating.

Summary This section has summarized six substantially different performance measures computed routinely by Morningstar:
q q q q q q

Sharpe ratio alpha best-fit alpha category risk-adjusted rating (and category rating) 3-year risk-adjusted rating (and 3-year star rating) overall risk-adjusted rating (and overall star rating)

The first five measures are based on fund returns over the most recent 36 months and thus provide different ways of analyzing a given body of data. The last covers periods of 3 years for some funds, 5 for others, and 10 for yet others using a procedure similar to that employed for the 3-year ratings, but on a different body of data. In subsequent sections, the emphasis will be on the first five measures.

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Morningstar Performance Measures: Computation

Footnotes
1. Amy C. Arnott, Morningstar Mutual Funds. December 6, 1996. 2. ibid.

Go to Table of Contents for this paper

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Morningstar's Performance Measures: Alternative Measures

Morningstar's Performance Measures Alternative Measures

While some of Morningstar's measures are similar to those used in academic papers and industry analyses, there are differences. For purposes of comparison, we introduce three key alternative performance measures:
q

excess return Sharpe ratio mean selection return selection Sharpe ratio

For emphasis, the sections describing these measures are highlighted in green:

Excess Return Sharpe Ratio Most academic studies compute historic Sharpe Ratios by dividing the mean of the differences between two return series by the standard deviation of the differences. In the case of monthly excess returns: MERSRi = AMERi / SDMERi where: AMERi = the arithmetic monthly average excess return on fund i during period T SDMERi = the standard deviation of monthly excess returns for fund i during period T MERSRi = the monthly excess return Sharpe ratio for period T

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Morningstar's Performance Measures: Alternative Measures

For purposes of comparisons, such measures are often scaled to give annualized equivalents, assuming no serial correlation and ignoring compounding. Under such conditions, the mean increases with the number of periods per year (here, 12), while the standard deviation increases with the square root of the number of periods per year. As a result, the annualized Sharpe ratio equals the original value times the square root of the number of periods per year. In this case: ERSRi = sqrt(12) * AMERi / SDMERi where: ERSRi = the annualized monthly excess return Sharpe ratio for period T Later, we will compare this measure with the slightly different one computed by Morningstar.

Selection Returns Two of Morningstar's performance measures can be characterized as summarizing information about differences between the returns on a fund and those of a benchmark portfolio. Such differences can be termed selection returns. Let: SelRetit = Rit - Rbp,t where: SelRetit = the selection return for fund i in month t Rit = the return on fund i in month t Rbp,t = the return on a benchmark portfolio in month t Different approaches can be used to select an appropriate benchmark portfolio for a fund. Such a portfolio might include only a single fund or index. Alternatively, it might include a fund plus a cash position.Or it might include several funds or indices. Morningstar's alpha and best-fit alpha measures fall in the second category (one index plus a cash position). Below, we describe a method that can utilize benchmark portfolios of as few as one or as many as several funds. Later, we compare the characteristics of measures using alternative approaches for the selection of an "appropriate" benchmark for each fund.

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Morningstar's Performance Measures: Alternative Measures

Mean Selection Return Once a benchmark is selected for a fund, selection returns can be computed for each of the T months in a period of interest (for example, the last 36 months). The average, or mean, can then be used to summarize the extent to which the fund "beat its benchmark" (if the mean is positive) or was "beaten by its benchmark" (if the mean is negative): MMnSelReti = ( 1 / T ) * sumt=1..T { SelRetit } where: MMSelReti = the mean monthly selection return for fund i over period T This value can be annualized with or without taking compounding into account. The corresponding results are given by the formulas: MnSelReti = 12 * MMSelReti ( 1 + CMnSelReti) = ( 1 + MMSelReti ) 12 where: MnSelReti = Annualized mean selection return CMnSelReti = Annualized compounded mean selection return While Morningstar uses the compounded version (CMnSelReti) we will use the other version (MnSelReti) for the sake of simplicity, and refer to it simply as the mean selection return.

Selection Standard Deviation The mean selection return summarizes the average performance of a fund relative to its benchmark but does not provide any indication of the consistency with which that performance was achieved. To measure the variation of the selection returns around the mean, we compute the monthly selection standard deviation: VMSelReti = ( 1 / T ) * sumt=1..T { ( SelRetit - MMnSelReti ) 2 }
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Morningstar's Performance Measures: Alternative Measures

SDMSelReti = sqrt { VMSelReti } where: VMSelReti = the variance of monthly selection returns for fund i during period T SDMSelReti = the standard deviation of monthly selection returns for fund i during period T

Selection Sharpe Ratio To take into account both the added (or subtracted) value provided by a fund vis-a-vis its benchmark and the added risk, we divide the monthly mean selection return by the standard deviation of monthly selection returns. This gives a monthly selection Sharpe ratio: MSelSRi = MMnSelReti / SDMSelReti where: MSelSRi = Monthly selection Sharpe ratio for fund i during period T To annualize this, we multiply by the square root of 12. The result will be termed simply the selection Sharpe ratio: SelSRi = sqrt { 12} * MSelSRi where: SelSRi = the annualized selection Sharpe ratio

Returns-based Style Analysis In addition to the methods used by Morningstar to select benchmark portfolios, we introduce results obtained using the method often termed returns-based style analysis, described in detail in Sharpe, Asset Allocation: Management Style and Performance Measurement. In this case we wish to find a
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Morningstar's Performance Measures: Alternative Measures

portfolio of up to m index funds. The return on any such portfolio in time t can be written as: Rbp,t = b1*R1t + b2*R2t + ... + bm*Rmt where: b1, b2, ..., bm = the proportions invested in index funds 1,2,.. m, respectively R1t, R2t, ... Rmt = the returns on index funds 1,2,...m in period t Rbp,t = the return on the benchmark portfolio in period t In order for the results to correspond to a portfolio, the sum of the b's must equal 1.0. In addition we impose the constraint that each of the b's must lie between 0.0 and 1.0, inclusive. Of course, a great many portfolios meet this requirements. Of all possible such portfolios, returns-based style analysis selects the one that will give the smallest selection standard deviation when used as the benchmark for the fund in question. This must be done using mathematical programming procedures, due to the presence of inequality constraints regarding the values of the b's. In effect, the analysis finds the combination of indices that "moved most like" the fund during the period analyzed. To provide results comparable to those produced by Morningstar, we compare the performance of each fund with that of the benchmark selected using returns-based style analysis on data covering the same period. Thus we use 36 months of data on the ten index funds and a selected mutual fund to (1) determine a benchmark portfolio with the most similar style, (2) compare the fund's returns with those of this benchmark portfolio for each of the 36 months to determine the monthly differences (selection returns), then (3) summarize the fund's relative performance by computing the associated mean selection return and selection Sharpe ratio. Note that this procedure is "in sample" -- the fund is compared with a strategy that could not have been identified before-the-fact, since the characteristics of the strategy are determined using data covering the period over which the performance is evaluated. This is also the case for the Morningstar measures. A more relevant study would use only "out-of-sample" measures of performance in which comparisons were made with investment alternatives that could be identified in advance and implemented, if desired. However, the task at hand is to compare alternative methods with those used by Morningstar on roughly equal ground. The far more important question of predicting future performance is left for other studies. To make the benchmark as relevant as possible, our analysis uses the following ten index funds offered by the Vanguard group: Vanguard Money Market Reserves -- Prime Portfolio
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Morningstar's Performance Measures: Alternative Measures

Vanguard Bond Index Fund -- Short-term Portfolio Vanguard Bond Index Fund -- Intermediate-term Portfolio Vanguard Bond Index Fund -- Long-term Portfolio Vanguard Index -- Value Vanguard Index -- Growth Vanguard Index Extended Market Vanguard International Equity Index -- European Vanguard International Equity Index -- Pacific Vanguard International Equity Index -- Emerging Market Since the emerging market fund was introduced in early 1994, we use returns for International Financial Corporation's Investable Index (minus 2 basis points per month) for the first four months of 1994 as estimates of the returns that might have been achieved during that period. Otherwise all returns are net returns obtained by investors in the funds (omitting, however, the one-time transactions fees charged by a few of the funds during the period). Further information about these funds can be found on the Vanguard home page. For the actual returns of the funds, see the monthly returns page.

Style Analysis R-squared The extent to which a benchmark portfolio's returns explain a fund's returns can be measured by one minus the ratio of (1) the variance of the selection returns to (2) the variance of the fund's returns. In the case of a benchmark portfolio determined using returns-based style analysis:: 1 - SAR2i = var ( SelReti ) / var ( Ri ) where: SAR2i = style analysis R-squared for fund i This is comparable to the Morningstar R-squared measure, except that in the latter the variance of the fund's excess returns is used in the denominator, rather than the variance of the fund's total returns.

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Morningstar's Performance Measures: Alternative Measures

All variances, standard deviations and R-squared values are computed from the data at hand without any adjustment for lost degrees of freedom. This follows Morningstar's practice. The statistics should thus be interepreted as summary measures of historic data, rather than as unbiased estimates of future values.

Go to Table of Contents for this paper

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Returns Data

Returns Data
This page provides links to files with monthly returns for mutual funds and security indices. Some files are provided at this site; others are provided by others. Each file at this site is stored with the extension .txt and may be either viewed as a plain text file using your browser or saved for later use. You may also use your browser's menu commands to copy some or all the information from a file into other locations, such as one of the worksheets provided at this site.

The Barr Rosenberg Funds


Returns for Selected Funds
q q q

Barr Rosenberg U.S. Small Cap Fund Barr Rosenberg Japan Fund Barr Rosenberg International Small Cap Fund

Index Returns
q

Cazenove Rosenberg Global Smaller Companies Index, Excluding the U.S.

For more information, see the Rosenberg Institutional Equity Management home page.

BARRA
Returns at the BARRA site
q q q q q q

S&P 500 S&P 500/BARRA Growth S&P 500/BARRA Value MidCap 400 MidCap 400/BARRA Growth MidCap 400/BARRA Value

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Returns Data
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SmallCap 600 SmallCap 600/BARRA Growth SmallCap 600/BARRA Value

For more information, see the BARRA home page

Independence International Associates, Inc.


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Monthly returns from 1975 through June, 1997 for 11 market segments in 22 countries and 8 regions

Smith Breeden Mutual Funds


Returns for Selected Funds
q q q q

Smith Breeden Short Duration U.S. Government Fund Smith Breeden Intermediate Duration U.S. Government Fund Smith Breeden Equity Market Plus Fund Smith Breeden Financial Services Fund

For more information, see the Smith Breeden home page.

The Vanguard Group


Returns for Selected Funds
q q

Vanguard Money Market Reserves -- Prime Portfolio Municipal Bond Funds r Vanguard Municipal Bond Fund -- Short-term Portfolio r Vanguard Municipal Bond Fund -- Intermediate-term Portfolio r Vanguard Municipal Bond Fund -- Long-term Portfolio

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Returns Data
q

Vanguard Bond Index Fund -- Total Bond Market r Vanguard Bond Index Fund -- Short-term r Vanguard Bond Index Fund -- Intermediate-term r Vanguard Bond Index Fund -- Long-term Vanguard Index -- Total Stock Market r Vanguard Index 500 s Vanguard Index -- Value s Vanguard Index -- Growth r Vanguard Index Extended Market s Vanguard Index -- Small Cap Stock Non-U.S. Stock Funds r Vanguard International Equity Index -- European r Vanguard International Equity Index -- Pacific r Vanguard International Equity Index -- Emerging Market

For more information, see the Vanguard home page

Wilshire
Returns at the Wilshire site
q q q

Wilshire 4500 Index Wilshire 5000 Index Wilshire Style Indices

Each of these links is to an ftp site. Each of the files has an extension of .bin, although the files use standard ascii text with commas as separators. Your browser will probably request that you specify a location on your disk to save the file. You may later open it in a word processor or in a spreadsheet. For example, you may open one of these files in Excel by specifying that commas are used as delimiters. For more information, see the Wilshire Home Page

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Worksheets

Worksheets
NOTICE These worksheets ONLY work with: Netscape 3.0 and above Internet Explorer 4.0 and above

The following worksheets uses a pre-defined definition of a "Matrix Object" and utilities that facilitate input and output of such objects. A simple example is given at ws_js.htm. For a description of this example and instructions for using the associated Javascript, see mat.htm. To see the contents of the Javascript file, select mat.js and view the source code.

Weighted Statistics
This worksheet computes means, standard deviations and correlation coefficients for data series such as monthly returns for mutual funds. If desired, each observation may be assigned a greater weight than its predecessor. Output can be obtained in formats suitable for direct input into other worksheets in this series.
q q

The weighted statistics worksheet Example using Vanguard Mutual Fund returns

Reverse Optimization
This worksheet finds expected returns that are consistent with the assumption that a particular portfolio is
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Worksheets

efficient for a given set of risks and correlations.


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The reverse optimization worksheet

Optimization
This worksheet finds a portfolio that maximizes investor utility subject to constraints on holdings.
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The optimization worksheet

Performance Measurement
This worksheet computes a number of "bottom line" measures of historic performance
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The performance measurement worksheet

Style Analysis
This worksheet performs a style analysis for a return series.
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The style analysis worksheet

Annuity Valuation
This worksheet provides the value of a single or joint annuity, given its characteristics and an appropriate discount rate.
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The annuity worksheet

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Worksheets

Retirement Worksheet
This worksheet provides estimates of the standard of living obtained by purchasing a real annuity at retirement, based on assumptions about pre-retirement savings and investment.
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The retirement worksheet

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Javascript Example

INPUT
port1 port2 Cash 10.5 55.8 Bonds 33.6 22.1 Stocks 55.1 17.3

DO IT!

OUTPUT

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mat.htm

Using the Javascript Matrix Object and Associated Functions


The following is the source for ws_js.htm, which illustrates the use of the Matrix Object and other functions contained in file wwwsharpe.stanford.edu/mat.js.

<HEAD> <TITLE>Javascript Example</TITLE> <SCRIPT SRC="mat.js"></SCRIPT> <SCRIPT> function doit() { // get matrix from form pval = s2mat(document.ws.inputs.value); // make new matrix for sum sumv = new mat(1,pval.ncols); sumv.row[1] = 'Sum'; // compute sum for each column for (j=1;j<=pval.ncols;j++) { // column heading sumv.col[j] = pval.col[j]; // sum rows s = 0; for (i=1;i<=pval.nrows;i++) { s = s + pval.cell(i,j); } sumv.pcell(1,j,s); } // put matrix on form document.ws.outputs.value = mat2s(sumv,10,2,'r'); } function clr() { // clear output area document.ws.outputs.value = ''; } </SCRIPT> </HEAD> <body bgcolor="#FFFFFF"> <CENTER> <FORM NAME="ws"> <H3>INPUT</H3> <TEXTAREA NAME="inputs" ROWS=6 COLS=90 OnChange="clr();"> Cash Bonds Stocks port1 10.5 33.6 55.1 port2 55.8 22.1 17.3 </TEXTAREA> <P>

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mat.htm

<INPUT TYPE="button" NAME="go" VALUE="DO IT!" OnClick="doit();document.ws.go.blur()"> <P> <H3>OUTPUT</H3> <TEXTAREA NAME="outputs" ROWS=6 COLS=90> </TEXTAREA> <P> </FORM> </CENTER> <HR> Prof. William F. Sharpe, Stanford University<BR> This version May 20, 1997<BR> <A HREF="home.htm">Go to my home page</A><BR> <A HREF="mailto:wfsharpe@leland.stanford.edu">Send me E-Mail</A> </BODY>

Javascript
There are two sets of Javascript, both contained in the header. The first statement includes the Javascript in file mat.js: <SCRIPT SRC="mat.js"></SCRIPT> For html files located at other sites, the full URL (hhtp:....) should be given as the SRC. The second set of Javascript is unique to this page but uses functions from mat.js. It will be described in sections.

Matrix Objects
A matrix object includes numbers and row and column names. The size of the matrix is determined by the number of rows and columns in the body. Consider matrix z: aaa 1.23 1.11 bbb 4.56 9.99 ccc 3.33 3.12

xxx yyy

This has 2 rows and 3 columns. The column names are: z.col[1] = 'aaa' z.col[2] = 'bbb' z.col[3] = 'ccc' Note the use of square brackets since z.col is an array. The row names are:

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mat.htm

z.row[1] = 'xxx' z.row[2] = 'yyy' Again, note the use of square brackets, since z.row is an array. The values in the cells of the matrix are: z.cell(1,1) z.cell(1,2) z.cell(1,3) z.cell(2,1) z.cell(2,2) z.cell(2,3) = = = = = = 1.23 4.56 3.33 1.11 9.99 3.12

Here, parentheses are used since a function is called to deal with the two-dimensional structure.

Getting a Matrix from a Form


It is simple to get a matrix from a form TEXTAREA if it is entered appropriately. Consider the example: <FORM NAME="ws"> <H3>INPUT</H3> <TEXTAREA NAME="inputs" ROWS=6 COLS=90 OnChange="clr();"> Cash Bonds Stocks port1 10.5 33.6 55.1 port2 55.8 22.1 17.3 </TEXTAREA> ....... </FORM> The textarea named "inputs" contains a matrix in the required format, with spaces and/or tabs used to separate "tokens" (contiguous sets of characters) and line feeds and/or carriage returns used to separate rows. Only one Javascript statement is required to convert this information to a matrix object: pval = s2mat(document.ws.inputs.value); The argument of function s2mat is the string (including line feeds, etc.) which is the value in the element inputs in form ws which is in the document. Function s2mat (provided in mat.js) converts this string to a matrix object which, in this case, will be named pval. While the format for such textareas is reasonably flexible, there are some requirements. The number of tokens found on the first line is taken as the number of columns, so it is important that each column heading be separated from the next by at least one space or tab. The first token on each subsequent line is considered a row name and may be alphabetic. All remaining tokens must be numeric. While extraneous blank lines are allowed, it is best not to use them. Note the use of the OnChange parameter in the TEXTAREA declaration. This causes function clr() to be invoked whenever the user changes any of the text in the element. This function, which clears the output window is contained in the Javascript section of the header:

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mat.htm

function clr() { // clear output area document.ws.outputs.value = ''; } The single statement in this function assigns an empty string to the value of the element outputs in form ws in the document.

Creating a New Matrix


It is a simple matter to create a new matrix object, as shown in this example: sumv = new mat(1,pval.ncols); This will create a matrix called sumv with 1 row and as many columns as there are in matrix pval. When created, the matrix will be empty with numeric row and column names.

Assigning Matrix Row and Column Names


A simple assignment statement can be used to assign a name to a row or column of a matrix. For example: sumv.row[1] = 'Sum'; sumv.col[j] = pval.col[j]; The first statement assigns the string 'Sum' as the name for row 1 of matrix sumv. The second statement assigns the name in column j of matrix pval as the name for column j of matrix sumv.

Assigning Values to Matrix Elements


To assign a value to a matrix element, use the pcell method. For example: sumv.pcell(1,j,s); This will assign the value of s to the element in row 1 and column j of matrix sumv.

Putting a Matrix on a Form


To put a matrix in an element on a form, use function mat2s, provided in file mat.js. It takes four arguments: the matrix to be assigned, the width of each field, the number of decimal places for each numeric value, and the justification for all fields. For example: document.ws.outputs.value = mat2s(sumv,10,2,'r');

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mat.htm

This will assign matrix sumv as the value of element outputs in form ws in the document. The output will be formatted with 10 spaces for each column and all numeric values will be shown with 2 decimal places. All elements will be right-justified within their fields (the other options are 'l' for left-justified and 'c' for centered).

Other features of the example


The remainder of the example is relatively easy to read. Javascript uses a syntax drawn from C++ as evidenced in the loop that does the calculations in this case: for (j=1;j<=pval.ncols;j++) { // column heading sumv.col[j] = pval.col[j]; // sum rows s = 0; for (i=1;i<=pval.nrows;i++) { s = s + pval.cell(i,j); } sumv.pcell(1,j,s); } The other feature of the example worth noting is the design of the button that activates the processing: <INPUT TYPE="button" NAME="go" VALUE="DO IT!" OnClick="doit();document.ws.go.blur()"> Note the type ("button") and the Javascript statements to be executed when it is clicked. The first calls function doit() which is contained in the Javascript portopn of the header and does the desired calculations. When this is finished, a second statement is executed. This uses the blur method of the button itself to remove the focus, signalling the user that the processing has been completed, which proves helpful in cases in which long times may be involved and changes in the output are not dramatic.

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/******************************************************* matrix objects and other general functions written by Prof. William F. Sharpe wfsharpe@leland.stanford.edu for more information, see: www-sharpe.stanford.edu/mat.htm This version: May 21, 1997

******************************************************* MAT objects: properties: nrows: number of rows in matrix ncols: number of columns in matrix row: array [1..nrows] of row names col: array [1..ncols] of column names methods: cell(i,j): value in row i, column j pcell(i,j,v): put value v in row i, column j Input and output: function s2mat(s) creates a matrix from an ascii string (input) function mat2s(m,w,d,just) creates an ascii string from a matrix (output) w: width, d: number of decimals, just: 'l','r','c' ******************************************************/ function cell(i,j) { // method to get value from cell i,j of a mat object var loc; loc = ((i-1)*this.ncols)+(j-1); return this.vec[loc]; } function pcell(i,j,v) { // method to put value v in cell i,j of a mat object var loc; loc = ((i-1)*this.ncols)+(j-1); this.vec[loc] = v; } function mat(nrows,ncols) { // definition for a mat object var cmd,tmpmat,tmprow,tmpcol,n,i; n = ncols; cmd = ' tmpcol = new Array(' + n + ');'; eval(cmd); for (i=1;i<=n;i++) { tmpcol[i] = i; } n = nrows; cmd = ' tmprow = new Array(' + n + ');'; eval(cmd); for (i=1;i<=n;i++) { tmprow[i] = i; } n = nrows*ncols-1; cmd = ' tmpmat = new Array(' + n + ');'; eval(cmd);

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this.nrows = parseInt(nrows); this.ncols = parseInt(ncols); this.col = tmpcol; this.row = tmprow; this.vec = tmpmat; this.pcell = pcell; this.cell = cell; } /******************** utilities *******************************/ function strrep(s,s1,s2) { // in s, replaces every occurrence of s1 with s2 while ((s.length>0) && (s.indexOf(s1)) >= 0) { s = s.substring(0,s.indexOf(s1)) + s2 + s.substring(s.indexOf(s1)+s1.length,s.length); } // return return s; } function strcln(s) { // cleans s of leading and trailing blanks while (s.charAt(0)==' ') { s = s.substring(1,s.length) } while (s.charAt(s.length-1)==' ') { s = s.substring(0,s.length-1) } // return return s; } function fmtstr(s,w,j) { // format string s to width w and justification j (l,r,c) var l,nsp,sf,nlft,nrt; var sp = ' s = ''+s; l = s.length; nsp = w - l; if (nsp<0) { nsp = 0; s = s.substring(0,w); } if (j=='c') { nlft = Math.round(nsp/2); nrt = nsp - nlft; sf = sp.substring(0,nlft) + s + sp.substring(0,nrt); } if (j=='r') { sf = sp.substring(0,nsp) + s; } if (j=='l') { sf = s + sp.substring(0,nsp); } return sf; }

';

function fmtnum(n,w,d,j) { // format number n to width w with decimal places d and justification j (l,r,c) var m,z,nn,np;
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m = '100000000000000000'; z = '0000000000000000000'; m = m.substring(0,d+1); nn = Math.round(m*n)/m; nn = ''+nn; if (nn.indexOf('.')<0) { nn = nn + '.'}; np = nn.length - nn.indexOf('.') - 1; if (d>np) { nn = nn + z.substring(0,d-np); } if (nn.charAt(0) == '.') { nn = '0' + nn; } nn = fmtstr(nn,w,j); return nn; } /*************** matrix input **********************************/ function s2mat(s) { // gets mat object from string s // local variables var rows,nrows,stg,colids,ncols,cmd,i,j,items; // for Mac, replace carriage returns with newlines if (navigator.appVersion.lastIndexOf('Mac') != -1){ s = strrep(s,"\r","\n"); } // get rows s = strrep(s,"\t"," "); s = strrep(s," "," "); s = strrep(s,"\r",""); s = strrep(s," \n","\n"); s = strrep(s,"\n\n","\n"); while (s.charAt(0)=='\n') {s = s.substring(1,s.length)}; rows = s.split("\n"); if (rows[rows.length-1].length == 0) {rows.length = rows.length-1} // get column ids stg = strrep(rows[0]," "," "); if (stg.charAt(0) == " ") {stg = stg.substring(1,stg.length) } stg = 'x '+stg; colids = stg.split(" "); if (colids[colids.length-1].length == 0) {colids.length = colids.length-1} // set up bm as a mat object bm = new mat(rows.length-1,colids.length-1); // put column ids in bm n = Math.min(colids.length,bm.ncols); for (i=1;i<=n;i++) { bm.col[i] = colids[i] } // put rows in bm for (i=1;i<=bm.nrows;i++) { s = rows[i]; s = strcln(s); items = s.split(" "); bm.row[i] = items[0]; for (j=1;j<=bm.ncols;j++) { bm.pcell(i,j,parseFloat(items[j])); } } // return bm

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return bm; } /******************** matrix output ***************************/ function mat2s(m,w,d,just) { // puts matrix in string // set newline if (navigator.appVersion.lastIndexOf('Win') != -1){ brk = "\r\n" } else { brk = "\r" } // puts matrix object m in string using column width w, // decimal places d and justification just (l,c,r) s = ''; // empty corner s = s + fmtstr(' ',w,just); // column ids for (j=1;j<=m.ncols;j++) { s = s + fmtstr(m.col[j],w,just); } s = s + brk; // rows for (i=1;i<=m.nrows;i++) { s = s+ fmtstr(m.row[i],w,'l'); for (j=1;j<=m.ncols;j++) { s = s + fmtnum(m.cell(i,j),w,d,just); } s = s + brk; } // return return s } //================================================================

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Weighted Statistics Worksheet

Weighted Statistics Worksheet (see instructions)

INPUTS
Values (one row per observation):
bonds stocks 9901 1.0 15.0 9902 1.5 2.0 9903 0.5 -10.0

0 1

Half-life in periods (0 for equal weight) Scale factor (12 to annualize monthly returns, 1 for no scaling)

Output format: Statistics Reverse optimization Optimization

PROCESS

MAKE RECORD

OUTPUT

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/ws_stat.htm (1 of 2) [15/10/2001 10:51:14]

Weighted Statistics Worksheet

NOTES

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/wi_stat.htm

Instructions for Weighted Statistics Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes. When finished, click any area outside the boxes on the form. You may copy inputs from other sources such as spreadsheets, word processing documents, and other worksheets in this series, then paste the results into the appropriate boxes on this form. To copy an area from an Excel spreadsheet, select it, then select Edit Copy. In the browser, select a position in the input box, then select Edit Paste. To copy an area from a box in the browser to an Excel spreadsheet, select the text in the browser and select Edit Copy. In the Excel spreadsheet, select a position, then select Edit Paste. This brings each row into the spreadsheet as text. To convert to a matrix, select the column in which the information is located (the left-most one shown), then select Data Text-to-columns. Choose Delimited and Spaces as delimiters and the information will appear in the requisite number of cells. When you save a page on your own disk (using the browser's File Save As command), only the original material in the form will be saved. To overcome this, you may click the MAKE RECORD button. This will create a new page with the relevant inputs and outputs from your most recent case. You may print this or save it on your own disk. At a later time you may open this file in your browser and copy information from it to a regular worksheet, if you wish. When you are through with the record page, choose either the File Close command or click the X in the upper right corner (or equivalent on your platform) to return to the worksheet. There are two other ways to save and retrieve worksheet information. You can copy the information you wish to save to some other document, such as a spreadsheet, word processing document or text file. You can also load the source (ws_***.htm) file in a word processor and edit it to include your inputs. You will find the default information in blocks marked TEXTAREA and in the VALUE attributes of INPUT tags. Simply replace the default values with your information, then save the page as a file on your disk under
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any desired name. Whenever you change an input, the output area will be cleared to avoid having old outputs appear simultaneusly with new inputs. To produce new outputs, click the PROCESS button.

Inputs
The Values box should contain the data observations, with each observation in a separate row. For each observation the first column contains an identifier (or row label) that is not used in the computations. An identifier may use any characters, but no spaces. The remaining entries in each row give the data values. These must be valid numbers using only digits and an optional decimal point. All entries must be separated by one or more spaces and/or tabs. The top row should contain column identifiers for the data values. Each should use six or fewer characters (of any type), but no spaces. Blank rows may be included in the table and it is not necessary for your data to "line up" in columns as long as it conforms to the rules given above. To avoid excessive processing time (and potentially running out of virtual memory) it is strongly recommended that you use a minimum number of spaces to separate entries. in the values box. The Half-life value controls the weightings used in the analysis. If the value entered here is zero, each observation is assigned the same weight. If another value is entered, each observation is assign a weight equal to 2^(1/h) times the prior observation, where h is the indicated half-life. This has the characteristic that the value h periods prior to the present period will receive half the weight assigned the present period (hence the name). The Scale factor can be used to annualize monthly or quarterly data. Mean values are multiplied by this factor, while standard deviations are multiplied by the square root of the factor. A scale factor of 1 will, in effect, provide no scaling. You may choose any of three different Output formats. If you want a table showing only the statistics, select the first. If you wish the output to be in a format ready to be used as input for the reverse optimization worksheet, select the second. To obtain output in a format ready to be used as input for the optimization worksheet, select the third.

Output

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The output is in the form of a table with columns for computed statistics and, optionally, other information needed for further analysis. Each Mean is an arithmetic mean for the data series, using the selecting weighting scheme and scale factor. Each Standard Deviation (StdDev) uses the selected weighting scheme and scale factor. No adjustment is made for "degrees of freedom", even when equal weights are assigned to the observations. Each of the Correlation Coefficients uses the selected weighting scheme; the scale factor need not be applied, since it does not affect correlation. The correlation coefficients are given in columns labelled c:*** where *** stands for the name of the asset class.

Notes
You may enter any desired text in this box to describe the source of the input data, etc..

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Weighted Statistics Worksheet

Weighted Statistics Worksheet (see instructions)

INPUTS
Values (one row per observation):
MmktBondsLgStxMSStxEuropePacific 1991010.641.124.326.012.763.04 1991020.540.787.159.27.7311 1991030.560.692.414.21-6.78-5.41 1991040.520.990.20.430.963.56 1991050.510.684.273.311.48-0.73 1991060.48-0.06-4.56-4.25-8.04-6.41 1991070.491.324.634.957.153.48 1991080.492.052.333.331.8-5.21 1991090.462.01-1.6703.238.01 0 12

Half-life in periods (0 for equal weight) Scale factor (12 to annualize monthly returns, 1 for no scaling)

Output format: Statistics Reverse optimization Optimization

PROCESS

MAKE RECORD

OUTPUT

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Weighted Statistics Worksheet

NOTES

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/ws_revo.htm

Reverse Optimization Worksheet (see instructions)

INPUTS
cash bonds stocks EffPrt StdDev c:cash c:bonds c:stocks 0.10 1.000 1.000 0.400 0.150 0.30 7.400 0.400 1.000 0.350 0.60 15.400 0.150 0.350 1.000

Asset Expected Returns: asset number 1 asset number 3 expected return 2.0 expected return 7.5

Output format: Expected Returns Optimization

PROCESS

MAKE RECORD

OUTPUT

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/ws_revo.htm

Risk tolerance for which efficient portfolio is optimal

NOTES
Sample data based on monthly real returns, 1980 - 1995 (equally weighted)

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Instructions for Optimization Worksheet

Instructions for Reverse Optimization Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes. When finished, click any area outside the boxes on the form. You may copy inputs from other sources such as spreadsheets, word processing documents, and other worksheets in this series, then paste the results into the appropriate boxes on this form. To copy an area from an Excel spreadsheet, select it, then select Edit Copy. In the browser, select a position in the input box, then select Edit Paste. To copy an area from a box in the browser to an Excel spreadsheet, select the text in the browser and select Edit Copy. In the Excel spreadsheet, select a position, then select Edit Paste. This brings each row into the spreadsheet as text. To convert to a matrix, select the column in which the information is located (the left-most one shown), then select Data Text-to-columns. Choose Delimited and Spaces as delimiters and the information will appear in the requisite number of cells. When you save a page on your own disk (using the browser's File Save As command), only the original material in the form will be saved. To overcome this, you may click the MAKE RECORD button. This will create a new page with the relevant inputs and outputs from your most recent case. You may print this or save it on your own disk. At a later time you may open this file in your browser and copy information from it to a regular worksheet, if you wish. When you are through with the record page, choose either the File Close command or click the X in the upper right corner (or equivalent on your platform) to return to the worksheet. There are two other ways to save and retrieve worksheet information. You can copy the information you wish to save to some other document, such as a spreadsheet, word processing document or text file. You can also load the source (ws_***.htm) file in a word processor and edit it to include your inputs. You will find the default information in blocks marked TEXTAREA and in the VALUE attributes of INPUT tags. Simply replace the default values with your information, then save the page as a file on your disk under
file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/wi_revo.htm (1 of 3) [15/10/2001 10:51:15]

Instructions for Optimization Worksheet

any desired name. Whenever you change an input, the output area will be cleared to avoid having old outputs appear simultaneusly with new inputs. To produce new outputs, click the PROCESS button.

Inputs
The Inputs box should contain all the needed input information other than the expected returns for two asset classes. Each row provides the inputs for a single decision variable (for example, an asset class). The columns must be in the order indicated below. Each must be given a short heading, although these are not actually checked for content. The first column indicates the proportions invested in the assets for a portfolio that is assumed to be efficient -- that is, to maximize utility for some risk tolerance. These proportions will usually sum to 1.0 although this is not necessary. The next column provides the Standard Deviations (StdDev) for the decision variables. These are usually stated in terms of return per year (for example, 10.5 for 10.5% per year). The remaining columns provide the Correlation Coefficients for the variables. The order must be the same as that used for the rows in the table. The other input boxes provides the Expected Returns for two selected asset classes (decision variables). Any two may be chosen and the expected returns must differ. You may choose either of two output formats. The first provides only the computed expected returns. The second provides all the information in the format used for inputs in the optimization worksheet.

Algorithm
The worksheet uses the method described in Sharpe ["Imputing Expected Returns From Portfolio Composition," Journal of Financial and Quantitative Analysis, June 1974, pp. 463-472] to find a full set of expected returns compatible with the inputs. If a unique solution cannot be obtained, an error message is shown.

Output

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Instructions for Optimization Worksheet

The major outputs are provided in a single box. A separate box shows the risk tolerance for which the given portfolio is optimal.

Notes
You may enter any desired text in this box to describe the source of the input data, etc..

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Performance Measurement Worksheet

Performance Measurement Worksheet (see instructions)

INPUTS
Bills Index SBEqPlus 199401 0.26 3.38 3.97 199402 0.23 -2.71 -3.21 199403 0.26 -4.39 -5.45 199404 0.27 1.29 1.21 199405 0.31 1.63 1.50 199406 0.32 -2.47 -2.48 199407 0.35 3.28 2.95 199408 0.37 4.08 4.06 199409 0.37 -2.45 -2.09 FidMag 3.95 -0.73 -4.64 1.00 -1.15 -4.34 3.35 4.74 -2.60

Mean-variance utility function


50

Risk tolerance

Piecewise linear utility function


2.25

Relative disutility of a negative excess return

PROCESS

MAKE RECORD

OUTPUT

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Performance Measurement Worksheet

NOTES

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Performance Measurement Worksheet

Bills: Vanguard Money Market Reserves - Prime Portfolio Index: Vanguard Index 500 fund SBEqPlus: Smith-Breeden Equity Plus fund FidMag: Fidelity Magellan fund.

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Instructions for Performance Measurement Worksheet

Instructions for Performance Measurement Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes. When finished, click any area outside the boxes on the form. You may copy inputs from other sources such as spreadsheets, word processing documents, and other worksheets in this series, then paste the results into the appropriate boxes on this form. To copy an area from an Excel spreadsheet, select it, then select Edit Copy. In the browser, select a position in the input box, then select Edit Paste. To copy an area from a box in the browser to an Excel spreadsheet, select the text in the browser and select Edit Copy. In the Excel spreadsheet, select a position, then select Edit Paste. This brings each row into the spreadsheet as text. To convert to a matrix, select the column in which the information is located (the left-most one shown), then select Data Text-to-columns. Choose Delimited and Spaces as delimiters and the information will appear in the requisite number of cells. When you save a page on your own disk (using the browser's File Save As command), only the original material in the form will be saved. There are two ways to save and retrieve this worksheet information. You can copy the information you wish to save to some other document, such as a spreadsheet, word processing document or text file. You can also load the source (ws_***.htm) file in a word processor and edit it to include your inputs. You will find the default information in blocks marked TEXTAREA and in the VALUE attributes of INPUT tags. Simply replace the default values with your information, then save the page as a file on your disk under any desired name. Whenever you change an input, the output area will be cleared to avoid having old outputs appear simultaneously with new inputs. To produce new outputs, click the PROCESS button.

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Instructions for Performance Measurement Worksheet

Inputs
The Inputs box should contain the data observations, with each observation in a separate row. For each observation the first column contains the month (preferably in form YYYYMM); it is not used in the computations. The remaining entries in each row give the monthly returns (as percentages -- thus 2.34 for 2.34% in that month).All returns must be separated by one or more spaces and/or tabs. The top row should contain column identifiers for the return series. Each should use six or fewer characters (of any type), but no spaces. Blank rows may be included in the table and it is not necessary for your data to "line up" in columns as long as it conforms to the rules given above. The first series should give the returns a one-month riskless asset. The second should give the returns on a benchmark portfolio. The remaining series should give the returns on one or more funds for which historic performance is to be evaluated. The Risk Tolerance parameter is used in the computation of mean-variance utility measures (described below). The Relative Disutility parameter is used An be used in the computation of linear utility measures (also described below).

Output and Computations


The output is in the form of a table with a columns for the benchmark portfolio and all the funds for which returns were provided. All statistics are based on the historic returns provided, with all observations weighted equally. The first row provides cumulative returns, based on the ratio of the ending value to the beginning value, assuming that returns are compounded throughout the period. Thus a cumulative return of 50% would indicate that $1 invested at the beginning of the period would have grown to $1.50 by the end of the period. The block labeled Monthly Rtn contains statistics computed from the monthly total returns, with the results expressed in terms of return per month. The first is the mean monthly return, computed by summing all the monthly returns and then dividing by the number of months. The second statistic gives the monthly standard deviation of return. This is computed by averaging the squared differences of the monthly returns from their mean, then taking the square root. No correction is made for degrees of freedom, so this can be considered as a "population" standard deviation. The third statistic is the geometric mean monthly return. This is the monthly return that, if earned every month, would compound to give the same cumulative value as did the investment in question.
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Instructions for Performance Measurement Worksheet

The block labeled Annualized Rtn contains annualized versions of the statistics in the first block. The annualized mean monthly return is simply the mean monthly return times 12. The annualized monthly standard deviation of return equals the monthly standard deviation of return times the square root of 12. The annualized geometric mean return is that return that, if earned every year, would compound to give the same cumulative value as did the investment in question. More precisely, if 1+ga raised to the number of years covered will equal one plus the cumulative return. The Monthly ER block contains statistics computed using monthly excess returns. The excess return for a benchmark or fund in a given month equals its return minus that of the risk-free asset. The first two statistics for an investment provide its mean monthly excess return, computed by summing all the monthly excess returns and then dividing by the number of months and the monthly standard deviation of excess return, computed by averaging the squared differences of the monthly excess returns from their mean, then taking the square root. As before, no correction is made for degrees of freedom, so this can be considered as a "population" standard deviation. The third statistic is the monthly Sharpe Ratio, computed by dividing the mean monthly excess return by the monthly standard deviation of excess return. The Annualized ER block contains statistics that are annualized versions of those in the prior block. The annualized mean monthly excess return is simply the mean monthly excess return times 12. The annualized monthly standard deviation of excess return equals the monthly standard deviation of excess return times the square root of 12. The annualized Sharpe Ratio is computed by dividing the annualized mean monthly excess return by the annualized monthly standard deviation of excess return. Equivalently, the annualized Sharpe Ratio equals the monthly Sharpe Ratio times the square root of 12. The subsequent block, labeled Mthly ER, provides statistics calculated separately for months in which excess returns were positive and those in which excess returns were negative. The first statistic (Prop >= 0) indicates the proportion of months in which the fund's excess return was positive or zero. The next row shows the mean monthly return in all such months. The next row (Prop < 0) shows the proportion of months in which the fund's excess return was negative, with the following row showing the mean monthly return in all such months. The Utility block provides measures of utility based on both the funds' historic performances and the parameters specified in the form. The first calculation uses the annualized mean total return (am) and annualized standard deviation of total return (asd) to compute a mean-variance utility of the form: u = am - ( asd^2) / t where t is the risk-tolerance specified in the form. The second calculation in the utility block is based on a piecewise linear utility function. Every positive excess return is given a utility equal to the excess return, while every negative excess return is given a utility equal to rd times its excess return, where rd is the relative disutility specified in the form. The resulting monthly utility values are averaged, then multiplied by 12 to give an annualized monthly utility.
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Instructions for Performance Measurement Worksheet

Thus: u = 12 * averaget ( u( ert ) ) where: u ( ert ) = k*ert with: k = 1 if er >0 k = rd if er < 0 The next block, labeled ER Regression, provides the results obtained by performing standard regression analyses in which the benchmark excess return is the independent variable and each of the fund' excess returns is, in turn, the dependent variable. The Beta value is the slope coefficient and the Monthly Alpha value the intercept. The Monthly Residual Standard Deviation (RSD) is the standard deviation of the residuals from the regression. In this calculation, the actual residual standard deviation is adjusted for two lost degrees of freedom and thus can be considered a "sample estimate". The final block (labeled Annualized) provides annualized performance measures derived from the excess return regression analysis. The Annualized Alpha value is equal to 12 times the monthly alpha value. The Annualized Alpha/Beta ratio equals the annualized alpha divided by the beta value. The value labeled RSD is the Annualized Monthly Residual Standard Deviation. It equals the Monthly Residual Standard Deviation times the square root of 12. The final value, Alpha/RSD, is the ratio of the Annualized Alpha divided by the Annualized Monthly Residual Standard Deviation. Otherwise stated, this is the Sharpe Ratio of the Residual.

Notes
You may enter any desired text in this box to describe the source of the input data, etc..

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Instructions for Performance Measurement Worksheet

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Weighted Statistics Worksheet

Style Analysis Worksheet (see instructions)

INPUTS
Asset Ranges and Returns (one row per observation):
MmktBondsLgStxMSStxEuropePacific MIN 0 0 0 0 0 0 MAX 1 1 1 1 1 1 1993010.271.890.812.070-0.26 1993020.231.861.36-1.410.864.51 1993030.250.372.113.385.112.31 1993040.240.74 -2.42-3.382.1215.82 1993050.240.142.654.071.584.1 1993060.241.80.270.77-1.36-2.72 1993070.250.61-0.420.440.45.78 Fidelity Balanced Fund

Fund Name

Fund Returns:
Return 199301 2.197 199302 2.707 199303 3.189 199304 3.191 199305 1.62 199306 0.07845 199307 1.318 199308 3.396 199309 -0.9583

PROCESS

MAKE RECORD

OUTPUT

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Weighted Statistics Worksheet

NOTES

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Weighted Statistics Worksheet

Asset returns for Vanguard Mutual Funds taken from the pages found under Monthly Returns on William F. Sharpe's home page. Funds: MM Vanguard Money Market Reserves - U.S. Treasury Portfolio Bonds Vanguard Bond Index: Total Bond Market LgStx Vanguard Index: 500 Portfolio MSStx Vanguard Index: Extended Market Europe Vanguard International Equity: European Pacific Vanguard International Equity: Pacific

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Instructions for Weighted Statistics Worksheet

Instructions for Style Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes. When finished, click any area outside the boxes on the form. You may copy inputs from other sources such as spreadsheets, word processing documents, and other worksheets in this series, then paste the results into the appropriate boxes on this form. To copy an area from an Excel spreadsheet, select it, then select Edit Copy. In the browser, select a position in the input box, then select Edit Paste. To copy an area from a box in the browser to an Excel spreadsheet, select the text in the browser and select Edit Copy. In the Excel spreadsheet, select a position, then select Edit Paste. This brings each row into the spreadsheet as text. To convert to a matrix, select the column in which the information is located (the left-most one shown), then select Data Text-to-columns. Choose Delimited and Spaces as delimiters and the information will appear in the requisite number of cells. When you save a page on your own disk (using the browser's File Save As command), only the original material in the form will be saved. To overcome this, you may click the MAKE RECORD button. This will create a new page with the relevant inputs and outputs from your most recent case. You may print this or save it on your own disk. At a later time you may open this file in your browser and copy information from it to a regular worksheet, if you wish. When you are through with the record page, choose either the File Close command or click the X in the upper right corner (or equivalent on your platform) to return to the worksheet. There are two other ways to save and retrieve worksheet information. You can copy the information you wish to save to some other document, such as a spreadsheet, word processing document or text file. You can also load the source (ws_***.htm) file in a word processor and edit it to include your inputs. You will find the default information in blocks marked TEXTAREA and in the VALUE attributes of INPUT tags. Simply replace the default values with your information, then save the page as a file on your disk under
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Instructions for Weighted Statistics Worksheet

any desired name. Whenever you change an input, the output area will be cleared to avoid having old outputs appear simultaneously with new inputs. To produce new outputs, click the PROCESS button.

Inputs
The Asset Range and Returns box should start with a row giving the identifiers for the assets to be used in the analysis. Each identifier should use six or fewer characters (of any type), but no spaces. The next row should indicate the minimum proportion for each asset class in the resulting style and the following row should give the maximum proportion for each class. It must be possible to construct at least one allocation among the classes that lies within or at the border of each of the specified ranges and adds to 1.0. The remaining rows contain monthly returns for the desired asset classes with each month in a separate row. In each row the first column contains the monthly in the form YYYYMM (for example, 199301) and the remaining columns the returns for the asset classes in that month. The months covered by the rows must be sequential. Within each row the entries must be separated by one or more spaces and/or tabs. Blank rows may be included in the table and it is not necessary for your data to "line up" in columns as long as it conforms to the rules given above. The Fund Name can contain any desired characters except quotation marks or apostrophes. It should be limited to fifty characters or less. The Fund Returns box provides returns for the fund to be analyzed. The first row contains only the single identifier (Return). Subsequent rows provide the fund returns for each month to be covered. The first item in each row is the month; the second is the fund return. For the first observation the month must be entered in YYYYMM format. Subsequent rows can use any desired identifier (e.g. 1) since they will be considered to be sequential observations in any event. The first fund return must be for a month that is contained in the asset returns box. The range of months covered will be the longest possible, given the periods covered by the asset and fund returns.

Output
The output is in the form of three tables, all contained in a single box. The first two rows in the output box show the name of the fund and the range of months used for the analysis.
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Instructions for Weighted Statistics Worksheet

The first table shows the Style of the fund for the period covered. Of all the feasible combinations of asset classes, this is the one that "tracked" the fund's returns most closely during the period. In this connection, feasible combinations of asset classes are those for which every asset proportion lies either at its required minimum, at its required maximum, or at some point between the minimum and maximum. Of all such feasible combinations, the one shown in the table had the lowest Selection Standard Deviation during the period. The next table shows annualized values for two measures of performance. The first row shows the annualized value of the arithmetic Mean monthly returns, obtained by multiplying each average monthly return by 12. The second row shows the annualized value of the Standard Deviation of monthly returns, obtained by multiplying each standard deviation of monthly returns by the square root of 12. The monthly standard deviation of the selection return is adjusted for degrees of freedom based on the number of nonzero asset exposures in its style -- the actual value is multiplied by the square root of nobs/(nobs-numpos1) where nobs if the number of observations (months) and numpos is the number of assets with positive exposures. In the table, the first column shows the values computed from the monthly returns for the Fund. The second column shows the values computed from the monthly returns for the combination of asset classes shown in the Style table. The third column shows the values computed for the monthly Selection Returns, where the selection return for each month is the difference between the fund return and the style return for that month. The final table provides statistics for the analysis. The Percent Active is computed by dividing the selection variance (standard deviation squared) by the fund variance (standard deviation squared), then multiplying the ratio by 100. This provides a measure of the proportion of the fund variance due to active management. The Selection Sharpe Ratio (SSR) is computed by dividing the annualized mean selection return by the annualized standard deviation of the selection returns. This provides a measure of value added through active management per unit of added risk. The T-statistic is computed by dividing the mean monthly selection return by (the standard deviation of monthly selection return divided by the square root of the number of months analyzed). This provides a measure of the statistical significance of the value added through active management. The Percentile is the approximate location of the T-statistic in a cumulative normal distribution. For example, if the Percentile is 80, one might assume that in a group of managers with zero skill, approximately 80% would have poorer performance due to luck and 20% would have better performance due to luck.

Notes
You may enter any desired text in this box to describe the source of the input data, etc..

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Instructions for Weighted Statistics Worksheet

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Annuity Worksheet

Annuity Worksheet (see instructions)

Type of Policy Single (worker only) Joint Payments


0.00 0

Worker Female
50

Male

Beneficiary (if joint) Female Male


50

Nearest age

Nearest age

Amount paid (if single)


1.00

Amount paid (if joint)


1.00 0.50

Growth rate (%/yr) Years deferred

Worker alive

Both alive Only worker

alive Only beneficiary alive Annuity discount rate


2.00 0.50

(% per year)

Worker mortality Life Insurance Applicants 0.75 Life, 0.25 Annuity 0.50 Life, 0.50 Annuity 0.25 Life, 0.75 Annuity Annuity Applicants

Beneficiary mortality Life Insurance Applicants 0.75 Life, 0.25 Annuity 0.50 Life, 0.50 Annuity 0.25 Life, 0.75 Annuity Annuity Applicants

PROCESS

=========>

Present value of annuity

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wi_ann.htm

Instructions for Annuity Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. Note, however, that the file saved will have all the initial settings rather than those you have changed. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes or select the desired radio buton. When finished, click any area outside the boxes on the form.

Inputs
This worksheet is designed to find the present value of a fixed annuity. It is not suitable for valuing an annuity involving payments that vary with investment performance. All inputs are contained in the table. The worksheet may be used for a joint annuity covering a worker and a beneficiary, or for a single annuity covering only a worker. In either case, data must be provided for a worker. For joint policies information must also be provided for the beneficiary. If a single annuity is chosen, any beneficiary information will be ignored. The key terms of the annuity are provided in an Amount paid block. Only the one applicable for the chosen type of policy (single or joint) will be used. Amounts entered may be nominal or real. They may be actual amounts (for example, 10,000) or relative (for example, 1.0 if both are alive and 0.5 if only one is alive). To aid readability, commas may be included in numbers entered in these boxes (they will be removed when the entry is processed).
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The values for the amounts paid values are used for the first year in which payments are made. In each subsequent year these amounts are increased by the percentage specified in the box for Growth rate in amount paid (for example, enter 3.50 for 3.50% per year). If a constant annuity is desired, enter zero in this box. If the annuity is to begin immediately, enter zero in the Years deferred box. For a deferred annuity, enter the number of years before the first payment is to be made. Two sets of mortality tables, taken from the Life Insurance Fact Book, are provided. The first is the Commissioners 1980 Standard Ordinary (1970-1975) table, designed for estimating mortality for those who apply for individual life insurance policies. The second is the 1983 Individual Annuity Table (19711976, projected to 1983), designed for estimating mortality for those who apply for individual annuity policies. According to the Fact Book: "Mortality rates contained in the 1980 Commissioners Standard Ordinary Table were obtained from experience of 1970-1985, but contain an added element designed to generate life insurance reserves of a conservative nature in keeping with the long-term guarantees inherent in life insurance contracts.... Mortality rates for the 1983 Individual Annuity Tables are, again, conservative as related to the actual and projected experience on which they are based." Five mortality assumption choices are provided. Either of the two tables can be used. Alternatively, a combination of the two can be selected. In the latter case, the death rate per 1,000 individuals of any given age and sex is computed by taking a weighted average of the corresponding figures from the two tables. For a typical individual, a 0.50/0.50 combination of the two tables may be the most appropriate choice. For a joint annuity, a selection must be made for both the worker and the beneficiary. For a single annuity, the latter information is ignored. The final input concerns the Annuity discount rate. This should be stated as an annual percentage rate (for example, 6.00 for 6.00% per year). All expected cash flows are discounted to the current date at this rate. If payments are nominal amounts an appropriate nominal rate of interest should be utilized. On the other hand, if the payments are real (that is, of constant purchasing power), a real rate of interest should be employed.

Algorithm
The worksheet computes the expected amount paid in each year, then discounts these amounts back to the present, using the assumed discount rate. The death rate for each age is taken as the probability that an individual of that age will die within the next 12 months (and hence live for 0.50 years). Expected values are based on the probabilities of the possible states of the world each year, along with the associated payments. State probabilities take into account the transition probabilities from each possible state to each of the other possible states, using the probabilities of death for the worker and (where applicable), the beneficiary.

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Output
When you wish to find the present value of the annuity described in the table, click the PROCESS button. The present value will appear in the box to the right of the button. The amount is stated in units of currency as of the current date (that is, the date at which the worker's age is that shown in the upper lefthand box in the table).

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Retirement Worksheet

Retirement Worksheet (see instructions)

Retirement Annuity Single (worker only) Joint (50% Survivor) Investment Real Return
5.00

Worker Female
50

Male

Beneficiary (if joint) Female Male


50

Nearest age

Nearest age

Real Annuity discount rate


2.00

Worker Retirement Age


65

Expected (% per

(% per year)

Retirement age

year)
15.00 Std Dev. (% per

year) Savings
5.0 15.0

Real Salary Increases


1.5

Current (yrs salary) Future (% of salary)

Annual (% per yr)

Analysis Geometric mean approximation Simulate 500 Pctls: 10


90

cases .

. 50

PROCESS

Replacement Ratio (% of final salary) ... ...

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Retirement Worksheet

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wi_ann.htm

Instructions for Retirement Worksheet

General Instructions
This worksheet has been designed and tested using Netscape 3.0. It should work with later versions of Netscape's browsers but will not work with other browsers. It uses only JavaScript for computations and should cause no problems when used with the appropriate browsers. The operative word here is "should" -the author cannot guarantee fault-free operation. You should be able to use the worksheet when not connected to the internet. Save the program file (ws_***.htm) and the accompanying instruction file (wi_***.htm) on your disk using the browser's command to File Save. At a later time you may retrieve the file using the browser's File Open file command; you may then use the page as you would if you were on the network. Note, however, that the file saved will have all the initial settings rather than those you have changed. When using the worksheet, you may change any inputs. To do so, click inside the appropriate box, then make your changes or select the desired radio button. When finished, click any area outside the boxes on the form.

Inputs
This worksheet is designed to find the range of likely post-retirement standards of living, based on specified savings and investment assumptions. It uses a very simple model of investment returns and hence should be considered only illustrative of more sophisticated methods that can be employed for this task. The worker (principal) is assumed to purchase a real annuity at retirement. Such an annuity is guaranteed to provide a nominal amount that varies with inflation so as to provide a specified real amount, based on its terms. The three blocks in the first row of the input table provide the information on the nature of the desired annuity. If only the worker is to be covered in a single annuity, only the sex and age of the worker need be provided. If a joint annuity is to be purchased at retirement, the sex and age of the beneficiary must also be given. If a joint annuity is selected, the benefit will drop to 50% of its initial amount on the death of either the worker or the beneficiary.

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The Investment Real Return block provides inputs for the expected annual real return and the standard deviation of the annual real return of the investments to be purchased with current and future savings up to the date of retirement. Note that the expected return is the expected value of the one-year return, not the long-term or geometric mean. The next block provides the assumed Real Annuity discount rate. This is the rate that an annuity provider is assumed to use to discount expected future cash flows to determine the cost of an annuity. The higher this rate, the cheaper will be a given annuity and the greater will be the standard of living associated with a given investment account value at retirement. The expected cash flows are derived using an equally-weighted average of the mortality rates in the Commissioners 1980 Standard Ordinary (19701975) table, designed for estimating mortality for those who apply for individual life insurance policies, and the 1983 Individual Annuity Table (1971-1976, projected to 1983), designed for estimating mortality for those who apply for individual annuity policies. The Worker Retirement Age is the age at which the worker wishes to retire. The worker is assumed to retire on the same date of the year that the analysis is performed. Thus if the Worker's Nearest Age is 60 and the retirement age is 65, the worker is assumed to retire at the end of 5 years. The Savings block provides details concerning current and planned future savings. The Current Savings equals the total amount currently invested, divided by current salary. This expresses savings in terms of the number of years of current salary, putting it in a useful relative context. The Future Savings is stated as a percent of future salary. This percentage of salary will be saved each year up to retirement and added to the investment account. The Real Salary Increase is stated as a percent of salary. The worker's real salary is assumed to increase each year up to retirement by this percentage. The Analysis block provides information concerning the desired analysis. Two approaches are provided. The first approach is deterministic -- the investment return is assumed to be the same every year, with the actual return equal to the geometric mean of the investment distribution. This is the estimated longrun (50/50) return for the specified expected return and standard deviation of return. The second approach is stochastic. Monte Carlo simulation methods are used to estimate the range of likely outcomes. In this procedure, many cases are generated. Each such case involves a year-by-year projection of results up to the retirement age followed by determination of the resulting standard of living. Annual investment returns are drawn randomly from a probability distribution with the specified expected return and standard deviation. When a case has been completed, the result is recorded and added to a list of results -- one per case. When all the requested cases have been completed, this list of results is sorted from best to worst. Then the outcomes lying at specified percentiles are determined. For example, if 1,000 cases are simulated, the 10'th percentile outcome is the 100'th from the bottom, the 50'th percentile outcome is the median outcome, and the 90'th percentile outcome is the 900'th from the bottom (and

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wi_ann.htm

100'th from the top). The Analysis block allows the user to specify both the number of cases and the percentiles for which outcomes are to be shown. In any given year the investment return is assumed to be earned on the initial account value plus half the annual contribution rate times the initial salary. This amount is added to the initial value of the account at year-end. Next, the salary is increased by the specified annual percentage. Finally, an amount equal to half the annual contribution rate times the ending salary is added to the account. The entire process is repeated for each year to retirement.

Output
All results are stated in terms of the replacement ratio at retirement. This is the ratio of the value of the annuity purchased at retirement to the worker's salary just prior to retirement. The greater the ratio, the higher the associated standard of living.

Algorithms
For the simulation, annual returns are assumed to be drawn from a lognormal distribution where the return (not the logarithm of return) has the expected return (e) and standard deviation (sd) specified in the input section. This is accomplished by drawing a normal random deviate and using it to determine the logarithm of the value-relative (1 + return) for the year. Let: zt = log ( 1 + rt ) where rt = the (proportional) return in year t The first and second moments (a and b) of the distribution of z are determined as follows: b = sqrt ( log ( ( v / (u^2) ) + 1 ) ) a = 0.5 * log ( (u^2) / exp(b^2) ) where: u = 1 + e / 100 v = ( sd / 100 )2

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Once a value for zt is drawn from a normal distribution with mean a and standard deviation b, the corresponding return is determined using: 1 + rt = exp (zt ) Random normal deviates are generated using the Box-Muller method (Box, G.E.P and M.E. Muller, A note on the generation of random normal deviates, Annals Math. Stat, V. 29, pp. 610-611).

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Independence International Associates

Independence International Associates, Inc.


Country and Market Segment Indices

Select a Country or Region


World ..International (Non-U.S.) ..North America ..Europe and Pacific ....Europe ....Pacific ......Pacific ex Japan ....Europe and Pacific ex Japan Australia

Select a Market Segment


Market ..Large Capitalization ....Large Capitalization Value ....Large Capitalization Growth ..Small Capitalization ....Small Capitalization Value ....Small Capitalization Growth ..Value ....Aggressive Value ..Growth ....Aggressive Growth

Press button below to put returns in a separate window (close when through)
Get Returns

Independence International Associates, Inc. International Style Indexes


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Independence International Associates

Independence International Associates, Inc. (IIA) maintains a family of international style indexes covering twenty-two equity markets. These indexes provide new insights into the value and growth segments as well as the large-cap and small-cap segments of these markets. The indexes begin in January 1975 and cover over 2,500 stocks. IIA creates its value and growth indexes market-by-market. In each market we rank stocks by their book-to-price ratio. We then select the highest book-to-price stocks one-by-one from the top of the list until we've accumulated exactly half the cap of the market. These stocks become the constituents of the value index and the remaining stocks become the growth index. The large-cap and small-cap indexes are computed in a similar fashion. In this case, however, stocks are ranked by their capitalization and each market is split 70/30. The large-cap index encompasses 70% of the market cap; the small-cap index covers the bottom 30%. All four indexes are cap weighted. For the four sub-segments (Large Value, Large Growth, Small Value and Small Growth), we sort by size first and then by book-to-price ratios. In other words, we use the Large Cap and the Small Cap Indexes as the starting points for splitting on Value and Growth. This produces the following market segments:
q

Large Value - 35% - the cheap half of the Largest Cap (largest 70% of the market) Large Growth -35% - the expensive half of the Largest Cap (largest 70% of the market) Small Value - 15% - the cheap half of the Smallest Cap (smallest 30% of market) Small Growth - 15% - the expensive half of the Smallest Cap (smallest 30% of market)

For the aggressive sorts -- i.e., Aggressive Value and Aggressive Growth, we select the cheapest 20% of the market and the most expensive 20% of the market,
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Independence International Associates

respectively, (as opposed to using 50% in the regular Value and Growth sorts.) These indices also represent the top 40% of the Value index and the bottom 40% of the Growth index, respectively. All the indices are re-constituted semi-annually on January 1st and July 1st, using data from December 31st and June 30th, respectively. Collectively, our indices facilitate simple monitoring of key style segments of the international markets, allows easy comparison of various indexing strategies and provide useful benchmarks for evaluating active strategies.

Independence International Associates, Inc.


a subsidiary of Independence Investment Associates, Inc. Independence Investment Associates was incorporated September 9, 1982 as a registered investment advisor. Its predecessor organization, the Portfolio Management Department of the John Hancock Mutual Life Insurance Company, managed corporate tax-exempt assets beginning in 1948. The subsidiary was formed to focus the investment philosophy and process exclusively on a quantitative investment approach that was developed at John Hancock in the early 1970's. Independence is a wholly-owned subsidiary of John Hancock Subsidiaries, Inc., a holding company owned by John Hancock Mutual Life Insurance Company. The firm currently manages approximately $26.8 billion in assets. We provide US domestic active quantitative management for equity, fixed income and balanced accounts and International active quantitative management for equity accounts. We currently provide services for an array of corporate, multi-employer, foundation and public funds. Independence International Associates, Inc. was founded on November 1, 1986 as Boston International Advisors, Inc. The firm registered with the SEC in 1987 and
file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/iia.htm (3 of 4) [15/10/2001 10:51:20]

Independence International Associates

began investing for tax-exempt clients in the international equity markets in February of that year. Boston International Advisors was acquired by Independence Investment Associates, Inc. in 1996. The international capabilities of both firms were developed in-house. Together, we have ten years of international investment experience.

Independence Investment Associates, Inc.


and

Independence International Associates, Inc. 53 State Street Boston, MA 02109 (617) 228 - 8700 marketing@independence.com

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vmpxx.txt

"The Vanguard Group of Investment Companies" "Vanguard Money Market Reserves -- Prime Portfolio" USD 198001 1.11 198002 1.04 198003 1.23 198004 1.32 198005 1.34 198006 0.84 198007 0.76 198008 0.75 198009 0.78 198010 0.90 198011 0.99 198012 1.31 198101 1.43 198102 1.31 198103 1.30 198104 1.18 198105 1.39 198106 1.46 198107 1.48 198108 1.50 198109 1.42 198110 1.34 198111 1.20 198112 1.03 198201 1.04 198202 0.99 198203 1.16 198204 1.15 198205 1.20 198206 1.13 198207 1.17 198208 1.05 198209 0.89 198210 0.83 198211 0.74 198212 0.72 198301 0.70 198302 0.63 198303 0.69 198304 0.68 198305 0.70 198306 0.68 198307 0.73 198308 0.76 198309 0.75 198310 0.77 198311 0.73 198312 0.76 198401 0.78 198402 0.72 198403 0.78 198404 0.79 198405 0.85 198406 0.86 198407 0.92 198408 0.95 198409 0.93 198410 0.93
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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vmpxx.txt

198411 198412 198501 198502 198503 198504 198505 198506 198507 198508 198509 198510 198511 198512 198601 198602 198603 198604 198605 198606 198607 198608 198609 198610 198611 198612 198701 198702 198703 198704 198705 198706 198707 198708 198709 198710 198711 198712 198801 198802 198803 198804 198805 198806 198807 198808 198809 198810 198811 198812 198901 198902 198903 198904 198905 198906 198907 198908 198909 198910

0.83 0.76 0.71 0.62 0.71 0.69 0.69 0.63 0.63 0.62 0.60 0.63 0.62 0.64 0.63 0.57 0.62 0.57 0.56 0.53 0.55 0.53 0.47 0.47 0.45 0.47 0.48 0.43 0.48 0.48 0.53 0.53 0.56 0.56 0.55 0.61 0.62 0.62 0.60 0.53 0.55 0.53 0.56 0.57 0.61 0.65 0.65 0.68 0.68 0.72 0.75 0.69 0.79 0.80 0.83 0.78 0.78 0.75 0.71 0.73

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vmpxx.txt

198911 198912 199001 199002 199003 199004 199005 199006 199007 199008 199009 199010 199011 199012 199101 199102 199103 199104 199105 199106 199107 199108 199109 199110 199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411

0.70 0.71 0.70 0.62 0.68 0.66 0.69 0.66 0.68 0.67 0.64 0.67 0.64 0.66 0.64 0.54 0.56 0.52 0.51 0.48 0.49 0.49 0.46 0.45 0.42 0.42 0.39 0.33 0.34 0.33 0.33 0.31 0.31 0.29 0.27 0.26 0.25 0.27 0.27 0.23 0.25 0.24 0.24 0.24 0.25 0.25 0.24 0.25 0.24 0.26 0.26 0.23 0.26 0.27 0.31 0.32 0.35 0.37 0.37 0.40 0.41

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vmpxx.txt

199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

0.46 0.48 0.44 0.50 0.48 0.50 0.48 0.48 0.47 0.45 0.47 0.45 0.47 0.46 0.41 0.43 0.41 0.429 0.420 0.438 0.439 0.426 0.441 0.423 0.438

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwstx.txt

"The Vanguard Group of Investment Companies" "Vanguard Municipal Bond Fund -- Short-Term" USD 198001 0.64 198002 0.31 198003 -0.01 198004 1.22 198005 0.94 198006 0.70 198007 0.27 198008 0.00 198009 0.26 198010 0.46 198011 -0.07 198012 0.44 198101 1.20 198102 0.61 198103 0.74 198104 0.42 198105 0.62 198106 0.52 198107 0.38 198108 0.13 198109 0.55 198110 1.08 198111 1.51 198112 0.23 198201 0.78 198202 0.71 198203 0.72 198204 0.91 198205 0.84 198206 0.46 198207 1.01 198208 1.48 198209 0.65 198210 0.89 198211 0.51 198212 0.75 198301 0.45 198302 1.02 198303 0.08 198304 0.47 198305 -0.12 198306 0.60 198307 0.46 198308 0.28 198309 0.80 198310 0.14 198311 0.48 198312 0.29 198401 1.04 198402 0.30 198403 0.37 198404 0.31 198405 -0.01 198406 0.67 198407 0.69 198408 0.56 198409 0.57 198410 0.97
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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwstx.txt

198411 198412 198501 198502 198503 198504 198505 198506 198507 198508 198509 198510 198511 198512 198601 198602 198603 198604 198605 198606 198607 198608 198609 198610 198611 198612 198701 198702 198703 198704 198705 198706 198707 198708 198709 198710 198711 198712 198801 198802 198803 198804 198805 198806 198807 198808 198809 198810 198811 198812 198901 198902 198903 198904 198905 198906 198907 198908 198909 198910

0.63 0.51 1.30 0.29 0.47 0.86 1.05 0.52 0.24 0.16 0.24 0.75 0.62 0.25 1.11 0.97 0.62 0.48 0.40 0.47 0.20 0.80 0.59 0.90 0.37 0.24 0.95 0.41 0.21 -0.81 0.41 1.06 0.28 0.34 -0.57 -0.11 0.99 0.89 1.16 0.55 0.35 0.41 0.17 0.50 0.32 0.13 0.73 0.60 0.20 0.35 0.61 0.08 0.10 0.76 1.02 0.89 0.82 0.23 0.36 0.69

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwstx.txt

198911 198912 199001 199002 199003 199004 199005 199006 199007 199008 199009 199010 199011 199012 199101 199102 199103 199104 199105 199106 199107 199108 199109 199110 199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411

0.69 0.63 0.36 0.62 0.23 0.23 0.89 0.62 0.62 0.31 0.43 0.70 0.75 0.63 0.79 0.67 0.27 0.65 0.51 0.24 0.49 0.62 0.56 0.48 0.55 1.13 0.32 0.24 -0.02 0.44 0.57 0.62 0.92 -0.11 0.54 0.01 0.48 0.60 0.40 0.72 -0.12 0.45 0.13 0.44 -0.09 0.56 0.30 0.23 0.29 0.47 0.33 -0.29 -0.11 0.16 0.29 0.22 0.35 0.23 0.12 0.12 0.05

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwstx.txt

199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

0.21 0.58 0.76 0.46 0.39 0.79 0.45 0.39 0.40 0.20 0.46 0.46 0.41 0.52 0.18 -0.06 0.19 0.278 0.314 0.442 0.199 0.380 0.517 0.444 0.231

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwitx.txt

"The Vanguard Group of Investment Companies" "Vanguard Municipal Bond Fund -- Intermediate-Term" USD 198001 -0.78 198002 -4.71 198003 -5.73 198004 6.18 198005 6.17 198006 1.72 198007 -2.22 198008 -3.64 198009 -2.24 198010 -0.37 198011 -1.18 198012 -3.27 198101 1.89 198102 0.02 198103 0.39 198104 -3.56 198105 1.22 198106 1.11 198107 -2.10 198108 -8.18 198109 -0.24 198110 2.87 198111 6.19 198112 -6.38 198201 1.74 198202 3.59 198203 0.88 198204 4.99 198205 1.50 198206 -2.09 198207 2.72 198208 6.10 198209 3.21 198210 2.14 198211 -1.58 198212 4.49 198301 0.30 198302 3.38 198303 0.18 198304 2.94 198305 -3.94 198306 1.74 198307 -0.33 198308 -0.16 198309 2.97 198310 -1.27 198311 0.12 198312 0.61 198401 3.76 198402 -1.08 198403 0.12 198404 -0.34 198405 -4.55 198406 1.98 198407 4.47 198408 1.13 198409 -0.02 198410 1.04
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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwitx.txt

198411 198412 198501 198502 198503 198504 198505 198506 198507 198508 198509 198510 198511 198512 198601 198602 198603 198604 198605 198606 198607 198608 198609 198610 198611 198612 198701 198702 198703 198704 198705 198706 198707 198708 198709 198710 198711 198712 198801 198802 198803 198804 198805 198806 198807 198808 198809 198810 198811 198812 198901 198902 198903 198904 198905 198906 198907 198908 198909 198910

1.42 1.50 4.53 -1.94 0.91 3.07 2.53 1.21 -0.32 -0.14 -0.48 3.36 2.37 1.19 4.19 2.09 0.96 0.27 -1.40 0.88 0.87 3.94 0.10 2.48 1.38 -0.49 2.76 0.63 -0.72 -6.04 -0.08 2.68 1.52 -0.02 -3.58 1.05 2.20 1.63 3.59 0.71 -1.21 0.82 -0.21 1.35 0.75 0.07 1.86 1.59 -0.85 1.19 1.76 -0.84 -0.17 2.21 1.76 1.09 1.34 -0.72 -0.17 0.75

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwitx.txt

198911 198912 199001 199002 199003 199004 199005 199006 199007 199008 199009 199010 199011 199012 199101 199102 199103 199104 199105 199106 199107 199108 199109 199110 199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411

1.64 0.99 -0.50 1.15 -0.18 -0.85 2.44 0.73 1.65 -1.66 0.06 1.75 2.10 0.39 1.54 0.78 0.21 1.52 0.86 -0.20 1.19 1.34 1.25 0.92 0.17 1.97 0.02 0.08 0.00 0.90 1.21 1.67 3.38 -1.44 0.47 -1.32 2.47 1.18 1.16 3.85 -1.44 0.98 0.53 1.50 -0.24 1.95 1.39 0.20 -0.69 1.89 0.93 -2.01 -2.14 0.60 0.98 -0.26 1.14 0.52 -1.17 -1.18 -1.37

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwitx.txt

199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

1.93 2.17 2.24 0.76 0.28 2.40 -0.49 1.21 0.90 0.50 1.04 1.18 0.72 1.02 -0.35 -1.15 -0.11 -0.098 0.654 1.047 -0.029 0.801 1.116 1.556 -0.296

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwltx.txt

"The Vanguard Group of Investment Companies" "Vanguard Municipal Bond Fund -- Long-Term" USD 198001 -0.90 198002 -8.56 198003 -8.31 198004 9.13 198005 6.16 198006 0.52 198007 -3.05 198008 -4.33 198009 -2.32 198010 -0.49 198011 -1.09 198012 -2.66 198101 0.87 198102 -0.49 198103 1.65 198104 -4.68 198105 2.19 198106 1.49 198107 -2.95 198108 -10.45 198109 -0.55 198110 3.66 198111 7.13 198112 -8.22 198201 2.21 198202 4.26 198203 0.92 198204 6.69 198205 1.24 198206 -2.48 198207 3.64 198208 7.58 198209 4.82 198210 1.66 198211 -1.73 198212 4.77 198301 0.55 198302 4.37 198303 0.29 198304 3.82 198305 -4.45 198306 1.28 198307 0.12 198308 -0.09 198309 3.45 198310 -1.24 198311 -0.09 198312 1.43 198401 3.01 198402 -1.24 198403 0.12 198404 0.23 198405 -7.75 198406 3.80 198407 5.19 198408 1.47 198409 -0.62 198410 1.13
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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwltx.txt

198411 198412 198501 198502 198503 198504 198505 198506 198507 198508 198509 198510 198511 198512 198601 198602 198603 198604 198605 198606 198607 198608 198609 198610 198611 198612 198701 198702 198703 198704 198705 198706 198707 198708 198709 198710 198711 198712 198801 198802 198803 198804 198805 198806 198807 198808 198809 198810 198811 198812 198901 198902 198903 198904 198905 198906 198907 198908 198909 198910

1.13 2.35 5.44 -1.93 0.88 3.10 3.43 1.33 0.92 -1.18 -0.93 2.70 3.12 2.40 4.63 3.78 1.02 -0.45 -1.40 1.22 0.47 4.96 -0.65 2.65 1.78 0.07 2.76 0.76 -0.65 -7.23 -1.19 2.99 0.81 0.14 -4.77 0.84 3.29 1.66 4.06 1.18 -2.22 0.61 -0.09 2.23 0.42 0.43 2.11 2.57 -1.42 1.90 2.07 -1.22 -0.06 2.77 2.33 1.46 1.18 -1.44 -0.44 1.46

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwltx.txt

198911 198912 199001 199002 199003 199004 199005 199006 199007 199008 199009 199010 199011 199012 199101 199102 199103 199104 199105 199106 199107 199108 199109 199110 199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411

2.30 0.68 -1.70 1.27 -0.09 -1.94 3.79 0.68 1.93 -2.95 -0.20 2.39 3.19 0.48 1.74 0.27 -0.01 1.93 0.86 -0.65 1.67 1.46 1.44 1.15 -0.14 3.07 -0.37 0.25 -0.30 1.13 1.79 2.02 4.20 -2.17 0.15 -2.14 3.30 1.26 1.16 4.94 -1.78 1.65 0.56 1.46 -0.69 2.72 1.43 -0.07 -0.94 2.45 0.80 -2.48 -4.37 0.67 1.53 -1.04 2.22 0.11 -2.06 -2.30 -1.88

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vwltx.txt

199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

3.17 3.36 3.41 0.68 -0.01 3.45 -1.32 1.05 1.14 0.37 1.70 2.31 1.28 0.73 -0.66 -1.55 -0.48 0.186 1.200 1.015 -0.103 1.560 1.097 1.997 -0.598

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbmfx.txt

"The Vanguard Group of Investment Companies" "Vanguard Bond Index Fund -- Total Bond Market" USD 198701 1.23 198702 0.58 198703 -0.60 198704 -3.23 198705 -0.39 198706 1.40 198707 -0.09 198708 -0.75 198709 -2.29 198710 3.48 198711 0.72 198712 1.21 198801 3.47 198802 1.23 198803 -1.18 198804 -0.57 198805 -0.89 198806 2.61 198807 -0.47 198808 0.19 198809 2.17 198810 1.50 198811 -0.89 198812 0.08 198901 1.31 198902 -0.72 198903 0.31 198904 1.98 198905 2.54 198906 2.91 198907 2.20 198908 -1.63 198909 0.47 198910 2.53 198911 0.69 198912 0.39 199001 -1.52 199002 0.38 199003 0.08 199004 -0.91 199005 2.86 199006 1.60 199007 1.27 199008 -1.21 199009 0.72 199010 1.49 199011 2.23 199012 1.45 199101 1.12 199102 0.78 199103 0.69 199104 0.99 199105 0.68 199106 -0.06 199107 1.32 199108 2.05 199109 2.01 199110 0.96
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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbmfx.txt

199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411 199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610

0.74 3.04 -1.39 0.62 -0.50 0.71 1.84 1.31 1.91 0.98 1.26 -1.22 -0.02 1.48 1.89 1.86 0.37 0.74 0.14 1.80 0.61 1.69 0.40 0.30 -0.97 0.48 1.39 -1.78 -2.30 -0.83 0.00 -0.18 1.84 0.14 -1.44 -0.07 -0.18 0.80 1.90 2.17 0.68 1.31 3.95 0.66 -0.25 1.17 0.95 1.47 1.44 1.44 0.63 -1.76 -0.77 -0.49 -0.174 1.274 0.248 -0.164 1.701 2.208

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbmfx.txt

199611 199612

1.759 -0.855

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbmfx.txt (3 of 3) [15/10/2001 10:51:22]

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbisx.txt

"The Vanguard Group of Investment Companies" "Vanguard Bond Index Fund -- Short-Term" USD 199404 -0.59 199405 0.04 199406 0.26 199407 1.10 199408 0.28 199409 -0.55 199410 0.09 199411 -0.54 199412 0.23 199501 1.60 199502 1.65 199503 0.66 199504 0.95 199505 2.40 199506 0.52 199507 0.33 199508 0.63 199509 0.61 199510 0.93 199511 1.00 199512 0.91 199601 0.90 199602 -0.63 199603 -0.37 199604 -0.12 199605 0.096 199606 0.897 199607 0.299 199608 0.302 199609 1.002 199610 1.421 199611 0.991 199612 -0.297

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbisx.txt [15/10/2001 10:51:22]

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbiix.txt

"The Vanguard Group of Investment Companies" "Vanguard Bond Index Fund -- Intermediate Term" USD 199404 -0.92 199405 -0.09 199406 -0.29 199407 1.83 199408 0.26 199409 -1.63 199410 -0.26 199411 -0.49 199412 0.85 199501 2.04 199502 2.60 199503 0.72 199504 1.54 199505 4.86 199506 0.84 199507 -0.54 199508 1.26 199509 1.13 199510 1.64 199511 1.80 199512 1.47 199601 0.71 199602 -2.21 199603 -1.01 199604 -0.99 199605 -0.369 199606 1.467 199607 0.149 199608 -0.249 199609 1.905 199610 2.620 199611 2.046 199612 -1.413

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbiix.txt [15/10/2001 10:51:22]

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbltx.txt

"The Vanguard Group of Investment Companies" "Vanguard Bond Index Fund -- Long-Term" USD 199404 -1.37 199405 -0.65 199406 -0.77 199407 3.14 199408 -0.64 199409 -2.91 199410 -0.45 199411 0.42 199412 1.69 199501 2.56 199502 2.67 199503 1.07 199504 1.79 199505 7.28 199506 0.97 199507 -1.30 199508 2.09 199509 1.74 199510 2.71 199511 2.36 199512 2.56 199601 0.07 199602 -4.52 199603 -1.80 199604 -1.65 199605 -0.336 199606 1.917 199607 0.069 199608 -1.161 199609 2.769 199610 3.849 199611 3.216 199612 -2.337

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vbltx.txt [15/10/2001 10:51:23]

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vtsmx.txt

"The Vanguard Group of Investment Companies" "Vanguard Index -- Total Stock Market" USD 199205 0.69 199206 -2.05 199207 3.98 199208 -2.20 199209 1.27 199210 1.17 199211 4.23 199212 1.57 199301 1.01 199302 0.46 199303 2.46 199304 -2.77 199305 3.03 199306 0.55 199307 -0.27 199308 3.93 199309 0.01 199310 1.64 199311 -1.62 199312 1.90 199401 3.08 199402 -2.16 199403 -4.52 199404 0.89 199405 0.97 199406 -2.73 199407 3.08 199408 4.39 199409 -1.85 199410 1.55 199411 -3.65 199412 1.23 199501 2.20 199502 4.04 199503 2.65 199504 2.51 199505 3.48 199506 2.98 199507 4.02 199508 1.07 199509 3.61 199510 -1.17 199511 4.17 199512 1.54 199601 2.66 199602 1.62 199603 1.14 199604 2.41 199605 2.661 199606 -0.843 199607 -5.369 199608 3.095 199609 5.380 199610 1.429 199611 6.812 199612 -1.269

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vfinx.txt

"The Vanguard Group of Investment Companies" "Vanguard Index 500" USD 198001 5.94 198002 0.39 198003 -9.81 198004 4.32 198005 5.52 198006 2.80 198007 6.62 198008 1.27 198009 2.68 198010 1.99 198011 10.96 198012 -3.14 198101 -4.43 198102 2.11 198103 3.74 198104 -2.18 198105 0.63 198106 -0.85 198107 0.00 198108 -5.44 198109 -5.02 198110 5.22 198111 4.40 198112 -2.75 198201 -1.48 198202 -5.10 198203 -0.69 198204 4.15 198205 -2.83 198206 -1.60 198207 -2.22 198208 12.43 198209 1.01 198210 11.13 198211 4.28 198212 1.68 198301 3.42 198302 2.48 198303 3.50 198304 7.60 198305 -0.88 198306 3.75 198307 -3.25 198308 1.83 198309 1.25 198310 -1.40 198311 2.25 198312 -0.64 198401 -0.51 198402 -3.32 198403 1.63 198404 0.73 198405 -5.41 198406 2.20 198407 -1.47 198408 11.20 198409 0.00 198410 0.25
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198411 198412 198501 198502 198503 198504 198505 198506 198507 198508 198509 198510 198511 198512 198601 198602 198603 198604 198605 198606 198607 198608 198609 198610 198611 198612 198701 198702 198703 198704 198705 198706 198707 198708 198709 198710 198711 198712 198801 198802 198803 198804 198805 198806 198807 198808 198809 198810 198811 198812 198901 198902 198903 198904 198905 198906 198907 198908 198909 198910

-1.00 2.60 7.58 1.38 0.01 -0.28 6.03 1.43 -0.22 -0.67 -3.14 4.40 6.94 4.67 0.43 7.58 5.48 -1.35 5.45 1.67 -5.74 7.45 -8.31 5.63 2.55 -2.64 13.27 3.97 2.89 -1.03 1.04 5.02 4.91 3.84 -2.29 -21.73 -8.19 7.55 4.17 4.59 -3.04 1.01 0.81 4.56 -0.37 -3.40 4.26 2.73 -1.40 1.66 7.32 -2.47 2.26 5.18 4.04 -0.59 9.01 1.86 -0.40 -2.34

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198911 198912 199001 199002 199003 199004 199005 199006 199007 199008 199009 199010 199011 199012 199101 199102 199103 199104 199105 199106 199107 199108 199109 199110 199111 199112 199201 199202 199203 199204 199205 199206 199207 199208 199209 199210 199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411

2.04 2.38 -6.72 1.27 2.61 -2.50 9.69 -0.69 -0.32 -9.03 -4.89 -0.41 6.44 2.72 4.32 7.15 2.41 0.20 4.27 -4.56 4.63 2.33 -1.67 1.33 -4.01 11.41 -1.88 1.24 -1.93 2.91 0.48 -1.49 4.04 -2.07 1.17 0.33 3.40 1.21 0.81 1.36 2.11 -2.42 2.65 0.27 -0.42 3.79 -0.79 2.08 -1.00 1.22 3.38 -2.71 -4.39 1.29 1.63 -2.47 3.28 4.08 -2.45 2.25 -3.65

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199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

1.46 2.58 3.88 2.95 2.94 3.95 2.31 3.30 0.25 4.23 -0.36 4.38 1.93 3.39 0.92 0.96 1.47 2.544 0.383 -4.420 2.096 5.606 2.756 7.564 -1.959

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vivax.txt

"The Vanguard Group of Investment Companies" "Vanguard Index -- Value" USD 199212 1.77 199301 2.72 199302 3.40 199303 2.75 199304 -0.45 199305 1.89 199306 1.34 199307 1.23 199308 3.90 199309 -0.08 199310 0.50 199311 -1.84 199312 1.76 199401 4.60 199402 -3.58 199403 -4.13 199404 2.06 199405 1.58 199406 -2.60 199407 3.39 199408 2.76 199409 -3.52 199410 2.10 199411 -4.03 199412 1.25 199501 2.70 199502 3.85 199503 2.80 199504 3.30 199505 4.39 199506 0.77 199507 3.51 199508 0.81 199509 3.52 199510 -1.56 199511 5.19 199512 2.76 199601 2.97 199602 0.92 199603 2.32 199604 1.10 199605 1.475 199606 -0.504 199607 -4.276 199608 2.800 199609 4.216 199610 3.375 199611 7.678 199612 -1.651

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vigrx.txt

"The Vanguard Group of Investment Companies" "Vanguard Index -- Growth" USD 199212 0.68 199301 -1.17 199302 -0.79 199303 1.40 199304 -4.63 199305 3.62 199306 -0.89 199307 -2.12 199308 3.62 199309 -1.49 199310 3.66 199311 0.00 199312 0.68 199401 2.06 199402 -1.73 199403 -4.71 199404 0.52 199405 1.54 199406 -2.13 199407 3.22 199408 5.33 199409 -1.43 199410 2.33 199411 -3.33 199412 1.67 199501 2.53 199502 3.80 199503 3.11 199504 2.67 199505 3.56 199506 3.77 199507 3.24 199508 -0.31 199509 4.88 199510 0.83 199511 3.59 199512 1.16 199601 3.79 199602 0.90 199603 -0.42 199604 1.87 199605 3.598 199606 1.246 199607 -4.545 199608 1.429 199609 6.909 199610 2.203 199611 7.451 199612 -2.303

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vigrx.txt [15/10/2001 10:51:24]

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/vexmx.txt

"The Vanguard Group of Investment Companies" "Vanguard Index Extended Market" USD 198801 4.00 198802 6.64 198803 1.71 198804 1.42 198805 -1.31 198806 6.03 198807 -1.51 198808 -1.95 198809 2.86 198810 -0.25 198811 -2.03 198812 3.04 198901 5.34 198902 0.41 198903 2.45 198904 4.64 198905 3.90 198906 -0.66 198907 5.11 198908 3.03 198909 0.62 198910 -4.89 198911 1.43 198912 0.88 199001 -8.76 199002 2.28 199003 2.23 199004 -4.09 199005 7.90 199006 -0.29 199007 -2.64 199008 -10.18 199009 -7.22 199010 -3.89 199011 7.72 199012 3.96 199101 6.01 199102 9.20 199103 4.21 199104 0.43 199105 3.31 199106 -4.25 199107 4.95 199108 3.33 199109 0.00 199110 3.02 199111 -3.45 199112 9.73 199201 3.67 199202 1.59 199203 -3.61 199204 -1.63 199205 1.27 199206 -3.14 199207 3.76 199208 -2.12 199209 1.34 199210 2.65
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199211 199212 199301 199302 199303 199304 199305 199306 199307 199308 199309 199310 199311 199312 199401 199402 199403 199404 199405 199406 199407 199408 199409 199410 199411 199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

5.71 2.81 2.07 -1.41 3.38 -3.38 4.07 0.77 0.44 4.36 2.09 1.28 -3.03 3.35 2.93 -1.45 -4.51 0.86 -0.42 -3.09 2.69 4.87 -1.02 0.52 -3.95 1.25 0.92 4.07 2.26 1.81 2.27 4.68 5.86 2.57 2.72 -2.73 4.12 1.18 1.29 3.36 1.40 4.36 3.076 -3.279 -7.086 5.371 4.786 -1.448 4.748 0.574

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/naesx.txt

"The Vanguard Group of Investment Companies" "Vanguard Index -- SmallCap Stock" USD 198910 -6.71 198911 0.54 198912 -0.24 199001 -8.34 199002 2.40 199003 4.43 199004 -3.41 199005 7.06 199006 0.27 199007 -4.27 199008 -12.91 199009 -8.85 199010 -5.96 199011 7.84 199012 4.54 199101 8.58 199102 11.38 199103 6.91 199104 -0.44 199105 4.36 199106 -5.45 199107 3.69 199108 4.08 199109 0.42 199110 2.74 199111 -4.94 199112 8.05 199201 7.96 199202 3.50 199203 -3.38 199204 -3.04 199205 1.18 199206 -4.80 199207 3.58 199208 -2.44 199209 1.69 199210 3.17 199211 6.98 199212 3.36 199301 3.77 199302 -1.85 199303 3.07 199304 -2.84 199305 4.25 199306 0.27 199307 0.93 199308 4.23 199309 2.85 199310 2.59 199311 -2.88 199312 3.29 199401 3.64 199402 -0.37 199403 -5.07 199404 0.72 199405 -0.84 199406 -3.26 199407 1.75
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199408 199409 199410 199411 199412 199501 199502 199503 199504 199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

5.50 -0.31 -0.38 -3.92 2.57 -1.00 3.64 2.15 2.23 1.87 4.95 5.82 2.15 1.72 -4.34 3.93 2.81 0.16 3.43 1.87 5.59 3.934 -3.785 -8.451 5.942 3.756 -1.448 4.358 2.410

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/veurx.txt

"The Vanguard Group of Investment Companies" "Vanguard International Equity Index -- European" USD 199007 4.59 199008 -10.36 199009 -11.46 199010 9.06 199011 0.86 199012 -1.58 199101 2.76 199102 7.73 199103 -6.78 199104 0.96 199105 1.48 199106 -8.04 199107 7.15 199108 1.80 199109 3.23 199110 -2.12 199111 -2.57 199112 7.65 199201 0.10 199202 0.50 199203 -3.71 199204 5.93 199205 5.50 199206 -0.84 199207 -3.66 199208 0.00 199209 -1.56 199210 -6.93 199211 -0.43 199212 2.47 199301 0.00 199302 0.86 199303 5.10 199304 2.12 199305 1.58 199306 -1.36 199307 0.40 199308 8.86 199309 -0.27 199310 3.72 199311 -2.19 199312 7.66 199401 4.71 199402 -3.62 199403 -3.01 199404 4.91 199405 -4.11 199406 -1.11 199407 5.29 199408 2.96 199409 -4.08 199410 4.08 199411 -3.84 199412 0.52 199501 -0.60 199502 1.97 199503 3.94 199504 4.20
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199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

2.56 1.21 5.22 -3.97 3.03 -0.57 0.58 3.08 0.57 1.70 1.40 0.62 1.164 1.353 -1.202 2.973 1.969 2.188 4.912 1.899

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"The Vanguard Group of Investment Companies" "Vanguard International Equity Index -- Pacific" USD 199007 0.10 199008 -9.85 199009 -15.05 199010 20.73 199011 -10.43 199012 4.25 199101 3.04 199102 11.00 199103 -5.41 199104 3.56 199105 -0.73 199106 -6.41 199107 3.48 199108 -5.21 199109 8.01 199110 4.13 199111 -6.51 199112 3.06 199201 -3.93 199202 -6.96 199203 -9.14 199204 -4.71 199205 7.96 199206 -7.62 199207 -1.93 199208 13.60 199209 -2.10 199210 -3.53 199211 2.09 199212 -1.31 199301 -0.26 199302 4.51 199303 12.31 199304 15.82 199305 4.10 199306 -2.72 199307 5.78 199308 3.10 199309 -3.45 199310 2.29 199311 -14.31 199312 6.90 199401 11.35 199402 2.30 199403 -5.37 199404 4.76 199405 2.53 199406 2.98 199407 -1.99 199408 1.69 199409 -2.49 199410 2.39 199411 -5.66 199412 0.98 199501 -6.10 199502 -2.82 199503 6.98 199504 5.08
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199505 199506 199507 199508 199509 199510 199511 199512 199601 199602 199603 199604 199605 199606 199607 199608 199609 199610 199611 199612

-3.88 -4.40 7.23 -3.85 1.00 -4.87 4.93 4.87 0.35 -1.21 3.07 5.19 -4.045 0.169 -4.798 -2.564 3.448 -4.649 2.852 -5.185

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/veiex.txt

"The Vanguard Group of Investment Companies" "Vanguard International Index -- Emerging Market" USD 199406 -4.43 199407 7.95 199408 12.36 199409 0.39 199410 -1.55 199411 -6.08 199412 -7.72 199501 -10.67 199502 0.41 199503 -1.03 199504 5.18 199505 7.68 199506 -0.55 199507 2.85 199508 -2.42 199509 0.18 199510 -4.30 199511 0.38 199512 4.10 199601 10.23 199602 -1.60 199603 1.54 199604 2.79 199605 1.398 199606 0.000 199607 -6.732 199608 3.130 199609 2.277 199610 -1.484 199611 3.515 199612 0.575

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Morningstar's Performance Measures: Fund Characteristics

Morningstar's Performance Measures Fund Characteristics

This section describes the set of mutual funds used for the analyses that follow. It also provides information on key characteristics of such funds. Expenses, turnover ratios and total assets for some funds as of December 1993 were taken from the Principia Plus CD-ROM issued in January 1994. All other data were obtained from Morningstar's Principia Plus CD-ROM issued in January 1997 which included data on fund returns and characteristics through the end of December 1996.

Funds and Total Assets


The following table shows the number of funds as of December 1996 for which Morningstar data were available for the last 1,3,5 and 10 years: Number of funds, December 1996 Asset Class Domestic Equity International Equity Taxable Bond Municipal Bond Total 1 Year 2,959 835 1,670 1,739 7,203 3 Years 1,826 383 1,104 1,129 4,442 5 Years 10 Years 1,058 185 597 580 2,430 598 60 242 257 1,157

Our analyses focus on funds with at least three years of data. The table below shows the number of such
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funds in each asset class, their total assets at the end of 1996, and the average amount of assets per fund. Number of funds, assets ($ million), and assets/fund ($ million), December 1996

Funds Domestic Equity International Equity Taxable Bond Municipal Bond Total 1,826 383 1,104 1,129 4,442

Assets Assets/Fund 1,340,582 230,570 339,307 243,966 2,154,425 734 602 307 216 485

The 3-year Sample of Diversified Equity Funds As the previous table shows, domestic equity funds have well over half the assets. Moreover, the bulk of those assets are held by funds which Morningstar assigns to its nine diversified equity categories. At the end of 1996, there were 1,306 such funds. Of these, 18 were not assigned to categories and were excluded from this study since our goal is to compare all the performance measures including those utilizing category information. In addition, two of the funds had extremely high expense ratios (greater than 10%). They were also excluded in order to avoid outliers that could dominate both performance statistics and some of the regression analyses. The tables below show, respectively, the number of funds, total assets at the end of 1996, and average assets per fund for the1,286 remaining funds: Number of funds, December 1996 Value Large Medium Small Total 159 79 94 332 Blend 370 123 74 567 Growth 107 170 110 387 Total 636 372 278 1,286

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Assets ($ million), December 1996 Value Large Medium Small Total 185,093 44,989 28,207 258,287 Blend 349,939 149,009 19,171 518,118 Growth 105,759 136,966 49,557 292,282 Total 640,790 330,963 96,934 1,068,687

Assets/Fund ($ million), December 1996 Value Large Medium Small Total 1,164 570 300 778 Blend 946 1,212 259 914 Growth 988 806 451 755 Total 1,008 890 349 831

As can be seen, blend funds held more assets than either value or growth funds. Large-capitalization funds held considerably more assets than medium-capitalization funds, which in turn held considerably more assets than small-capitalization funds. Finally, small-capitalization funds were themselves small, holding fewer assets per fund on average than their medium and large-capitalization counterparts. These 1,286 diversified equity funds make up our main ("3-year") sample. At the end of 1996, they held approximately half the assets held by mutual funds with at least three years of history, and thus constituted a major portion of the industry.

The 6-year Sample of Diversified Equity Funds For some analyses we utilize the subset of the funds in the 3-year sample for which returns are available beginning with December 1990 or earlier and for which expense ratios, turnover percentages and total assets as of the end of 1993 were included on the Morningstar CDROM produced at the time. Of the 1,286 funds in the 3-year sample, 541 fulfilled these conditions. The primary reason that this is a much

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smaller sample is the rapid increase in the number of funds in the 1990's. Many of the funds in existence in 1994 were formed during the prior 3 years. However, some of the funds in existence at the end of 1993 undoubtedly subsequently disappeared through merger or liquidation or changed objective sufficiently to be renamed and/or reclassified by Morningstar. For the latter reasons, the 6-year sample is subject to survivor biases of unkown magnitude and results of our "out of sample" tests should be interepreted with considerable caution.

Expense Ratios Two characteristics that affect the net performance of a fund are (1) the costs of management and administration, summarized in its expense ratio and (2) the magnitude of its security purchases and sales, summarized in its turnover ratio. Morningstar's expense ratio is: "A figure taken from the fund's prospectus that represents the percentage of fund assets paid for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund, except brokerage costs.... Sales charges are not included.." 1 The following diagrams show the cumulative distribution of expense ratios. For convenience, only ratios from 0 to 2% are shown, although the entire range is used for calculations and the determination of the curves. In the first case, each fund is given equal weight. The vertical axis thus shows the proportion of funds with expense ratios smaller than the value shown at the corresponding point on the horizontal axis. For example, to see the median expense ratio, select the 0.5 point on the vertical axis. Move right to the leftmost point on of the shaded distribution, then down to the horizontal axis. The value on the latter is 1.19. Thus, 50% (0.50) of the funds had expense ratios smaller than 1.19 (and 50% had ratios greater than 1.19). Continuing in this manner, the graph shows that 20% (0.20 on the vertical axis) of the funds had expense ratios smaller than approximately 0.90 (on the horizontal axis), and 80% thus had ratios greater than 0.90. Cumulative distribution of expense ratios: equally-weighted

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While it is interesting to determine the expense ratio for the average fund, for many purposes it is more relevant to determine the expense ratio for the average dollar invested in a set of mutual funds. To do so, one must weight larger funds more heavily than smaller funds. The diagram below does this. As can be seen, the median expense ratio is considerably smaller (well less than 1.00). Cumulative distribution of expense ratios: dollar-weighted

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The table below provides summary information for both cases. Due to the presence of a few funds with very high expense ratios (not shown on the graphs), the mean is higher than the median in each case. Moreover, the values are considerably lower when dollar weights are used instead of equal weights. Perhaps the most relevant number in the table is the one in the lower left. Investors in this group of mutual funds collectively paid expenses equal to 0.952%, or 95.2 cents per year on every $100 invested. It is reassuring that the dollar-weighted figures are considerably smaller than the frequently quoted and less relevant equal-weighted numbers (such as the 1.305% in this sample). Note, however, that the inclusion of low-expense index funds in the sample gives lower values than would be obtained if only actively-managed funds were analyzed. Expense ratios Mean Median Equal1.305 Weighted Dollar0.952 Weighted 1.190 0.920

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Morningstar's Performance Measures: Fund Characteristics

Turnover Ratios Morningstar obtains the turnover ratio from fund shareholder reports. To compute it, "A fund divides the lesser of purchases or sales (expressed in dollars and excluding all securities with maturities of less than one year) by the fund's average monthly assets." 2 The diagrams and table below provide information on the turnover ratios of the funds in our sample. Only ratios from 0 to 200 percent are shown, although all values are used for the calculations and the determination of the curves. Cumulative distribution of turnover ratios: equal-weighted

Cumulative distribution of turnover ratios: dollar-weighted

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Turnover ratios Mean Median Equal80.4 Weighted Dollar73.8 Weighted 64.0 53.0

Here, too, the dollar-weighted mean is the most relevant. Approximately 73.8% of the dollars invested in this set of diversified equity funds were turned over each year. This clearly added to fund and investor's costs. Whether or not commensurate gains in value were obtained remains to be seen.

Relationships among Fund Characteristics

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The difference between the dollar-weighted and equal-weighted expense ratios shows that on average, larger funds have lower expense ratios due, no doubt, to their economies of scale and ability to spread fixed costs over more assets. The diagram below shows that this holds quite regularly. Each bar shows the (equally-weighted) average expense ratio of the funds in each of ten deciles (129 fundsin each of the first nine deciles and 125 in the tenth) based on assets under management. Thus the average fund in the lowest size decile charged 1.89% per year in expenses, while the average fund in the largest size decile charged 0.96%. Average expense ratios for ten deciles based on asset value

Size does not appear to be closely related to turnover as the diagram below indicates. Average turnover ratios for ten deciles based on asset value

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While size is not related to turnover, expense ratio is, as the diagram below shows. The roughly ten percent of funds with the lowest expense ratios averaged a turnover of slightly over 40%, while those with the highest expense ratios averaged more than 100%. Since the costs of trading (explicit and implicit) are generally excluded when computing expense ratios, this suggests that funds with high stated expenses tend to also have high unstated expenses. Since both types of expenses reduce returns, managers of such funds would have to increase gross returns by larger amounts than their low-expense counterparts in order to even match the latter's net returns. Analyses of net performance are required to see if they succeed. Average turnover ratios for ten deciles based on expense ratios

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1. Advanced Analytics for Morningstar Principia Plus 2. Morningstar Mutual Funds User's Guide

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Morningstar's Performance Measures: 3-year and Overall Ratings

Morningstar's Performance Measures 3-year and Overall Ratings

As indicated in the section on computations, most of Morningstar's performance measures are based on returns for the 36 months preceding the reporting date. However, risk-adjusted ratings and the related star ratings are determined for several periods (1,3, 5 and 10 years), data permitting. Moreover, an overall star rating is computed for each fund, using results for 3, 5 and 10 years, as available. This overall measure is often used for comparisons and is likely to be the basis for labeling a fund as "five-star", "four-star" and so on. From statistical and economic viewpoints, the use of mixture of different periods when ranking funds is difficult to justify. For some of the funds used in the comparison, values are based on the last three years. For others, the values are based on a combination of the last three years and the last five years. For yet others, the values are based on a combination of the last three, five, and ten years. The table below shows the number of diversified equity funds in our sample in each of these groups at the end of 1996. Available ratings, diversified equity funds Number of Funds 543 320 423 1,286

Available 3 Years 3 and 5 Years 3, 5, and 10 Years Total

Only the last three years are analyzed for 543 out of the 1,286 funds. For an additional 320 funds, both three year and five-year results are used. In such cases the five-year figures are given a higher weight, but since they include the most recent three years, the influence of the latter is still substantial. A similar situation applies for the 423 funds for which ten years of historic returns are available. While the weightings of the five-year and ten-years results are considerable, each of these periods includes the most recent three years, still giving the latter substantial influence.
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The importance of the last three years can be seen by comparing the number of stars awarded a fund based on the last three years with its overall star rating. The following table provides a breakdown of the number of funds based on the two ratings. 3-Year versus overall ratings, diversified equity funds with returns for more than 3 years 3yr = 1 Overall = 1 Overall = 2 Overall = 3 Overall = 4 Overall = 5 69 27 7 1 0 3yr = 2 7 193 43 8 0 3yr = 3 1 49 303 67 0 3yr = 4 0 2 73 256 29 3yr = 5 0 0 2 42 107

The results are striking. For 72.2% of the funds, the 3-year and overall ratings are identical. And for 98.4% of the funds, the 3-year and overall ratings differ by no more than one star. Of course, this comparison is heavily influenced by the funds for which only three years of data are available and for which the 3-year and overall ratings must be the same. When only funds with longer histories are considered, the results become somewhat less dramatic, as shown in the next table. 3-Year versus overall ratings, diversified equity funds with returns for more than 5 years 3yr = 1 Overall = 1 Overall = 2 17 27 3yr = 2 7 83 3yr = 3 1 49 3yr = 4 0 2 3yr = 5 0 0

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Overall = 3 Overall = 4 Overall = 5

7 1 0

43 8 0

141 67 0

73 109 29

2 42 35

Even in this case, the two ratings are the same for 51.8% of the funds. And for 97.2% of the funds, the rating based on the last three years is within one star of the overall rating. While it is possible that the decade from 1987 through 1996 is not representative in this regard, it seems likely that 3-year and overall star ratings will be fairly similar across funds in the future. This is just as well, for the economic and statistical properties of the latter are almost impossible to assess. For practical and theoretical reasons, we deal henceforth with only the measures computed using 36 months of returns, leaving further analysis of any differences between 3-year and overall star ratings to others.

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Morningstar's Performance Measures: Sharpe Ratios

Morningstar's Performance Measures Sharpe Ratios

Morningstar versus Return Sharpe Ratios As shown earlier, Morningstar computes its version of the Sharpe Ratio using substantially different procedures from those typically used in academic studies. Here, we contrast the Morningstar version (msSR) with ERSR, the annualized version of the traditional measure.

Morningstar and excess return Sharpe ratios

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Clearly, the two measures are highly correlated across funds. While some curvature appears in the relationship, within the range in which most fund ratios lie (0 to 2.0 in this period), the points fall very close to a 45-degree line, since the results are very similar in magnitude. To compare rankings based on two measures we cross-plot the corresponding percentiles for the funds. Percentiles are computed as follows. First the funds are ranked on the basis of the value in question (for example, the Morningstar Sharpe ratio). The fund with the highest value is assigned rank 1286, the fund with the smallest value is assigned rank 1, and all other funds are assigned ranks between 1 and 1286, in order. Then the ranks are converted to percentiles, with rank 1 assigned percentile 1/1286, rank 2 assigned percentile 2/1286, and so on up to rank 1286, which is assigned percentile 1.0 (100%). Below we plot the percentiles based on the two Sharpe ratios. Not surprisingly, they are very similar. Morningstar and excess return Sharpe ratio percentiles

The relationships we have shown graphically can also be summarized numerically in terms of correlation coefficients. Broadly, a correlation coefficient of 0 indicates no (linear) relationship between the variables, while a coefficient of 1.0 indicates a perfectly positive linear relationship. In this case, the correlation coefficient for the Sharpe ratios themselves was 0.995, while that for the percentiles was 0.997. Whatever the merits or demerits of one of these measures vis-a-vis the other, the choice between
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them seems to make little difference in practice.

The Economic Meaning of the Excess Return Sharpe Ratio As indicated earlier, it is useful to consider any performance measure as a statistic designed to help answer a specific investment question (or questions). The evaluate the relevance of a measure for a given task one must know the question that it is designed to help answer. What, then, is the question for which the Excess Return Sharpe Ratio may be at least a partial answer? As described in William F. Sharpe, The Sharpe Ratio, (The Journal of Portfolio Management, Fall 1994), a Sharpe Ratio is a measure of the expected return per unit of standard deviation of return for a zeroinvestment strategy. Such a strategy involves taking a short position in one asset or set of assets and an equal and offsetting long position in another asset or set of assets. As such it can, in principle, be undertaken at any desired scale. While the expected return and standard deviation of such a strategy will depend on the chosen scale, their ratio will not. Hence, the Sharpe ratio is unaffected by scale. More importantly, for any given desired level of risk, a strategy based on, say, fund X will provide higher expected return than one based on fund Y if and only if the Sharpe Ratio of X exceeds that of Y. When the Excess Return Sharpe Ratio is used, the strategy being considered involves borrowing at a short-term interest rate and using the proceeds to purchase a risky investment such as a mutual fund. In the present context, the Sharpe ratio of any strategy involving a combination of treasury bills and a given mutual fund will be the same. This is illustrated in the figure below, in which X and Y are two mutual funds. Excess Return Sharpe Ratios for Two Funds

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Consider an investor who plans to put all her money in either fund X or fund Y. Moreover, assume that the graph plots the best possible predictions of future expected return and future risk, measured by the standard deviation of return. She might choose X, based on its higher expected return, despite its greater risk. Or, she might choose Y, based on its lower risk, despite its lower expected return. Her choice should depend on her tolerance for accepting risk in pursuit of higher expected return. Absent some knowledge of her preferences, an outside analyst cannot argue that X is better than Y or the converse. But what if the investor can choose to put some money in one of these funds and the rest in treasury bills which offer the certain return shown at point B? Say that she has decided that she would prefer a risk (standard deviation) of 10%. She could get this by putting all her money in fund Y, thereby obtaining an expected return or 11%. Alternatively, she could put 2/3 of her money in fund X and 1/3 in Treasury Bills. This would give her the prospects plotted at point X' -- the same risk (10%) and a higher expected return (12%). Thus a Fund/Bill strategy using fund X would dominate a Fund/Bill strategy using fund Y. This would also be true for an investor who desired, say, a risk of 5%. And, if it were possible to borrow at the same rate of interest, it would be true for an investor who desired, say, a risk of 15%. In the latter case, fund X (by itself) would dominate a strategy in which fund Y is levered up to obtain the same level of overall risk. Note that in this comparison it is assumed that only one risky investment is to be undertaken. The reason that the Excess Return Sharpe Ratio is, in principle, designed to deal with this situation is not difficult to see -- the measure of risk is the total risk of the fund in question. But in a multi-fund portfolio, both the

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total risk of a fund and its correlation with movements in other funds is relevant. Since the Excess Return Sharpe Ratio deals only with the former, it is best suited to investors who wish to choose only one risky mutual fund. Prospectively, the Excess Return Sharpe Ratio is best suited to an investor who wishes to answer the question: If I can invest in only one fund and engage in borrowing or lending, if desired, which is the single best fund? Retrospectively, an historic Excess Return Sharpe Ratio can provide an answer for an investor with the question: If I had invested in only one fund and engaged in borrowing or lending, as desired, which would have been the single best fund? Of course, Excess Return Sharpe Ratio may prove to be useful for answering other questions to the extent that it can serve as an adequate proxy for a measure that is, in principle, more applicable. Such possibilities will be explored subsequently.

Negative Sharpe Ratios In practice, there are situations in which funds underperform treasury bills on average and hence have negative average excess returns. In such cases it is often considered paradoxical that a fund with greater standard deviation and worse average performance may nonetheless have a higher (less negative) Excess Return Sharpe Ratio and thus be considered to have been "better". Given the basis for the use of the measure, however, this is not a paradox. Consider the case shown below. Excess Return Sharpe Ratios for Two Funds

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Here X by itself was clearly inferior to Y (and both were inferior to Treasury Bills). But, for an investor who had planned for a standard deviation of 10%, the combination of 2/3 X and 1/3 Bills would have broken even, while investment in fund Y would have lost money. Thus a Fund/Bills strategy using the fund with the higher (or less negative) Excess Return Sharpe Ratio would have been better. Of course, one would never invest in funds such as X or Y if their prospects involved risk with negative expected excess returns. But, after the fact, the Sharpe Ratio comparison remains valid, even in this case, if the preconditions for its use were in effect.

Costs, Assets and Sharpe Ratios Whatever the relevance of the Excess Return Sharpe Ratio may be, it is useful to investigate the relationship between fund performance, so measured, and fund characteristics.. We investigate three such characteristics: expense ratios, turnover ratios and total assets. Since all our measures of performance are based on net returns, higher costs would lead to lower net returns and hence poorer performance unless more than offset by higher gross performance. Moreover, since larger funds tend to have lower proportional expenses, they would provide better net performance unless their gross performance were commensurately lower. We choose the traditional annualized excess return Sharpe ratio (ERSR) for this analysis, since it is more
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familiar and has somewhat better statistical and economic properties. However, results using the Morningstar measure would have differed little from those shown here. Here (and later) we first consider each of the three variables in isolation, following the method used earlier. We group the funds into deciles of 129 funds each (except that there are 125 funds in the tenth decile) based on the variable of interest (for example, expense ratio). We then compute the average Sharpe ratio for the funds in each decile and graph the average values for each of the ten deciles. If the variable has explanatory power, the deciles will vary in average performance by economically meaningful amounts. We begin with expense ratios, the results for which are shown below: Average Sharpe ratios for ten deciles based on expense ratios

While by no means uniform, the bars become considerably shorter as one goes from left to right. The average Sharpe ratio for the funds with the smallest expense ratios was over 75% greater than that of the funds with the greatest expense ratios. This is evidence in support of the thesis that higher expenses add far more to expense than they add to performance. A similar result is obtained when turnover ratios are considered:

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Average Sharpe ratios for ten deciles based on turnover ratios

While the magnitude of the difference between the largest and smallest decile is somewhat smaller than that obtained when funds were grouped based on expense ratios, the greater uniformity of the decline in bar height from left to right is impressive. This is evidence that the greater costs incurred by funds with high turnover are not offset by commensurate performance gains. Since large funds tend to have lower expenses and somewhat lower turnover, we would expect performance to increase with asset size, given the two previous results. As the next graph shows, such is the case. Average Sharpe ratios for ten deciles based on total assets

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While bigger funds tend to have had better performance, this may be due entirely to their tendency to have lower expenses and turnover. To try to separate out the influences of these three fund characteristics, we perform a multiple regression analysis with all three characteristics as independent variables and the Sharpe ratios as the dependent variable. For each variable, two statistics are reported below -- one measuring the variable's statistical significance, the other its economic significance. Multiple regression, dependent variable: Sharpe ratio Effect of one SD change -0.1336 -0.0936 +0.0137

t-value Expense Ratio -14.25

Turnover -10.11 Ratio Assets + 1.49

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From a statistical standpoint, both expense ratios and turnover ratios are highly significantly related to Sharpe ratios. A standard rule of thumb considers a variable statistically significant if the t-value from a multiple regression has an absolute value greater than 2.0. In this sense, the two cost measures are highly significant while the size of the fund, per se, is not. Statistical significance is important, but economic significance measures the effect of a variable on an investor's overall wealth. To capture the latter we compute the impact of a change in each variable equal to one cross-sectional standard deviation of that variable for the funds in the analysis. For example, let the average expense ratio for the funds be aE and the standard deviation of expense ratios for the funds be sdE. In this case, aE=1.3047 and sdE = 0.6552. In the multiple regression equation the coefficient for the expense ratio was -0.2039. This indicates that moving from a fund with an expense ratio equal to aE to one with an expense ratio of aE+sdE would, on average, reduce the fund's Sharpe ratio by 0.2039*0.6552, or 0.1336. Roughly, going from a typical fund to one in the 84'th percentile in terms of expense ratios would, on average, lower performance measured by the Sharpe ratio by 0.1336. As the figures in the final column of the table indicate, expense ratio was the most economically important determinant of performance in this analysis, with turnover ratio a fairly close second, and assets, per se, a distant third.

In-sample and Out-of-sample Analyses of the Impact of Expenses Evidence that fund net performance tends to be lower when expenses are high than when they are low is not new. Nor is evidence that higher turnover tends to lower net performance. However, our results may overstate the importance of each of these factors. Consider, for example, two funds with equal dollar expenses, each of which is fixed and unaffected by assets under management. If one fund does well while the other does poorly, the expense ratios at the end of the measurement period will differ, with the ratio of dollar costs to asset value lower for the fund that provided the better performance, even though the performance was unrelated to its expenses. In practice, fund expense ratios do not decline as rapidly with size as our example would suggest. Nonetheless, it is likely that our results overstate the relationship between expenses (and possibly turnover) measured before the fact and subsequent performance. To provide at least some measure of the latter, we examine the relationship between expenses ratios at the end of 1993 and Sharpe Ratios for the 1994-1996 period for the 540 funds in our 6-year sample. The figures below show average Sharpe Ratios for fund deciles based on prior measures of , respectively, expense ratios, turnover ratios and fund size.

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Note that the differences in performance are somewhat smaller than in the prior analyses, but they are still substantial and in the same directions. The table below shows the results of a multiple regression in which the Sharpe Ratio for 1994-1996 was the dependent variable and the three measures determined in 1993 were the independent variables.

Multiple regression, dependent variable: Sharpe ratio Effect of one SD change - 0.1309

t-value Prior Expense Ratio

- 8.40

Prior Turnover - 4.88 Ratio

- 0.0743

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Prior Assets

+ 0.48

+ 0.0073

All the numbers in the table are smaller in absolute value than their counterparts in the prior analysis, again suggesting that the earlier analysis was in fact biased as expected. This being said, the coefficients for expenses and turnover are both statistically and economically highly significant. One final comment about these results is in order. Note that the sample does not include all the funds for which expense ratios and turnover data were available in later 1993. Most of the missing funds are likely to have performed poorly between 1994 and 1996. If they tended to have had high expenses and/or turnovers, our results may well understate the negative impact of such characteristics. This seems more likely than the alternative hypothesis that our results understate the impact of expenses and turnover. However, lacking complete data on the missing ("dead") funds, no definitive statement regarding the sign or size of the bias can be made.

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Morningstar's Performance Measures Category Ratings

Utility-based and Scale-independent Performance Measures Before analyzing Morningstar's Category Ratings it is useful to define two broad general categories of risk-adjusted performance measures. Scale-independent measures are unaffected by the scale at which an investment strategy is undertaken. They measure the performance of zero-investment strategies that can be undertaken at any desired level of risk and return. They require few assumptions about investor preferences other than that return is good (more is preferred to less) and that risk is bad (less is preferred to more). Generally, such measures are formed by dividing a return measure by a risk measure. All variations of the Sharpe ratio are included in this category. Utility-based measures are designed to indicate the desirability of a particular investment strategy for an investor with a specific attitude toward risk vis-a-vis return. Even if the strategy in question can be taken at alternative scales, the measure applies to a specific scale. Such measures generally are formed by subtracting from a measure of return the product of a measure of risk times a measure of the investor's risk aversion (or the result obtained by dividing the measure of risk by a measure of the investor's risk tolerance). Such measures assume not only that return is good and risk is bad, but also that the investor's willingness to accept more risk in pursuit of more return can be quantified and is equal to the particular value of risk aversion or risk tolerance utilized in the computation. A utility-based measure is typically used for a strategy that involves the outlay of funds, as opposed to a zero-investment strategy. As we will show, Morningstar's risk-adjusted ratings have the form of a utility-based performance measure but are adjusted so that in many cases they are closely aligned with scale-independent measures.

Morningstar's Category Risk-adjusted Rating as a Utility-based Performance Measure To compute its category risk-adjusted rating, Morningstar subtracts a fund's category risk measure from
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its category return measure: msCRARi = msCReti - msCRiski Each of the components is, in turn, computed by dividing the appropriate measure for the fund by a base value that is the same for all the funds in the category: msCReti = EVRi / RetBasec(i) msCRiski = AMLi / RiskBasec(i) Substituting these equations in the formula for the category risk-adjusted rating gives: msCRARi = EVRi / RetBasec(i) - AMLi / RiskBasec(i) Rewriting: msCRARi = (1 / RetBasec(i) ) [ EVRi - ( RetBasec(i) / RiskBasec(i) ) AMLi ] Given the procedures used to determine the return base, the term outside the square brackets will always be a positive constant greater than zero and will be the same for all the funds within a given category. Thus both the rankings and relative values of the category risk-adjusted rating will be the same as if only the term in the square brackets were utilized. This can be written as: EVRi - rac(i) AMLi where: rac(i) = RetBasec(i) / RiskBasec(i) This shows that in form, at least, Morningstar's category risk-adjusted rating is a utility-based performance measure, with the ratio of a category's return base to its risk base serving as a measure of investor risk aversion. However, two aspects are unusual for such a measure. First, the components are based on zero-investment strategies, so the measure can be made larger or smaller by changes in the scale. Second, the risk-aversion parameter is determined by the historic performance of the funds in the category to which the fund in question has been assigned. As will be shown, the second attribute gives the category risk-adjusted rating some of the characteristics of a scale-independent measure.

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A More Consistent Risk-adjusted Rating It is difficult to characterize the category risk-adjusted rating as a measure of expected utility derived from a more fundamental function relating an investor's utility to fund return. It uses a return measure based on the annualized difference between the three-year compounded return on the fund and that obtained from Treasury bills in conjunction with a risk measure based on an arithmetic average of monthly losses, hence combining in one measure statistics appropriate for investors with two different horizons. A more consistent approach would utilize a fund's average monthly excess return for the first component, making it consistent with the second component. The combined measure would then be appropriate for an investor with a horizon of one month or for an investor who believed that the resulting statistics could be used to project results for longer horizons based on a maintained hypothesis of zero serial correlation of monthly values. In practice, average monthly excess returns are closely related to the return measures used by Morningstar. The figure below shows a cross-plot of the two for the funds in our 3-year sample. Since Morningstar's measure is annualized, while the average monthly excess return is not, the scales differ but the correlation (0.993) is very high.

Morningstar Mean Excess Return versus Average Monthly Excess Return

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The similarity of the two return measures allows us to interpret Morningstar's category risk-adjusted rating as an approximation to a function of the following form: EUi = AMERi - k * AMLi where AMERi = fund i's average monthly excess return AMLi = fund i's average monthly loss EUi = the expected utility of fund i's performance We are now ready to answer a key question. If this formula gives the expected utility for a fund, what is the underlying utility function whose expected value is being measured? The answer is that the function in question is composed of two linear segments, with a kink at the point representing the return on bills. We will call this a bi-linear utility function. First, we show its
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consistency with the performance measure, then consider its relevance for investment decision-making.

Expected Utility for an Investor with a Bi-linear Utility Function Consider a utility function of the form: U= ( Ri - B ) if Ri >= B kk * ( Ri - B ) if Ri < B where B is the return on a Treasury bill and kk is a constant. As can be seen below for an example in which kk =2.5 and B=4, such a utility function plots as two straight lines and hence can be termed bilinear.

A bilinear utility function with kk = 2.5 and a bill return of 4%

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Now consider the following utility function U= ( Ri - B ) + ( kk - 1) * ( Ri - B ) if Ri < B If Ri exceeds B, this will give the same utility as the previous function; this will also be the case if Ri is less than B. Hence this is the same bi-linear utility function. Now consider a set of t possible Ri values. Let pt be the probability that Ri will equal Rit. Then the expected utility will be: EUi = sumt { pt * ( Rit - B) } +

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( kk -1 ) * sumt { pt * ( Rit - B) } for Rit < B When historic data are utilized, frequencies replace probabilities ( with1/t substituted for each pt ), but the procedure is the same. In this case the first sum will equal the average monthly excess return while the second sum will equal the average monthly loss. Thus: EUi = AMERi + ( kk -1 ) * AMLi or: EUi = AMERi + k * AMLi where: k = kk -1 Note that the second expression is the approximation for the category risk-adjusted rating. Hence we conclude that the latter is appropriate for an investor with a bilinear utility function that has its "kink point" at the level of the return on Treasury bills.

Attributes of Bi-linear Utility Functions A key attribute of a bi-linear utility function is its "kink" at a "reference point". Outcomes that are superior to the reference points are considered gains while those that are inferior to the reference point are considered losses. The change in slope at the reference point reflects the assumption that the investor considers the disutility associated with a small loss to be greater than the utility associated with a small gain of equal absolute magnitude. This attitude, found in countless experiments in cognitive psychology, was termed loss-aversion by Kahneman and Tversy1. It is a central part of their prospect theory, designed to model the behavior of individuals when making decisions under uncertainty. In the bilinear version, parameter k measures the degree of the investor's loss aversion -- the greater the value of k, the greater the disutility of a loss relative to the utility of a gain. While experiments show that individuals differ significantly in their degree of loss aversion, values from 2.0 to 2.5 are relatively typical. While the bilinear utility function captures one aspect of investor behavior, it leaves out other aspects included in the models of prospect theory. Kahneman and Tversky found that many investors exhibit risk aversion in gains and risk preference in losses, giving utility functions considerably more complex than the bi-linear version. Moreover, prospect theory takes into account that, when evaluating uncertain prospects, individuals assign weights to possible outcomes that differ in predictable ways from objective estimates of probabilities. None of these added complexities is reflected in our simple utility function and
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hence none is taken into account in an explicit manner in the Morningstar risk-adjusted ratings. While the bi-linear utility function captures important aspects of individual behavior, the use of a onemonth horizon (at least for losses) and the return on bills as a reference point may be subject to debate. Concerning the latter, the question is whether an investor regards, say, 0.1%. as a loss when she could have earned 0.4% from a Treasury bill. At least some experimental evidence would indicate that investors consider any absolute return to be a gain. Measures that associate significant disutility with opportunity losses rather than with only actual losses may thus fail to fully conform to investors' notions of risk.

Average Loss versus Standard Deviation as a Measure of Risk Given the ubiquity of loss-aversion, Morningstar's emphasis on average loss can be understood as an attempt to appeal to investors' basic notions of risk. Indeed, much is made of the difference between this intuitive measure of risk and standard deviation, the somewhat less easily accessible measure used by academics and some other industry practitcioners. As a practical matter, however, there appears to be little difference between the two measures when used in conjunction with measures of expected or average return. Consider the relationship between the average monthly loss and the monthly standard deviation of excess returns. Each point in the figure below plots one of the funds in our 3-year sample. As can be seen, there is a close relationship between the two measures -- the correlation coefficient is 0.932.

Average Monthly Loss versus Monthly Standard Deviation of Excess Returns

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Even this understates the similarity of the "downside risk" and "mean-variance" approaches. The ultimate question is whether decisions made on the basis of expected return and downside risk are likely to differ significantly from those made on the basis of expected return and standard deviation. This can better be addressed by examining the extent to which a fund's average monthly loss can be estimated, given its average excess return and standard deviation of excess return. A multiple regression analysis shows that the correlation is extremely high. Both independent variables (average monthly excess return and standard deviation of monthly excess returns) are highly significant, with an overall R-squared value of 0.9797. The figure below plots the actual and estimated average monthly losses -- not surprisingly, they differ little due to the high correlation, which is in excess of 0.99 (the square root of 0.9797) .

Average Monthly Losses: Actual versus Estimates based on Average Excess Return and Standard Deviation of Excess Return

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Given the dangers associated with assuming future return distributions will be precisely like those of the past, it appears that the set of funds regarded as efficient on the basis of mean and average loss will be very similar to that regarded as efficient on the basis of mean and standard deviation of excess returns. In the present context, any significant differences between Morningstar's approach and those associated with mean-variance analyses will almost certainly be attributable to other factors than the differences in measures of risk.

Selecting the Loss-aversion Parameter We have argued that, in form at least, the Morningstar risk-adjusted ratings are utility-based performance measures. If they were intended to serve as such one would expect that the loss-aversion parameter would be given a value considered representative of a class of investors and that the same value would be used consistently through time. This is, in fact, not the case. Instead, the parameter is determined by the performance of the funds in the peer group being evaluated. Thus it differs across categories for the category ratings and across major asset classes for the star ratings. Moreover, the parameter may differ from period to period for a given category or asset class. It is thus difficult to give a risk-adjusted rating a meaningful interpretation as a utility-based measure, given the seemingly arbitrary and inconsistent
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manner in which the key parameter is determined in each instance. Some other explanation is clearly needed. In fact, there is scant evidence in Morningstar's literature that the ratings are even considered utilitybased measures.One might speculate that they simply evolved through time. Possibly Morningstar started with the traditional 3-year cumulative return measure. Then a Treasury bill 3-year return was subtracted to better measure the added (or subtracted) performance due to risk-taking. Next, a plausible and intuitively appealing measure of risk (average monthly loss) was computed to take risk into account. To combined both measures, normalization was employed -- first within each asset class for the star ratings and later within each category for the category ratings. At some point is was probably realized that the use of average values for the return denominator could pose a problem so a somewhat arbitrary rule was devised to provide a lower bound equal to the 3-year return on Treasury bills. While each of the aspects of the computation seems reasonable, when viewed as a whole, the procedure seems to lack a consistent basis. But it is important to look beyond the formal rules for the calculation of the Morningstar measures to their effects. Due to the somewhat ad hoc change in the procedure when an asset class or category falls provides less than twice the return on Treasury bills, we must approach this question in two stages. To simplify the exposition we define a good time for a category or asset class is one in which the average excess value relative for the funds in the category or asset class is at least twice as great as the growth in value obtained from Treasury bills. Conversely, a bad time for a category or asset class is one in which the average excess value relative for the funds in the category or asset class is less than two times the growth in value obtained from Treasury bills. The distinction is critical, since the method used to calculate the denominator for the return rating and hence the implied loss-aversion in the utility function differs in the two cases. We turn first the the results obtained in god times.

Morningstar's Ratings in Good Times If the last 3 years has been a good time for the funds in a category, the utility function used by Morningstar will be: EVRi - rac(i) AMLi where: rac(i) = RetBasec(i) / RiskBasec(i) and:

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RetBasec(i) = avgj in c { EVRj } RiskBasec(i) = avgj in c { AMLj } For purposes of our analysis, we use the similar (but more consistent) version in which average monthly excess return serves as the measure of return. The corresponding measures would be: EUi = AMERi + k * AMLi where: k = avg{AMER} / avg{AML} Consider now a fund for which AMERi = avg{AMER} and AMLi= avg{AML}. We will call this an average fund and denote it with the subscript a. Note that for such a fund the expected utility (EUa) is zero, as is the expected utility of a Treasury bill (for which both AMER and AML are zero). In the figure below, the horizontal axis plots risk (here, AML) and the vertical axis expected or average return (here, AMER). The average fund is represented by the red plus sign, and Treasury bills by the blue plus sign at the origin. All funds that plot on the red line running through these two points have the same expected utility (zero). This is an indifference (iso-expected utility) curve for the utility function in question -- that is, a curve showing a set of risk-return combinations among which the investor is assumed to be indifferent. Note that in this construction the curve is a straight line with a slope equal to the loss aversion parameter (k) and an intercept equal to the associated expected utility (here, zero). The diagram also shows additional indifference curves -- each corresponding to a selected levels of expected utility. Points on higher curves provide more expected utility (are given higher ratings), while those on lower curves provide less expected utility (are given lower ratings).

Iso-utility Indifference Curves

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Now consider a scale-independent measure of performance. First, note that both AMER and Morningstar's return measure relate to the return of a zero-investment strategy in which a long position is taken in the fund in question and a short position in Treasury bills. If these positions were doubled in size, the returns relative to the investor's notional position would also be doubled. But this is also true both our measures of risk -- AML and the standard deviation of monthly excess returns. Thus by doubling positions, utility could be doubled. Note, however, that whatever the scale, the ratio of either return measure to either risk measure would be the same. Thus such a ratio will be scale-independent. In this example, we use the AMER/AML ratio as a scale-independent performance measure. Given these relationships it is clear that any point on the red line in the figure above can be obtained with an appropriate combination of the average fund and Treasury bills. More generally, any point on a ray from the origin can be obtained by combining a fund that plots on that ray with Treasury bills. The arguments given in the section on the Sharpe ratio thus apply directly, and funds with greater AMER/AML ratios would be preferred to those with smaller ratios by any investor able to lever holdings up or down to obtain a desired level of risk. The figure below shows a number of other lines showing sets of funds with equal AMER/AML ratios (or, more generally, return/risk ratios for a zero-investment strategy).

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Iso-utility Indifference Curves and Iso-Return/Risk Curves in Good Times

We note in passing some troublesome implications of the simple bi-linear utility function. Consider an investor faced with one or more funds plotting on the red line. He or she would be indifferent among all combinations of risk and return that could be obtained by levering one or more such funds up or down. An investor faced with one or more funds plotting on one of the blue lines plotting below the red line would choose to put all of his or her funds in Treasury bills. On the other hand, an investor faced with funds plotting on one of the blue lines plotting above the red line would choose to lever up to obtain the maximum allowable risk and return. If investors really had utility functions of this type we would observe primarily extreme risk-return strategies -- a result inconsistent with observed behavior in which most investors choose combinations of cash, bonds and stocks. This calls into serious question the underlying assumptions needed to formally derive some of the simplistic performance measures incorporating downside risk. This diversion completed, we now turn to a comparison of fund rankings based on the two performance measures (Morningstar's and one using the ratio of return to risk). First, note that the two measures give the same results along the red line. Moreover, note that any fund with a greater AMER/AML ratio than that of the average fund (k) will be considered superior to the average fund no matter which measure is

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used. Conversely, any fund with a smaller AMER/AML ratio than that of the average fund (k) will be considered inferior to the average fund, no matter which measure is used. Whether intentionally or not, by selecting a loss aversion parameter equal to the AMER/AML ratio for the average fund Morningstar assures equality of implications in at least this respect. When comparing two funds plotting above the red line, the two measures may, of course, give contradictory results. This may also be the case when comparing two funds plotting below the red line. But as long as funds plot relatively near the point representing the characteristics of the average fund rankings may be reasonably similar, as can be seen from the figure. By construction, then, in good times the procedures used by Morningstar could well result in fund rankings that are similar to those that would be obtained with a scale-independent performance measure. This is evidenced by the results for the 1994-1996 period, which was a "good time" for every one of the diversified equity categories. Each point in the figure below plots (1) the rank of a fund within its category based on its Morningstar category risk-adjusted rating (msCRARi) on the horizontal axis and (2) its rank based its monthly excess return Sharpe ratio (MERSRi) on the vertical axis. As can be seen, the ranks differ relatively little( the correlation coefficient is 0.986).

Utility-based and Scale-independent Rankings within Categories

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The similarity of results is striking, especially considering the differences in the methods used in the calculations, summarized in the table below. Morningstar Risk-adjusted Rating Return Risk Annualized difference in Value Relatives of Fund and Bills Average Monthly loss (negative excess return) Sharpe Ratio Average Monthly Excess Return Standard Deviation of Monthly Excess Returns Return/Risk

Performance Return - k*Risk

It seems warranted to conclude that whatever its intuitive advantages or logical failings, in good times Morningstar's risk-adjusted rating system may well give results similar to those that could be obtained using the simpler and more traditional excess return Sharpe Ratio. In such situations, Morningstar's

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measure may in fact be a scale-independent ratio in utility-based clothing.

Morningstar's Ratings in Bad Times In a period in which the average fund in an asset class or category fails to do twice as well as Treasury bills, the loss aversion parameter in the implicit utility function corresponding to Morningstar's measure is based on the ratio of the performance of Treasury bills to the average monthly loss of the average fund. This insures that the associated indifference curves will have positive slopes, even though the average fund may have a small, zero or even negative average excess return and hence ratio of average excess return to average monthly loss. A rather extreme case in which funds actually lose money on average is shown below.

Iso-utility Indifference Curves and Iso-Return/Risk Curves in Bad Times

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Here, as before, the measure of return is assumed to be the average excess return, so that Treasury bills plot at the origin (shown by the blue plus sign). The average fund, shown by the red plus sign, experienced negative excess returns on average and hence plots below the origin. In this case the indifference curve on which the average fund plots does not coincide with the ray from the origin on which the fund plots -- the indifference curve in question is the green line going through the fund's point while the ray from the origin is shown by the red line. Thus even for funds in the region near the point representing the average fund there can be significant differences in rankings by the two measures. Consider, for example, a point just below the red line with less risk than that of the average fund. It will have a lower return/risk ratio than the average fund but a considerably greater utility. On the other hand, a point just above the red line with more risk than the average fund will have a higher return/risk ratio than the average fund but a significantly lower utility. Since the two types of measures diverge in this situation, it is important to evaluate the desirability of one versus the other. If a single fund is to be chosen for the investor's entire portfolio and if no borrowing or lending is allowed, the utility-based measure is almost certainly preferable. If a single fund is to be chosen but it is also possible to combine investment in the fund with the purchase of a riskless asset or to borrow to buy additional units of the fund, the return/risk ratio is clearly more appropriate. The choice of a measure depends on the context in which it is to be applied. But what about the more common situation in which a fund is to be evaluated for its suitability as part of a portfolio? In such cases, as we will show in subsequent sections, neither the Morningstar risk-adjusted rating nor the excess return Sharpe ratio is the measure of choice. Fortunately for investors, but unfortunately for analysts, stock returns have been well in excess of those on Treasury bills for most of the years since Morningstar began publishing ratings. Survivor bias in the current data sample makes it impossible to fully judge the results that would have been obtained with the two types of measures in earlier periods. However, likely results can be approximated by using the subset of our sample that was in existence in each three-year period from 1980 onwards. Since prior category memberships are not available we combine all available funds for each period in one sample. For each period we then compute a Morningstar risk-adjusted rating and an excess return Sharpe ratio for every fund, rank the funds based on the two measures and compute the correlation of the two rankings. In all, 15 such analyses were performed. The lowest correlation was 0.947, obtained for the 1980-1982 period, when Treasury bills provided a cumulative return of 40.83% and the average fund provided 68.37% -less than twice as much. Note, however, that the average fund performance obtained in this analysis is almost certainly an upward-biased estimate of that which would have been obtained at the time due to the lack of funds that "died" in succeeding years. Moreover, other asset classes and categories experienced considerably worse times during some of the three-year periods since 1980 and hence could well have exhibited significant differences in rankings using the two measures. In sum, we would expect Morningstar's procedure to give results reasonably similar to those obtained using the simpler excess return Sharpe ratio except in situations in which the average fund in an asset

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class or category provides significantly poor performance. In the latter instances, a choice between the two should depend on the type of investment decision to be made. In many cases, as we will argue, neither measure is especially appropriate. In other cases, one might surmise that the Sharpe ratio would be preferred since investors generally can invest in Treasury bills, borrow funds if desired, and predict fund risk reasonably well -- conditions under which scale-independent measures are germane and utilitybased measures are not.

Footnotes 1. Kahneman, Daniel and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica, XXXXVII (1979), 263-91.

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Morningstar's Performance Measures Star Ratings

Star versus Category Ratings Most of the discussion of the attributes of Morningstar's category ratings applies as well to their threeyear star ratings, which we cover here. However there are three key differences. First, cumulative returns are adjusted for any load charges when computing the star ratings but such charges are not taken into account in the category ratings. Second, the bases used to compute compute relative returns and risks are different. A common base, computed using all funds in an asset class, is used for computing star ratings. For category ratings, each group of funds uses a separate base, computed using all funds in the category. Finally, stars are assigned by ranking all funds in an asset class while category ratings are assigned by ranking funds separately within each category. The differences between the two ratings for diversified equity funds can be seen in the figure below. Each point represents one fund. The horizontal axis plots a fund's category risk-adjusted rating while the vertical axis plots its three-year star risk-adjusted rating.

Star versus Category Risk-adjusted Ratings

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As can be seen in the figure, there appear to be separate clusters of funds lying along more or less parallel straight lines. This is not surprising. Recall that a fund's category risk-adjusted rating is can be calculated by multiplying the fund's average monthly loss by a constant and then subtracting the result from its its excess value relative. The fund's three-year star risk-adjusted rating is calculated by multiplying its average monthly loss by another constant, then subtracting the result from its loadadjusted excess value relative. For no-load funds, the only differences between the two measures result from the different constants by which average monthly loss is multiplied. For load funds the return measures also differ, but not by large amounts. The net result is that all funds in a given category lie on or near a fairly straight line in the diagram. Funds in categories with better historic performance during the period lie on higher lines; those in categories with poorer historic performance lie on lower lines. While the correlation between the two measures is fairly high (0.887), the differences are highly significant economically. A fund's star risk-adjusted rating is determined by (1) how well its category performed and (2) how well it performed within its category. Roughly, the influence of the former can be measured by the spread between the top and bottom implicit lines in the figure. A more direct measure can be obtained by computing the mean star risk-adjusted rating for all the funds in each category. The results are shown in the table below.

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Category Mean Three-year Star Risk-adjusted Ratings Value Blend Growth Large 0.497 0.430 0.219 0.106 -0.290 -0.447 Medium 0.158 0.100 Small 0.115

The results are striking. In the 1994-1996 period the average large value fund had a three-year star riskadjusted rating of 0.497, while the average small growth fund had a rating of -0.447. A small growth fund that did well relative to others in its category would almost certainly receive fewer stars during this period than a large value fund that did poorly relative to others in its category. The conclusion is inescapable. Star risk-adjusted ratings summarize both the performance of the domain in which a fund operates and the performance of the fund relative to others in its domain. Selection of funds with high star risk-adjusted ratings is far more likely to result in the choice of funds in categories with strong recent performance rather than in funds in categories with poor recent performance. In many cases this is likely to be a poor approach to fund selection. There is little evidence that investment in categories that have done well in the last three years is a superior investment strategy.

Star Ratings and Sharpe Ratios We have shown that ranking funds within a category based on their category risk-adjusted ratings gives results that are similar to those obtained when ranking on the basis of excess return Sharpe ratios, at least when the average performance of the funds in the category has been good. The theoretical and empirical reasons for such results also apply with regard to star risk-adjusted ratings, but the greater diversity of risks and returns within an asset class is likely to make the correspondence somewhat smaller in magnitude. Differences will also be greater due to the inclusion of load charges in one measure but not the other. Nonetheless, the two give quite similar results, as shown in the figure below.

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In this case the correlation between the two measures is 0.955 -- lower than that obtained when ranking within categories, but quite high nonetheless. Star risk-adjusted ratings, like category risk-adjusted ratings, appear to be scale-independent measures in utility-based measures' clothing. As such, they share both the good and the bad attributes of the more traditional excess return Sharpe ratios.

Star Ratings and Efficient Mean-variance Combinations Thus far we have concentrated on the risk-adjusted ratings that are used to award stars to funds. We turn finally to the stars themselves. The figure below plots the annualized mean monthly excess return and annualized monthly standard deviation of each fund in our three-year sample. Funds awarded 5 stars are shown by blue circles, those awarded 4 stars by red circles, 3 stars by green plus signs, 2 by blue plus signs and 1 by red plus signs. Despite the many differences in underlying procedures, the end results are remarkably similar. For each level of risk, the 5-star funds generally provided the best performance, the 4 star funds the next best, and so on down to the 1 star funds, which did worst. Traditional mean-variance analysis would thus have reached similar conclusions concerning performance. Average Excess Return and Standard Deviation of Excess Return by Star
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Rating

Finally, note that the five clusters in the figure appear to fall along more or less straight lines. This is consistent with the fact that a risk-adjusted rating is equivalent to the sum of normalized measures of risk and return. Consider instead a set of rays from the origin, each representing the locus of funds with the same excess return Sharpe ratio. As can be seen visually, funds with 1 star will generally have the lowest Sharpe ratios, those with 2 stars the next lowest, and so on up to the 5 star funds that will tend to have the highest such ratios. This shows again that within this range of outcomes, rankings by Sharpe ratios are similar to those based on Morningstar's more complex measure.

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Morningstar's Performance Measures: Alphas and Selection Returns

Morningstar's Performance Measures Alphas and Selection Returns


Selection Returns The raw measures analyzed thus far were "bottom-line" -- based on risks and returns calculated using either fund total returns or excess returns. While excess returns are calculated by taking the difference between two returns, the return that is subtracted from a fund's return is that of Treasury bills, not the return on a benchmark considered to be similar to the fund itself. While it is true that the relative measures computed by normalizing raw measures and/or ranking results for funds within an asset class or category can be considered "benchmarked", at a theoretical level this is subject to criticism. Take, for example, the category rating. It incorporates a risk measure that is appropriate if the fund in question constitutes the entirety of the investor's portfolio. By normalizing this and the measure of return, then ranking all the funds in a category, one obtains an answer to the following question: If I had chosen one fund and had limited my choice to funds in this category, which would have been the best? In principle, at least, this is very different from the more common question: If I had put some of my money in a fund in this category, which would have been the best? As we will argue, to answer the latter question, a different type of measure is called for -- one involving the difference between a fund's return and that of an appropriate benchmark. We have defined a fund's selection return in month t as the difference between its return and that of a benchmark:

SelRetit = Rit - Rbp,t where: SelRetit = the selection return for fund i in month t Rit = the return on fund i in month t

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Rbp,t = the return on a benchmark portfolio in month t As we will show, Morningstar's alpha measures are, in effect, measures of mean selection returns.

Morningstar's Alpha Measures as a Mean Selection Returns from a Style Analysis To compute its measure of alpha, Morningstar performs a regression analysis to fit the following equation: ERit = ai + msBetai * ERindex,t + eit where: ERit = the excess return on fund i in month t ERindex,t = the excess return on the index in month t ai = the regression intercept msBetai = the regression slope coefficient eit = fund i's residual return in month i The alpha value for fund i is then computed as an annualized value of the regression interecept: 1 + msAlphai = ( 1 + ai ) 12 To show that ai is equal to a mean monthly selection return, we begin by substituting the components of the two excess returns in the regression equation: Rit -Bt = ai + msBetai * ( Rindex,t - Bt ) + eit where: Bt = the return on a Treasury bill in month t Rearranging and simplifying gives:
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Rit - [ ( 1 - msBetai ) * Bt + msBetai * Rindex,t ] = ai + eit The term in the brackets is the return on a portfolio with (1-msBetai) invested in Treasury bills and msBetai invested in the index. This can be considered a benchmark portfolio, thus: Rbp,t = b1 * Bt + b2 * Rindex,t where: b1 = 1 - msBetai b2 = msBetai Note that the proportions invested ( b1 and b2 ) sum to one, although one of the coefficients may be negative (representing a short position) and the other greater than one (representing investment of the initial amount plus the proceeds from the short sale). We can now interpret results from the regression equation as selection returns: SelRetit = Rit - Rbp,t = ai + eit Over a period of T months, the mean monthly selection return will be: MMnSelReti = ( 1 / T ) * sumt=1..T { SelRetit } Standard linear regression methods select parameters (here, ai and msBetai ) to minimize the variance of the residuals ( here, the variance of the eit terms). As a byproduct, the average value of the residuals ( eit's ) will be zero. Hence the mean difference between the return on the fund and that of the benchmark will equal ai. But this is the monthly mean selection return. Thus: MMnSelReti = ai Finally, note that the minimand in a standard regression analysis is the same as that in a standard style analysis. The only difference concerns the upper and lower bounds, which are not present in a regression analysis. This leads to the interpretation of Morningstar's procedure for calculating a fund's alpha value as equivalent to (1) determining the mean selection return obtained from a style analysis in which the assets are the index used for the asset class (for diversified equity funds, the S&P500) and Treasury bills, with upper and lower bounds set at sufficiently extreme values (e.g. plus 10 and minus 10 respectively)
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to be non-binding, then (2) annualizing the resulting value. Our measure of mean selection return uses a simple annualization: MnSelReti = 12 * MMSelReti MnSelReti = Annualized mean selection return This differs slightly from Morningstar's procedure, which assumes compounding. However, the magnitudes of monthly mean selection returns tend to be quite small -- hence any differences due solely to the choice of an annualization method will be slight.

Alternative Measures of Mean Selection Return We wish to analyze three measures of mean selection returns: msAlphai : Morningstar's Alpha msBFAlphai Morningstar's Best-Fit Alpha MnSelReti : Ten-asset Style Analysis Mean Selection Return Except for slight differences in annualization methods, all can be considered measures of mean selection return using benchmarks obtained from in-sample style analyses. The key differences concern the assets allowed in the analyses and the upper and lower bounds employed. For our group of diversified equity funds the alternatives are: Morningstar's Alpha: Assets: Treasury Bills Standard and Poor's 500 index Short sales allowed

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Morningstar's Best-Fit Alpha: Assets: Treasury Bills and one of: Lehman Brothers Long-term Treasury Index First Boston High-Yield Bond Index Standard and Poor's 500 Index Standard and Poor's MidCap 400 Index Russell 2000 Index Wilshire 4500 Index Morgan Stanley Capital International All Country Index MSCI Europe, Australia and South East Asia Index Morgan Stanley Capital International Europe Index Morgan Stanley Capital International Pacific Index Morgan Stanley Capital International Pacific ex Japan Index Morgan Stanley Capital International World ex U.S. Index JSE Gold Index Wilshire Real Estate Investment Trust Index Short sales allowed

Ten-asset Style Analysis Mean Selection Return Assets: Vanguard Money Market Reserves -Prime Portfolio Vanguard Bond Index Fund -- Shortterm Portfolio Vanguard Bond Index Fund -Intermediate-term Portfolio Vanguard Bond Index Fund -- Longterm Portfolio Vanguard Index -- Value Vanguard Index -- Growth Vanguard Index Extended Market Vanguard International Equity Index -- European

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Vanguard International Equity Index -- Pacific Vanguard International Equity Index -- Emerging Market No short sales allowed As described earlier, the Best-Fit Alpha is obtained by performing a series of two-asset style analyses, each involving Treasury Bills and one of the listed asset classes. From the results, the one with the best fit (lowest variance of eit values) is then selected. Having described the similarities among these three measures, we are now ready to examine their characteristics.

Morningstar Alpha Values The figure below shows the distribution of Morningstar Alpha values for the 1,268 funds in our threeyear sample for which the value was between -10% and +10% per year.

Morningstar Alphas, 1,268 funds, 1994-1996

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Morningstar's Performance Measures: Alphas and Selection Returns

The results are dramatic. For the full set of 1,286 funds the mean alpha value was -2.14% per year. Moreover, 77.0% of the funds had negative alpha values. While one expects the average active fund to underperform a suitably chosen passive benchmark, the magnitudes of these results suggest that the S&P500 was not an appropriate benchmark for many of these funds. The distribution of fund betas relative to the S&P500 is also of interest. It is shown below:

Morningstar Betas, 1,286 funds, 1994-1996

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Morningstar's Performance Measures: Alphas and Selection Returns

The average beta was 0.916. None was negative, but 335 of the funds had beta values greater than 1.0. In each such case, the benchmark portfolio required borrowing at the Treasury bill rate with investment of the proceeds as well as the initial amount in the S&P500 index. To the extent that actual borrowing would be more expensive, the net return on the benchmark would be smaller and the resultant alpha larger. For these funds, at least, the Morningstar alpha results may be biased downward relative to values that could reasonably be obtained in practice. Finally, there is the question of the extent to which diversified fund excess returns can be explained by their comovement with the S&P500. This is measured by the Morningstar R-squared. The distribution of the values for our three-year sample is shown below:

Morningstar R-squared values, 1,286 funds, 19941996

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Morningstar's Performance Measures: Alphas and Selection Returns

The average R-squared value was 68.0%. Thus movements in the S&P500 explained only 67.9% of the variation in monthly returns for the average diversified equity fund in this time period.

Morningstar Best-Fit Alpha Values While the S&P500 may not be the best benchmark for some funds, it may be better than a number of alternatives if only one index is to be used along with Treasury bills for the purpose. When selecting a best-fit benchmark for an equity fund, Morningstar evaluates 14 different indices. However, only four represent domestic equity securities, and these differ only in capitalization. Surprisingly, given its emphasis on value, growth and blend categories, Morningstar does not employ any value or growth indices for this analysis. Only six of the 14 indices were selected in the analysis. The table below shows the number of funds for which each of these was the best-fit index, the average R-squared value for such funds based on the S&P500 results, the average R-squared value based on the best-fit index, and the improvement in Rsquared associated with the use of the best-fit index instead of the S&P500. The bottom line provides summary values for all 1,286 funds in our sample.
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Morningstar's Performance Measures: Alphas and Selection Returns

Best-Fit Index Standard and Poor's 500 Index Wilshire 4500 Index Standard and Poor's MidCap 400 Index Russell 2000 Index Morgan Stanley Capital International All Country Index Lehman Brothers Long-term Treasury Index All

Number Avg R2 584 241 263 191 5 2 1,286 87.6 45.5 68.0 35.7 69.8 23.0 67.9

Avg Best-Fit R2 87.6 77.3 78.5 77.6 72.8 35.5 82.2

Improvement 0 31.8 10.5 41.9 3.0 12.5 14.4

As can be seen, the S&P500 Index was the best for only 45% of the funds (584 out of 1,286). For the vast majority of the remaining funds a smaller-capitalization U.S. stock index was the best of the allowed set. Improvements in fit were substantial, with the overall average R-squared increasing from 67.9% to 82.2%. The difference can be seen in the distribution of the Best-Fit R-squared values, which is shown below.

Morningstar R-squared values, 1,286 funds, 19941996

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Morningstar's Performance Measures: Alphas and Selection Returns

It should be remembered that all these results are in-sample and that no adjustments are made for lost degrees of freedom, hence it is not surprising that the R-squared values are greater for many of the funds. However, the magnitudes of the improvements are large enough that it seems highly improbable that they would be found to be insignificant in a more relevant out-of-sample test. We turn now to the best-fit alpha values. The figure below shows the distribution for the 1,268 funds in our three-year sample for which the value was between -10% and +10% per year.

Morningstar Best-Fit Alphas, 1,269 funds, 1994-1996

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Morningstar's Performance Measures: Alphas and Selection Returns

These results differ considerably from those based on comparisons with only the S&P500 Index. Here, the average alpha value is -0.58%, roughly consistent with the underperformance expected given fund expenses. Moreover, only 59.6% of the funds had negative best-fit alphas. This illustrates the dangers associated with use of inappropriate indices. The typical diversified equity fund has an average capitalization well below that of the S&P500 Index. By comparing the performance of every fund with that of this index one mixes results due to differences in style (here, capitalization) with those due to differences in selection. During the 1994-1996 period small stocks tended to underperform large stocks, so the average alpha against the S&P500 was very negative. In other periods the bias could be reversed. In either case, comparisons with more appropriate benchmarks could better measure the extent to which a manager had outperformed or underperformed a passive strategy invested in the same sector of the market. The Best-Fit alpha is clearly a step in the right direction. Finally, we show the distributions of Best-Fit Betas.

Morningstar Best-Fit Betas, 1,286 funds, 1994-1996

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Morningstar's Performance Measures: Alphas and Selection Returns

The average best-fit beta was 0.970. None was negative, but 425 of the funds had beta values greater than 1.0 and thus involved comparisons with benchmark portfolios requiring borrowing at the Treasury bill rate, with the resultant possibility that the computed value was biased downward.

Ten-Asset Styles and Mean Selection Returns We turn now to the results obtained using style analysis with the ten Vanguard funds as asset classes. Note that the assets used in this case are investable funds and that the returns are net of all recurring costs. This makes the comparisons more relevant (and also more favorable for the mutual funds) than those involving indices that may or may not be investable and returns that do not take into account any of the costs that could be incurred when investing passively in the associated sectors. The table below shows the average exposures to the assets for the 1,286 funds, based on returns from 1994 through 1996.

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Morningstar's Performance Measures: Alphas and Selection Returns

Asset Vanguard Money Market Reserves -- Prime Portfolio Vanguard Bond Index Fund -- Short-term Portfolio Vanguard Bond Index Fund -- Intermediate-term Portfolio Vanguard Bond Index Fund -- Long-term Portfolio Vanguard Index -- Value Vanguard Index -- Growth Vanguard Index Extended Market Vanguard International Equity Index -- European Vanguard International Equity Index -- Pacific Vanguard International Equity Index -- Emerging Market

Average Exposure (%) 4.1 1.6 1.4 1.0 20.4 20.0 46.1 1.7 1.5 2.1

Summarizing by major type of asset: Cash Bonds U.S. Stocks Non-U.S. Stocks 4.1 4.0 86.5 5.4

It is notable that the average "diversified U.S. equity fund" has an economic exposure to portions of the U.S. stock market equal only to that of 86.5 cents per dollar invested. From an economic standpoint, allocation to funds in this sector is likely to bring exposure to fixed income instruments and to stock markets outside the United States. The style results are consistent in a major respect to those obtained in the Best-Fit analysis. The average fund has more exposure to the stocks in the bottom 30% of the market (represented by the Wilshire 4500 index) than to those in the top half (represented by the S&P500 index). Due to the lack of index funds specializing in small-capitalization value or growth stocks, we are unable to determine whether or not the average small-capitalization fund has a growth or value tilt. However, the results suggest that at least in the large-capitalization sector, exposures are more or less evenly divided between value and growth emphases
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We turn now to the counterpart of the Morningstar alpha measures -- the mean selection returns for the funds. The figure below shows the distribution for the 1,267 funds for which the results were between 10% and +10% per year. . Ten-Asset Mean Selection Returns, 1,267 Funds, 1994-1996

In this case the results are more evenly distributed around zero. In fact, the average mean selection return for the full set of 1,286 funds is only -0.09% per year and only 53.6% of the funds have negative values. Such differences are due in no small measure to our use of actual index fund returns net of costs as surrogates for asset classes. Not surprisingly, the counterparts of R-squared values are high using this procedure.

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Morningstar's Performance Measures: Alphas and Selection Returns

1996

The average value was 83.2% -- slightly higher than that obtained in the best-fit analysis.Of course, these are in-sample values with no attempts made to correct for lost degrees of freedom. Since the sample properties of statistics obtained using inequalities or selection from among a set of separate regression results are not easily specified, questions concerning "true" fit are best left for out-of-sample studies in which benchmarks are chosen before-the-fact.

Go to Table of Contents for this paper

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Morningstar's Performance Measures: Comparisons

Morningstar's Performance Measures Peer-Group Comparisons

We now have a plethora of measures. Some are absolute, others relative. Some of the relative measures provide ranks within the set of all equity funds, others within a set of funds in a narrower equity category. In this section we take as given the use of the nine diversified equity categories. More specifically, we assume that an investor plans to allocate funds among these categories, then choose one or more funds from each category based on a single performance measure. Since such a procedure is almost certainly suboptimal we do not endorse it. However, this sort of hierarchic taxonomic approach explicitly or implicitly motivates the use of performance measures for ranking funds within investment categories. In this spirit we analyze the rankings of funds within categories based on five different measures:
q

Excess Return Sharpe Ratios Morningstar Category Risk-adjusted Ratings Morningstar Overall (Star) Risk-adjusted Ratings Style Analysis Selection Means Style Analysis Selection Sharpe Ratios

For each performance measure, a list of all 1,286 funds was then prepared, with each fund's percentile within its category listed. Then the lists were compared with one another to determine the correlations between the rankings based on different measures. The table below provides the resulting correlation coefficients: ERSR msCRAR msRAR MnSelRet SelSR

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Morningstar's Performance Measures: Comparisons

Excess Return Sharpe Ratio (ERSR) Category Riskadjusted rating (msCRAR) Star Riskadjusted Rating (msRAR) Selection Mean (MnSelRet)

1.000 0.986

0.945

0.831

0.744

0.986 1.000

0.957

0.829

0.735

0.945 0.957

1.000

0.790

0.694

0.831 0.829

0.790 0.694

1.000 0.940

0.940 1.000

Selection Sharpe 0.744 0.735 Ratio (SelSR)

Note that rankings based on selection means and selection Sharpe ratios were fairly similar (the correlation coefficient was 0.940). This provides at least some solace to those who wish to take selection risk into account, but not to the full extent associated with the selection Sharpe ratio. As seen in earlier comparisons, rankings within categories based on Excess Return Sharpe Ratios, Category Risk-adjusted Ratings and Overall (Star) Risk-adjusted Ratings were fairly similar, as shown by the correlation coefficients in the upper left hand (3x3) portion of the table, all of which are greater than 0.945. If one assumes that the best measure for ranking funds is either the selection mean or the selection Sharpe Ratio but wishes to use one of the two Morningstar rankings as a surrogate, the choice appears to be relatively clear. The Category Risk-adjusted Rating is more highly correlated with each of the stylebased measures than is the Overall (Star) Risk-adjusted Rating (0.829 versus 0.790 for the mean selection return and 0.735 versus 0.694 for the selection Sharpe ratio). However these correlations are far from perfect. The following figures provide more detailed comparisons of the rankings based on the Morningstar Category measures with (1) those based on Style analysis-based mean selection returns and (2) style analysis-based selection Sharpe ratios.

Category Rating versus Style analysis Mean Selection Return

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Category Rating versus Style analysis Selection Sharpe Ratio

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Morningstar's Performance Measures: Comparisons

As can be seen, limiting one's attention to, say, funds with Category ratings of 5 wouldl exclude a significant number of funds with large historic mean selection returns and/or selection Sharpe ratios. Moreover, the set of funds with Category ratings of 5 would include some funds with less-than-stellar historic mean selection returns and/or selection Sharpe ratios.

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Articles and Papers

Articles and Papers


Articles, Papers, Talks and Cases Available for Direct Viewing

"The Parable of the Money Managers," Reprinted with permission from The Financial Analysts Journal, July/August 1976. A somewhat whimsical discourse on active and passive management. Autobiography An autobiography prepared for the Nobel Foundation in 1990. More than you would want to know about my life to that point. "The Arithmetic of Active Management," Reprinted with permission from The Financial Analysts Journal, January/February 1991 A more serious treatment of active and passive management. Asset Allocation: Management Style and Performance Measurement. Reprinted with permission from The Journal of Portfolio Management, Winter 1992. Presents the method now generally known as Returns-based Style Analysis and shows results obtained from the analysis of U.S. mutual funds. The Sharpe Ratio. Reprinted with permission from The Journal of Portfolio Management, Fall 1994. Presents this measure of return per unit of risk and discusses its strengths and limitations. The Styles and Performance of Large Seasoned U.S. Mutual Funds Published on the World Wide Web, March 1995. A study of the style and performance of 100 large, seasoned U.S. mutual funds. Tests the hypothesis that "winners repeat". Setting the Record Straight on Style Analysis Reprinted with permission from Dow-Jones Fee Advisor, November/December 1995. An extensive interview with Barry Vinocur that deals with a number of questions about this technique.

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Articles and Papers

Financial Economists Roundtable Statment on Risk Disclosure by Mutual Funds A statement issued in 1996 concerning risk disclosure by mutual funds. Morningstar's Performance Measures An empirical study of Morningstar's performance measures and alternative measures used in academic and other industry analyses. Completed in December, 1997. Bob Boomer A case involving an individual who must decide how to use a 401(k) plan to save and invest for his retirement. Vanguard Interview An interview in the Summer 1997 issue of the publication In the Vanguard on basic issues of investing. Mutual Fund Performance Measures "Slides" from a presentation to the Institute for Quantitative Finance, October 7, 1997 Financial Planning in Fantasyland A paper about the deficiencies of some financial planning software. Completed in December, 1997. Morningstar's Risk-adusted Ratings (web version) A paper on the theoretical aspects of the measures that form the basis for Morningstar's "Star" ratings. Completed in January, 1998. Morningstar's Risk-adusted Ratings (published version) A link to a .pdf file of this paper, published in the July/August 1998 issue of the Financial Analysts Journal, pp. 21-33. Revisiting the Capital Asset Pricing Model Reprinted with permission from Dow Jones Asset Management, May/June 1998. An interview with Jonathan Burton that deals with a number of issues about the CAPM, factor models, and more. Investors Need Quality Low-Cost Advice: A Conversation with Financial Engines' William Sharpe An interview for the Mutual Fund Cafe' website with Virginia Munger Kahn on Financial Engines' approach to investment advice The Journal Interview An interview on performance measurement, from the Journal of Performance Measurement, Winter 1998/1999
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Articles and Papers

The Distribution Builder: A Tool for Inferring Investor Preferences A paper (with Daniel G. Goldstein and Philip W. Blyth) on a method for inferring an investor's preferences, September 2000

Selected Publications
Books
The Economics of Computers, The Columbia University Press (New York), 1969, 571 pages. Portfolio Theory and Capital Markets, McGraw-Hill Book Company (New York), 1970, 316 pages. Introduction to Managerial Economics, Columbia University Press, 1973. BASIC: An Introduction to Computer Programming Using the Basic Language, (Third Edition, with Nancy L. Jacob), The Free Press (New York), 1979. Asset Allocation Tools, (Second Edition), The Scientific Press, 1987, 139 pages. Investments (Fifth Edition,w ith Gordon J. Alexander and Jeffrey V. Bailey), Prentice-Hall, 1995. Fundamentals of Investments (Second Edition, with Gordon J. Alexander and Jeffrey V. Bailey), Prentice-Hall, 1993.

Articles
"A Simplified Model for Portfolio Analysis," Management Science, January 1963, pp. 277-293.

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Articles and Papers

"Capital Asset Prices - A Theory of Market Equilibrium Under Conditions of Risk," Journal of Finance, September 1964, pp. 425-442. "Risk-Aversion in the Stock Market - Some Empirical Evidence," Journal of Finance, September 1965, pp. 416-422. "Mutual Fund Performance," Journal of Business, January 1966, pp. 119-138. "A Linear Programming Algorithm for Mutual Fund Portfolio Selection," Management Science, March 1967, pp. 499-510. "Mean-Absolute Deviation Characteristic Lines for Securities and Portfolios," Management Science, October 1971, pp. B-1-B-13. "A Linear Programming Approximation for the General Portfolio Analysis Problem," Journal of Financial and Quantitative Analysis, December 1971, pp. 1263-1275. "Risk, Market Sensitivity and Diversification," Financial Analysts Journal, January/February 1972, pp. 74-79. "Risk-Return Classes of New York Stock Exchange Common Stocks, 1931-1967," (with Guy M. Cooper), Financial Analysts Journal, March/April 1972, pp. 46-54, 81, 95-101. "The Capital Asset Pricing Model: Traditional and 'Zero-Beta' Versions," Journal of the Midwest Finance Association, 1973, pp. 1-12. "Bonds Versus Stocks: Some Lessons From Capital Market Theory," Financial Analysts Journal, November/December 1973, pp. 74-80. "Imputing Expected Returns From Portfolio Composition," Journal of Financial and Quantitative Analysis, June 1974, pp. 463-472. "Adjusting for Risk in Portfolio Performance Measurement," Journal of Portfolio Management, Winter 1975. "Closed-end Investment Companies in the United States" (with Howard B. Sosin), European Finance Association, 1974 Proceedings (B. Jacquillat, Editor), North-Holland, 1975, pp. 37-63. "Likely Gains From Market Timing," Financial Analysts Journal, March/April 1975, pp. 60-69.

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Articles and Papers

"Risk, Return and Yield: New York Stock Exchange Common Stocks, 1928-1969" (with Howard B. Sosin), Financial Analysts Journal, March/April 1976, pp. 33-42. "Corporate Pension Funding Policy," Journal of Financial Economics, June 1976, pp. 183-193. "The Capital Asset Pricing Model: A 'Multi-Beta' Interpretation," Financial Decision Making Under Uncertainty, (Haim Levy and Marshall Sarnat, Editors), Academic Press (New York), 1977, pp. 127-136. "Bank Capital Adequacy, Deposit Insurance, and Security Values," Journal of Financial and Quantitative Analysis, November 1978, pp. 701-718. "Duration and Security Risk", (with Ronald Lanstein) Journal of Financial and Quantitative Analysis, November 1978, pp. 653668. "Decentralized Investment Management," Journal of Finance, May 1981, pp. 217-234. "Bank Capital Adequacy, Deposit Insurance, and Security Values Risk and Capital Adequacy in Commercial Banks, (Sherman J. Maisel, Editor), University of Chicago Press, 1981, pp. 187-202. "Some Factors in New York Stock Exchange Security Returns, 1931-1979," Journal of Portfolio Management, Summer 1982, pp. 5-19. "Optimal Funding and Asset Allocation Rules for Defined-Benefit Pension Plans", (with J. Michael Harrison), Financial Aspects of the United States Pension System , (Zvi Bodie and John B. Shoven, Editors), The University of Chicago Press (Chicago), 1983, pp. 91-105. "Factor models, CAPMs, and the APT," Journal of Portfolio Management, Fall 1984, pp. 21-25. "Practical Aspects of Portfolio Optimization," Improving the Investment Decision Process: Quantitative Assistance for the Practitioner and for the Firm, Dow-Jones Irwin (Homewood, Illinois), 1984, pp. 52-65. "Financial Implications of South African Divestment,", (with Blake R. Grossman)Financial Analysts Journal, July/August 1986, pp. 15-29. "An Algorithm for Portfolio Improvement," Advances in Mathematical Programming and Financial Planning, (K.D. Lawrence, J.B.
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Articles and Papers

Guerard, Jr., and Gary D. Reeves, Editors), JAI Press, Inc., 1987, pp. 155-170. "Integrated Asset Allocation," Financial Analysts Journal, September/October 1987, pp. 25-32. "Dynamic Strategies for Asset Allocation", (with Andre Perold), Financial Analysts Journal, January/February 1988, pp. 16-27. "Determining a Fund's Effective Asset Mix," Investment Management Review, November/December 1988, pp. 59-69. "Asset Allocation," Managing Investment Portfolios, A Dynamic Process, (John L. Maginn and Donald L. Tuttle, Editors), Warren, Gorham & Lamont, 1990, pp. 7-1 through 7-71. "Investor Wealth Measures and Expected Return," Quantifying the Market Risk Premium Phenomenon for Investment Decision Making, The Institute of Chartered Financial Analysts, 1990, pp. 29-37 . "Liabilities -- A New Approach," (with Lawrence G. Tint), Journal of Portfolio Management, Winter 1990, pp. 5-10. "Capital Asset Prices with and without Negative Holdings," Journal of Finance, June 1991, pp. 489-509. "Policy Asset Mix, Tactical Asset Allocation and Portfolio Insurance," Active Asset Allocation, State-of-the-Art Portfolio Policies, Strategies & Tactics, (Robert D. Arnott and Frank J. Fabozzi, Editors), Probus Publishing Company, 1992, pp. 115-133. "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. "International Value and Growth Stock Returns," (with Carlo Capaul and Ian Rowley) Financial Analyst's Journal, January/February 1993, pp. 2736. "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58. "Nuclear Financial Economics," Risk Management: Problems & Solutions, (William H. Beaver and George Parker, editors), McGraw-Hill, 1995, pp. 17-35.

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Articles and Papers

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Untitled Normal Page

The Parable of the Money Managers


William F. Sharpe

Reprinted with permission from The Financial Analysts' Journal Vol. 32, No. 4, July/August 1976. p. 4 Copyright 1976, Association for Investment Management and Research, Charlottesville, VA

Some years ago, in a land called Indicia, revolution led to the overthrow of a socialist regime and the restoration of a system of private property. Former government enterprises were reformed as corporations, which then issued stocks and bonds. These securities were given to a central agency, which offered them for sale to individuals, pension funds, and the like (all armed with newly printed money). Almost immediately a group of money managers came forth to assist these investors. Recalling the words of a venerated elder, uttered before the previous revolution ("Invest in Corporate Indicia"), they invited clients to give them money, with which they would buy a cross-section of all the newly issued securities. Investors considered this a reasonable idea, and soon everyone held a piece of Corporate lndicia. Before long the money managers became bored because there was little for them to do. Soon they fell into the habit of gathering at a beachfront casino where they passed the time playing roulette, craps, and similar games, for low stakes, with their own money. After a while, the owner of the casino suggested a new idea. He would furnish an impressive set of rooms which would be designated the Money Managers' Club. There the members could place bets with one another about the fortunes of various corporations, industries, the level of the Gross National Product, foreign trade, etc. To make the betting more exciting, the casino owner suggested that the managers use their clients' money for this purpose. The offer was immediately accepted, and soon the money managers were betting eagerly with one another. At the end of each week, some found that they had won money for their clients, while others found that they had lost. But the losses always exceeded the gains, for a certain amount was deducted from each bet to cover the costs of the elegant surroundings in which the gambling took place.

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Before long a group of professors from Indicia U. suggested that investors were not well served by the activities being conducted at the Money Managers' Club. "Why pay people to gamble with your money? Why not just hold your own piece of Corporate Indicia?" they said. This argument seemed sensible to some of the investors, and they raised the issue with their money managers. A few capitulated, announcing that they would henceforth stay away from the casino and use their clients' money only to buy proportionate shares of all the stocks and bonds issued by corporations. The converts, who became known as managers of Indicia funds, were initially shunned by those who continued to frequent the Money Managers' Club, but in time, grudging acceptance replaced outright hostility. The wave of puritan reform some had predicted failed to materialize, and gambling remained legal. Many managers continued to make their daily pilgrimage to the casino. But they exercised more restraint than before, placed smaller bets, and generally behaved in a manner consonant with their responsibilities. Even the members of the Lawyers' Club found it difficult to object to the small amount of gambling that still went on. And everyone but the casino owner lived happily ever after.

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active

The Arithmetic of Active Management


William F. Sharpe

Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9 Copyright, 1991, Association for Investment Management and Research Charlottesville, VA

"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?" "In small stocks, especially, you're probably better off with an active manager than buying the market." "The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets." "Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle." Statements such as these are made with alarming frequency by investment professionals1. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers. If "active" and "passive" management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
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active

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required. Of course, certain definitions of the key terms are necessary. First a market must be selected -- the stocks in the S&P 500, for example, or a set of "small" stocks. Then each investor who holds securities from the market must be classified as either active or passive.
q

A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 per cent of the value of the securities in the market, a passive investor's portfolio will have 3 per cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market2. An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently -- hence the term "active."

Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights3. Each passive manager will obtain precisely the market return, before costs4. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also. This proves assertion number 1. Note that only simple principles of arithmetic were used in the process. To be sure, we have seriously belabored the obvious, but the ubiquity of statements such as those quoted earlier suggests that such labor is not in vain. To prove assertion number 2, we need only rely on the fact that the costs of actively managing a given number of dollars will exceed those of passive management. Active managers must pay for more research and must pay more for trading. Security analysis (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders, specialists and other market-makers. Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

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active

This proves assertion number 2. Once again, the proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic. Enough (lower) mathematics. Let's turn to the practical issues. Why do sensible investment professionals continue to make statements that seemingly fly in the face of the simple and obvious relations we have described? How can presented evidence show active managers beating "the market" or "the index" or "passive managers"? Three reasons stand out5.
q

First, the passive managers in question may not be truly passive (i.e., conform to our definition of the term). Some index fund managers "sample" the market of choice, rather than hold all the securities in market proportions. Some may even charge high enough fees to bring their total costs to equal or exceed those of active managers. Second, active managers may not fully represent the "non-passive" component of the market in question. For example, the set of active managers may exclude some active holders of securities within the market (e.g., individual investors). Many empirical analyses consider only "professional" or "institutional" active managers. It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after costs, For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance. Another example arises when the active managers hold securities from outside the market in question. For example, returns on equity mutual funds with cash holdings are often compared with returns on an all-equity index or index fund. In such comparisons, the funds are generally beaten badly by the index in up markets, but sometimes exceed index performance in down markets. Yet another example arises when the set of active mangers excludes those who have gone out of business during the period in question. Because such managers are likely to have experienced especially poor returns, the resulting "survivorship bias" will tend to produce results that are better than those obtained by the average actively managed dollar. Third, and possibly most important in practice, the summary statistics for active managers may not truly represent the performance of the average actively managed dollar. To compute the latter, each manager's return should be weighted by the dollars he or she has under management at the beginning of the period. Some comparisons use a simple average of the performance of all managers (large and small); others use the performance of the median active manager. While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities persist. Perhaps most important, equity fund managers with smaller amounts of money tend to favor stocks with smaller outstanding values. Thus, de facto, an equally weighted average of active manager returns has a bias toward smaller-capitalization stocks vis-a-vis the market as a whole. As a result, the "average active manager" tends to be beaten badly in periods when smallcapitalization stocks underperform large-capitalization stocks, but may exceed the market's

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performance in periods when small-capitalization stocks do well. In both cases, of course, the average actively managed dollar will underperform the market, net of costs. To repeat: Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement. This need not be taken as a counsel of despair. It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds. An important corollary is the importance of appropriate performance measurement. "Peer group" comparisons are dangerous. Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases. Moreover, investing equal amounts with many managers is not a practical alternative. Nor, a fortiori, is investing with the median" manager (whose identity is not even known in advance). The best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative. The latter -- often termed a "benchmark" or "normal portfolio" -- should be a feasible alternative identified in advance of the period over which performance is measured. Only when this type of measurement is in place can an active manager (or one who hires active managers) know whether he or she is in the minority of those who have beaten viable passive alternatives.

Footnotes
1. The first two quotations can be found in the September 3, 1990 issue of Forbes. 2. When computing such amounts, "cross-holdings" within the market should be netted out. 3. Events such as mergers, new listings and reinvestment of dividends that take place during the period require more complex calculations but do not affect the basic principles stated here. To keep things simple, we ignore them.

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4. We assume here that passive managers purchase their securities before the beginning of the period in question and do not sell them until after the period ends. When passive managers do buy or sell, they may have to trade with active managers, because of the active managers' willingness to provide desired liquidity (at a price). 5. There are others, such as differential treatment of dividend reinvestment, mergers and acquisitions, but they are typically of less importance.

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The Styles and Performance of Large Seasoned U.S. Mutual Funds, 1985-1994

The Styles and Performance of Large Seasoned U.S. Mutual Funds, 1985-1994
William F. Sharpe March, 1995
The following material provides the results of a number of analyses of the performance of an important subset of U.S. mutual funds, termed the LS100 funds. Each year, 100 large, seasoned U.S. funds are chosen from among those categorized as bond funds, stock funds, balanced funds, global and international funds. To be included in a given year, a fund must have been in existence for at least five prior years. From among all such funds, the 100 largest are selected each year. The LS100 funds invest a large proportion of the money available to funds in their categories. Moreover, they tend to have lower expenses and better prior performance than the remainder of such funds. Hence their styles and performance are of considerable interest. The following sections provide details concerning the ways in which the analyses were performed as well as their results. They are meant to be read in the order shown.
q

The LS100: Large, Seasoned U.S. Mutual Funds Details concerning the selection criteria and characteristics of the resulting sets. Computing the Styles of the LS100 Funds Details on the use of Style Analysis to estimate the style of each fund. Styles of the 1994 LS100 Funds Graphs of the style of each of the funds in the 1994 LS100. The Performance of the LS100 Index from 1985 through 1994 Overall performance of the LS100 funds compared with that of passive investments with the same styles. The Performance of Subsets of the LS100 Funds from 1985 through 1994 The performance of portfolios utilizing subsets of the LS100 funds. Presumptive evidence on the important question: do winners repeat?

Data Source Micropal, Inc. For more information, please call 617-451-1585

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The Styles and Performance of Large Seasoned U.S. Mutual Funds, 1985-1994

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The LS100 Funds

The LS100: Large, Seasoned U.S. Mutual Funds

The LS100 Funds


This section provides information on the procedures used to select sets of large, seasoned U.S. mutual funds over the period from 1985 through 1994. All fund information was taken from an extensive historical database provided by Micropal, an international firm based in the U.K. that maintains a comprehensive database of collective investments throughout the world. The data utilized for this study include virtually all U.S. mutual (open-end) funds available for purchase by the general public during the period from 1980 through 1994. Of particular importance: both "dead" and "alive" funds are included in the database. For example, a fund that was merged into another in 1987 and thus "disappeared" at that time is included for all months prior to the merger, although it does not exist (in its initial form) today. This characteristic of the database makes it possible to avoid survivor bias, which plagues many studies of fund performance. A surprising number of funds disappear each year (approximately 3% by some estimates), and such funds are typically those with poor performance. Hence measurement of the historic performance of samples of funds that have existed unchanged for several years will inevitably give results subject to an upward bias. Simply put, the average performance of funds that survive is almost certainly greater than that of all funds -- those that survive and those that do not. This study is not subject to this error. Initially, the database was filtered to remove all funds classified by Micropal as falling into the following categories: money market funds, funds specializing in tax-favored securities (e.g. municipal bond funds), funds specializing in securities of specific industries (e.g. natural resource funds, utility funds), and funds specializing in the use of options. The remaining Micropal categories are:
q q q q q q q q q

AG: Aggressive Growth BL: Balanced BQ: Bond - quality BY: Bond - high yield GB: Global bond GE: Global equity GI: Growth and income GM: Government - mortgages GS: Government - securities

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The LS100 Funds


q q q q

IE: International equity IN: Income LG: Long-term growth TR: Total Return

From the remaining database, 100 funds were selected for inclusion in each of the ten years. Consider, for example, the funds chosen for the calendar year 1986. The selection process utilized data available in December, 1985 and could, in fact, have been performed during that month. First, the availability of historic returns was checked. Only funds with at least 60 months of such returns were retained. In this case, returns from December, 1980 through November, 1985 (inclusive) were required. We define funds meeting this criterion as being seasoned at the time. The seasoned funds obtained in this manner were ranked, based on total net assets as of the end of November, 1985. The 100 largest funds were then selected to form the "LS100" set of funds for 1986. This process was utilized for every year from 1985 through 1995, with one minor exception. For the set of funds used in 1985, only 59 monthly returns were required, since only returns from January 1980 onward were used in the study.

Changes in the Sets of the LS100 Funds


Since each set of LS100 funds was chosen independently, there were some changes in composition from year to year. On average, less than 14 of the 100 funds were replaced in the set from one year to the next. Not surprisingly, the funds that changed tended to be smaller than those that did not. On average, the value of new funds added in a year was 9.5% percent of the total value of all funds in the set. While the LS100 funds are only a subset of the funds in the included categories (e.g. bond, stock, balanced, global and international), they represent a substantial portion of the dollars invested in such funds. The figure below shows the total number of such funds at each year-end. Due to the rapid increase in the number of U.S. mutual funds, our 100 funds represent a diminishing percentage of the total.

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The LS100 Funds

At year-end 1994, the LS100 funds represented less than 3% percent of the total number of bond, stock, balanced and international U.S. mutual funds. However, approximately 44% percent of the dollars invested in such funds were invested in these 100 funds. The figure below shows the ratio of total net assets of each year's LS100 funds to that of all funds in these categories.

Differences between the LS100 and Other Funds


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The LS100 Funds

Since the LS100 funds invest a significant proportion of the money in their sector of the U.S. mutual fund industry, their aggregate performance is of considerable interest. This is not to say that their performance is necessarily representative of that of the remainder of the industry. The LS100 funds are clearly larger than the remaining funds. Among other things, this suggests that their expenses will be smaller, when expressed as a percentage of the assets under management. If performance before expenses is unrelated to size, then one would expect that the average performance net of expenses of the LS100 funds would be better than that of the remaining funds. It is important to note that the funds selected for inclusion in the LS100 set in a given year are likely to have had better performance in prior years than those not selected, since investors tend to invest new assets in funds with better historic performance. If there is any tendency for performance to be consistent through time, this would suggest that the aggregate performance of the LS100 funds might be better than that of the remaining funds. In sum, the performance of the LS100 is likely to be at least as good as that of the remaining funds, and may well be superior. If the latter were the case, such funds would be of particular interest, since an astute investor could identify (and invest in) such funds each year. For all these reasons, the aggregate performance of the LS100 should be of substantial interest.

The LS100 Fund Index


To measure the performance of the average dollar invested in large, seasoned U.S. mutual funds, we utilize a value-weighted index of the LS100 funds. More specifically, we assume that at the end of each December, a portfolio of all 100 funds selected at the time is formed, with the dollars invested in proportion to the funds' total net assets at the end of the prior month (November). The resulting shares of each fund are held throughout the subsequent year. Whenever a fund provides a dividend or capital gains distribution, the money is reinvested in the fund in question. In effect, a truly buy-and-hold strategy is followed throughout each year. At the end of the year some rebalancing is required, but only to accommodate changes in the funds included in the LS100. The total value of a given LS100 portfolio is computed at the end of each month from the prior December through the December of the year in question. The percentage change in this value for any given month constitutes the total return for the LS100 Index in that month. This process is repeated for each year. The resulting set of monthly returns from January 1985 through December 1994 constitutes the set of returns for the LS100 fund index over the total period. The same procedure is utilized for subsets of the LS100 -- each such portfolio is formed at the end of each December, using relative net asset values as of the end of November, with each position held through the following year, with the changes in the value of the total portfolio used as measures of performance. Data Source Micropal, Inc. For more information, please call 617-451-1585

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The LS100 Funds

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Computing the LS100 Styles

Computing the Styles of the LS100 Funds

Style and Selection


Ultimately, a mutual fund provides returns for its investors. The return for a mutual fund is, of course, determined by its investments and the return on each of those investments. However, a relatively limited number of factors will greatly influence the return on a typical fund. Analysts find it useful to identify a key number of important factors, then attribute some of the return on a fund to the joint effect of its exposures to those factors and the performance of the factors. The remaining portion of the fund's return is attributed to the choice of specific securities as vehicles for obtaining the particular set of factor exposures. We follow this general approach, using the returns on broad indices of particular types of securities as factors. Each such index represents a specific asset class. A fund's exposures to such asset classes constitutes its style. The proportion of a fund's return not due to style is termed its selection return.

Asset Classes
We use 15 asset classes for our analyses. The following list provides a description of each asset class and the index used to represent its returns.
q

U.S. Dollars Salomon Brothers' 1 to 3 month Treasury Bills Japanese Yen Based on the difference between the currency-hedged FTA Japanese Stock Index and the FTA Japanese Stock Index (unhedged) European and Asian Deposits Based on the difference between the currency-hedged FTA Europac ex-Japan Stock Index and the FTA Europac ex-Japan Stock Index (unhedged) U.S. Government Intermediate-term Bonds Lehman Brothers' Intermediate Government Bonds U.S. Government Long-term Bonds Lehman Brothers' Long-term Government Bonds

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Computing the LS100 Styles


q

U.S. Corporate Bonds Lehman Brothers' Corporate Bonds U.S. Mortgage-related Securities Lehman Brothers' Mortgage-related Securities U.S. Large-capitalization Value Stocks S&P/BARRA Value Stock Index U.S. Large-capitalization Growth Stocks S&P/BARRA Growth Stock Index U.S. Medium-capitalization Value Stocks Sharpe/BARRA Medium Value Stock Index U.S. Medium-capitalization Growth Stocks Sharpe/BARRA Medium Growth Stock Index U.S. Small-capitalization Stocks Sharpe/BARRA Small Stock Index Non-U.S. Government Bonds Salomon Brothers' Non-U.S. Government Bond Index European and Asian Stocks FTA Europac ex-Japan Stock Index Japanese Stocks FTA Japanese Stock Index

These returns are expressed in U.S. Dollars. The returns on Japanese Yen and European/Asian deposits are estimated from the returns obtained from futures markets in currencies. Investing in a one-month U.S. treasury bill and agreeing to trade the proceeds for Yen at the end of the month (by "selling yen futures") is similar economically to converting U.S. dollars to Yen today, then investing the proceeds in a onemonth Yen deposit account. In each case, the ultimate return in U.S. Dollars will depend on the rate at which Yen can be exchanged for Dollars at the end of the month. Since the FTA currency-hedged indices incorporate the results obtained from positions in currency futures, we utilize the difference between their returns and those of the unhedged indices to "back out" the effects of the futures positions, then incorporate the return on U.S. deposits to estimate returns on the two non-U.S. deposit asset classes.

Style Analysis
To estimate the exposures of a fund to a set of selected asset classes, we utilize the procedure known as style analysis (sometimes termed "returns-based style analysis"). For details, see:
q

William F. Sharpe, "Determining a Fund's Effective Asset Mix," Investment Management Review, November/December 1988, pp. 59-69. William F. Sharpe, "Asset allocation: Management Style and Performance Measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19.

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Computing the LS100 Styles

The monthly returns on a fund over a period of time are lined up with those on the selected asset classes, then a computer is asked to find a mixture of the asset classes that "moved most" with the fund. More specifically, let x represent a specific portfolio made up solely of investments in the asset classes. Let Rx[t] be the return on this portfolio in month t and Rf[t] be the return on the fund in month t. Define e[t] = Rf[t]-Rx[t] as the tracking error of the fund relative to asset mix (portfolio) Rx[t] in month t. Finally, let V(e[t]) be the variance of e[t] over a chosen historic period. The goal of style analysis is to select from all allowed asset mixes (x's) the one that would have provided the minimum tracking variance . V(e[t]). In practice we modify this general approach somewhat to place more emphasis on recent months than on more distant months. In particular, we seek to minimize the weighted tracking variance, with each month assigned a weight equal to 2^(1/60) times the weight assigned the prior month. In effect, each month receives slightly over 1% more weight than its predecessor. This procedure can be characterized as using a "60-month half-life", since a half the weight is assigned to month t-60 as is assigned to month t. If no constraints were imposed on asset holdings, problems of this type could be solved using standard techniques of regression analysis. However, in this context, such an approach typically gives ineffective (and sometimes bizarre) results. By adding constraints reflecting minimal information about the investments the fund actually makes, one can usually obtain greatly improved results. Since such constraints typically include inequalities, quadratic programming methods must be utilized. Fortunately, software that can solve problems of this type is relatively widely available.

Using Excess Returns


Were it not for the use of non-US asset classes, we might follow the approach described in the papers referenced above, which employed the following constraints:
q q q

Each asset exposure greater than or equal to zero Each asset exposure less than or equal to 1 The sum of the asset exposures equal to 1

However, this would not make it possible to represent partial or complete hedging of the currency risk associated with non-US security positions. To do so in a parsimonious manner, we transform the problem to one involving (1) exposure to currencies (deposits) and (2) non-deposit, risky assets. Each of our first three asset classes represents investment in a form that is relatively risk-free in its own currency (although the latter two are risky in terms of dollar returns). We retain these three classes in their original form and require that the quadratic program select exposures to them that sum to 1 and that each exposure lie between zero and one, inclusive. In a sense, the decision to invest in the currency of a foreign country involves acceptance of the risk of that country.

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Computing the LS100 Styles

To reflect the decision to take risk within a country, we utilize excess returns for each of the remaining asset classes. In the case of U.S. securities, this involves subtracting each month's Treasury Bill return from the return on the asset class in question. In the case of Japanese Stocks, it involves subtracting the return on Yen deposits from the return on the index of stocks. For European/Asian stocks, we subtract the return on European/Asian deposits. Finally, the excess return on Non-US Government bonds is estimated by subtracting from the return on the original index a 50/50 blend of Japanese and European/Asian deposits. An excess return can be considered the return obtained by borrowing money in the relevant country and investing the proceeds in the risky securities under consideration. In principle it takes no investment, per se. We sometimes term such an approach a zero-investment strategy. A very similar result could be obtained by taking positions in index futures contracts. In the latter case another investment may have to be "posted as margin" to guarantee performance if the investor must make a net payment to the counterparty in question. While in principle a fund could take exposures in risky securities that sum to more than 1.0, this is relatively rare. We thus require that the sum of such exposures be less than or equal to 1.0. We also rule out short positions in any risky asset class.

Summarizing the Results


Although the formal style analysis is performed using deposits (including US dollars) and zeroinvestment strategies, the results can easily be transformed to exposures stated in more conventional terms. The exposure to each risky asset class is the same as the exposure to its excess return. The net exposure to a deposit equals that found in the initial analyses less the sum of the amounts of the deposit in question associated with the zero-investment strategies. We use the following measures to summarize the estimated style of a fund:
q

Currency exposures exposures to the US Dollar and other currencies Exposures to risky securities exposures to the risks associated with securities

The information on the style of each of the individual funds is presented in this form. The style of a portfolio of funds is computed by weighting the styles of the component funds by their relative values. Data Source Micropal, Inc. For more information, please call 617-451-1585

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Computing the LS100 Styles

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Styles of the 1994 LS100 Funds

Styles of the 1994 LS100 Funds


Contents:
q q q

Introduction An Example of the Results View the Fund Styles (requires Netscape 3.0 or above).

Introduction
To illustrate the types of results obtained with Style Analysis, this section provides information about the styles of each of the LS100 funds chosen at the end of 1993 for inclusion in the set used for investment analysis in 1994. Details of the computations are provided in the section titled Computing the Styles of the LS100 Funds.

An Example of the Results


To illustrate the method, we show the results for Merrill Lynch's Capital /A Fund. Each of the five sections of the report is shown below, with a brief description.

Merrill Capital /A
Active Management (Selection Variance / Fund Variance)
q

5%

This section gives the name of the fund and a key summary measure. The Active Management (Selection Variance / Fund Variance) indicates the ratio of the variance of the selection return to that of the fund as a whole over the prior 36 months (in this case, from December 1990 through November 1993, inclusive). The selection return in each month is the difference between the return on the fund and that of its most recently-computed style, based on all available returns up to two month's earlier (for example, the style used to compute the selection return for November 1993 used returns through and including September 1993). The larger is the ratio of selection variance to total fund variance, the more active is the fund. A

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Styles of the 1994 LS100 Funds

large value indicates relatively little diversification within asset classes, frequent rotation among asset classes, or both. In this case, only 5% of the fund's variance in returns from month to month was attributed to selection, indicating a relatively passive investment approach.

Currency Exposures
93% US Dollar 7% Other |============================================== |=== |__________________________________________________ 10 20 30 40 50 60 70 80 90 100

The US Dollar Exposure indicates the proportion of the fund that is not exposed to movements in the exchange rates of other currencies vis-a-vis the US Dollar. In this case it is 93%. The exposures to movements in other currencies is thus 7%. As will be seen, the latter is slightly greater than the exposures of the fund to Non-US Security classes, suggesting lack of currency hedging of such positions and possibly small positions in foreign short-term fixed income instruments. When a fund chooses to hedge some or all of its foreign currency, the percentage shown for exposures to other currencies will generally be smaller than that shown for exposures to Non-US Securities Classes.

Asset Group Exposures


15% 12% 68% 5% Deposits US Bonds US Stocks Non-US |======= |====== |================================== |== |__________________________________________________ 10 20 30 40 50 60 70 80 90 100

This bar chart shows the exposures to the major types of securities included in the Style Analysis. Each is determined by summing the exposures to the specific asset classes in each group. It is important to remember two things about all the results obtained from a Style Analysis. First, the exposures are based solely on the comovements of the fund's returns with those of the asset classes. Hence they reflect the behavior of the fund, and may not necessarily equal the proportions invested in various asset classes as conventionally defined. The goal is to estimate the economics of the fund as best one can with limited data. To put it colloquially: if it walks like a duck and talks like a

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Styles of the 1994 LS100 Funds

duck, for all important purposes, it is a duck. The second point is equally important. At the very best, Style Analysis can indicate a fund's exposures over a past period. In our analyses we weight the more recent past more heavily than the more distant past, but of necessity, the procedure cannot reflect the precise exposures of the fund in the most recent week or month (unless they just happen to coincide with the longer-term average). The key question that must be answered when considering this fact concerns the purpose for which the analysis is performed. If the estimated style is to be used to select funds to be held for a reasonably long period of time (e.g. from one to five years), it may well be that past average style is a better predictor of future average style than is the particular style that the fund utilized a day or week ago. In any event, Style Analysis can only provide an estimate of a fund's (possibly weighted) average style over a period of many months. In this case, the analysis indicates that the fund's returns acted as if the fund had invested a majority of its assets in US Stocks, with a small exposure to Non-US Securities and the remainder invested in US Bonds and Deposits. Since the Non-US Dollar Exposure was slightly larger than the Non-US Securities exposure, some of Deposits may have been held abroad, but the majority were probably held in the US. While the fund acted as if it had invested in US Bonds and US Deposits, this could reflect a strategy of holding bonds of shorter maturity than those in the US Bond asset classes used for the Style Analysis. Similarly, some of the Deposit Exposure could have reflected investment in more defensive ("low-beta") US Stocks than those included in the US Stock indices. As always, it is important to remember the Duck Theorem.

US Bond Exposures ( 12% of fund)


67% 33% 0% 0% Int Govt Long Govt Corporate Mortgage |================================= |================ | | |__________________________________________________ 10 20 30 40 50 60 70 80 90 100

This chart breaks down the exposure shown in the initial chart into the portions attributed to each of the four US Bond classes. In this case the fund returns acted as if roughly 2/3 of the bond portfolio (representing 12% of the overall fund) was invested in Intermediate US Government Bonds, with the remaining 1/3 in Long-term US Government Bonds. The corresponding portions of the overall portfolio would thus be 8% and 4%.

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Styles of the 1994 LS100 Funds

US Stock Exposures ( 68% of fund)


49% 23% 8% 6% 14% Lrg Value Lrg Growth Med Value Med Growth Small |======================== |=========== |==== |=== |======= |__________________________________________________ 10 20 30 40 50 60 70 80 90 100

In this chart the overall exposure to US Stocks (68% of the fund) is broken into five components, each reflecting one of the included US Stock Asset Classes. The fund acted as if it had held a stock portfolio diversified across all five classes, with 72% in large capitalization stocks. Within the large capitalization area, the fund also appears to have had a preference for Value (low price/book) stocks.

Non-US Security Exposures ( 5% of fund)


0% Bonds 23% Japan Stk 77% Other Stk | |=========== |====================================== |__________________________________________________ 10 20 30 40 50 60 70 80 90 100

The final chart breaks out the fund's overall exposure of 5% to Non-US Securities. In this case the relatively small exposure appears to have been restricted to stocks rather than bonds. Among Non-US holdings, Japanese Stock exposure was smaller than that in Europe and Asia outside of Japan..

Funds
To view the funds you must use the Netscape 3.0 browser (or above). If you have the required browser, you may proceed to the mutual fund page. You may then select any desired fund by clicking in the radio button alongside its name. When you are finished, click the BACK arrow on your browser twice to return to this page. Data Source Micropal, Inc. For more information, please call 617-451-1585

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Styles of the 1994 LS100 Funds

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Performance of the LS100 Funds

Performance of the LS100 Funds: 1985 through 1994

The LS100 Total Returns


Throughout, we utilize the monthly total returns computed by Micropal. Each such return takes into account changes in net asset values and any distributions (dividends, capital gains, etc.). Each is net of any expenses charged to the fund and, of course, all transactions costs. However, load charges -- selling costs not charged to the fund but paid directly by the investor -- are not taken into account. Some of the LS100 funds levy such charges on at least some investors; the amount charged depends on the size of the investment. It also may be waived if investment is made through an intermediary or for certain types of savings plans (e.g. Individual Retirement Accounts). In some cases a fund will offer two or more classes of shares. For example, the A shares may require a "front-end" load charge, while the B shares pay a continuing amount from the fund to compensate sales staffs. For the former, sales costs are not taken into account when total returns are computed; for the latter they are. In terms of total returns, (so computed) the decade from January 1985 through December 1994 was a good one for the LS100 funds and their investors. The average annual return during the period was 11.95%. However, there was considerable variation from year to year. The standard deviation of annual returns was 9.69%. The figure below shows the total returns for each year.

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Performance of the LS100 Funds

The LS100 Excess Returns


While total returns represent money that can, eventually, be "taken to the bank", it is also important to compare such returns with those that could have been earned by putting money in a bank. We represent the latter by the return on 1 to 3 month U.S. Treasury Bills. The difference between the return on the LS100 funds and that on a strategy of investing in such Bills is termed the excess return on the LS100. It averaged 5.84% over the decade, with a standard deviation of 9.33%. While the latter was broadly typical of the variation in returns for bond/stock mixes similar to those of the LS100, the former was higher than usual. The year-by-year excess returns are shown below.

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Performance of the LS100 Funds

The LS100 Style Mix


While the LS100 funds now control less than half of the assets invested in bond, stock and international U.S. mutual funds, they still represent a significant portion of the market: 44% at the end of 1994. To compute the style of the index as a whole, we value-weight the styles of the individual funds. The figures below show the composite style for 1994, based on returns through November 1993 and net asset values at the end of November 1993.

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Performance of the LS100 Funds

Not surprisingly, the aggregate of all 100 funds provided significant exposures to all of the asset classes. The NonUS dollar exposure was approximately 5% -- somewhat smaller than the exposure to Non-US Securities, suggesting a modest amount of currency hedging. Among these funds there appears to be a preference for value (low price/book) among large-capitalization stocks but for growth (low price/book) among medium-capitalization stocks.

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Performance of the LS100 Funds

The Importance of Style


The managers of most of the LS100 funds can be considered active: they attempt to select securities that will, over time, "beat the market", or "do better than average", given their type. To give meaning to such aspects, of course, one has to define the relevant market for each fund. Equivalently, one has to specify the "types" of securities in which each fund invests. For this purpose we use the Style Analysis method described in W.F. Sharpe, "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19, with some variations. The style of a fund, determined in December of the prior year is taken as a benchmark against which the fund's performance is to be compared. In effect, a style mix portfolio is formed for each fund at the end of December of each year, and the performance of the mix computed, month by month during the following year. In doing so, it is assumed that the returns on the component asset classes can be obtained without cost. In effect, we assume the use of index funds that track their indices perfectly and do so for no charge. Clearly, this is unreasonable. A typical expense ratio for a large no-load index fund is approximately 0.20% ("20 basis points") per year. Hence as a practical matter, even an efficient index fund is likely to underperform its style benchmark by this amount. To assess the performance of the LS100 as a whole, we form a aggregate style mix at the end of each year, using the relative values of the underlying funds and their individual style mixes as components. We then compute the performance of this mix over the subsequent year. For example, the style mix return for each month of 1994 was determined by computing the total return on a mix that had the composition shown in the previous section at the end of December 1993. Due to market movements among the asset classes, the composition by value of this "buyand-hold" style mix changed from month to month during the year. The mix also changed in each of the prior Decembers, based on the results of the annual style analyses. How different were the performances of the LS100 funds and the style mixes designed to represent a similar set of passive investments? The figure below tells the story. Each point represents one month in the decade. The horizontal axis indicates the return on the aggregate style mix, while the vertical axis shows the overall return on the LS100 funds.

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Performance of the LS100 Funds

The similarities are striking. At this level, at least, our estimates of funds' asset allocations account for the vast majority of the variations in return from month to month. This shows both that asset allocation is of great importance and that our procedures provide good estimates of funds' actual asset allocations. The next figure shows total returns for each of the ten years for both the LS100 fund mix and the aggregate style mix. As can be seen, the latter outperformed the former in eight of the ten years.

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Performance of the LS100 Funds

Selection Returns
We define a fund's selection return as the difference between its return and that of its style. For the LS100 funds as a whole, the selection return can be computed by subtracting the return on the aggregate style mix from that on the mix of the funds. The figure below shows the results of doing so.

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Performance of the LS100 Funds

The average difference between the returns on the LS100 funds and those of a strategy with a similar style was 0.64% per year. The standard deviation of the difference was 1.28% per year. The average underperformance was somewhat greater than that likely to be achieved with a truly passive strategy (e.g. -0.20%). However, given the variation in the differences, the average cannot be said to be statistically significantly different from either -0.20% or zero. However, the data provide little support for those who believe that the performance of a typical activelymanaged fund is likely to beat a passive alternative (i.e. index fund) with the same style. The ratio of the variance of the aggregate selection return to that of the LS100 fund mix gives an indication of the importance of the effects of active management on a strategy involving diversification across many funds. It was 1.75%. Thus active management added relatively little risk at the aggregate level. However, for a more typical portfolio concentrated in a relatively few funds, the impact of active management on risk would have been considerably greater. For a portfolio invested in only one fund it would have been greater yet: the average ratio of selection variance to fund variance for a single fund was 20.6% over the three-year period from 1991 through 1993. These results suggest that active management is likely to account for approximately 20% of the risk of a typical large seasoned fund. For portfolios that include between more than one but fewer than 100 funds, the risk associated with active management is likely to account for from 20% to 2% of total risk, with the actual amount closer to the latter, the greater the diversification across funds. Data Source Micropal, Inc. For more information, please call 617-451-1585

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Performance of the LS100 Funds

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LS100 Subsets

The Performance of Subsets of the LS100 Funds, 1985-1994

Introduction
In this section we report the results of experiments that test various procedures for selecting potential future winners from among each year's LS100 funds. In no small measure, this is an exercise in data mining -- one of the more serious sins in empirical investigation. Not surprisingly, if enough procedures are tested, one can invariably find some that would have "worked" in at least some periods. But this hardly guarantees that they will work in the future. Studies of this sort are subject to a potentially huge selection bias. Despite these caveats, our findings are of some interest. To allow the reader to fully evaluate them, we summarize the results for all the methods that were tested. However, even this can provide a deceptive view, since the methods analyzed were chosen, to at least an extent, because they were similar to procedures that others had proposed, based on analyses of data from some of the years that we utilize. As with any empirical study of this type, the reader is advised to proceed at his or her own peril.

Performance Measurement
A passive manager provides investors with style. An active manager provides both style and selection. Since we are interested in the possibility of selecting active managers who will be successful in the future, we focus on selection returns. Initially, we concentrate on the ability of a group of funds to produce superior average selection returns. Later we analyze the abilities of various groups to produce selection returns with desirable mean/standard deviation ratios, often termed Sharpe Ratios (for a discussion of the latter, see William F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58.). In each case we utilize monthly selection returns. Each experiment begins by choosing a selection criterion, implemented using data available in December of each year. The LS100 funds to be used in the following year are ranked on the basis of this "selector", then grouped into four portfolios, each with 25 funds. Within each of the resulting four quartile portfolios, funds are weighted in accordance with their net asset values at the end of November. The performance of each such portfolio is calculated over each of the next twelve months, with each fund position held throughout the year. The entire process is repeated each year. For each strategy we compute our two performance measures (average selection return and selection return
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LS100 Subsets

Sharpe Ratio) for (1) the 120 months in the entire period from January 1985 through December 1994 and (2) the 60 months from January 1990 through December 1994. We refer to these as the "10 Year" and "5 Year" periods, respectively.

The Performance of the LS100


The performance of the aggregate index of all the LS100 funds is shown below. 10 Yrs -------.04 -.17 5 Yrs -------.01 -.04

Mean Sharpe Ratio

All results are based on monthly returns, expressed in percentage terms. Thus the average selection return for the LS100 over the 10 year period was -.04, or -.04% (4 basis points) per month, approximately equal to 0.48% per year. Overall, the funds offered performance that was better (less b ad) in the last 5 years than it was in the last 10 years. In the last 5 years the average performance was approximately -.01% per month, somewhat better than that associated with a typical index fund, which is closer to -.02% per month (-.20% per year).

Size
Our first experiment utilized size (total net asset value) as a selector. The table below shows the average selection returns over each of the periods for each of four portfolios. Portfolio 1 comprised the 25 funds with the largest total net asset values, portfolio 2 the next 25, portfolio 3 the next, and portfolio 4 the 25 funds with the smallest total net asset values. As in all the experiments, within each portfolio funds were weighted in accordance with their net asset values. 10 Yrs -------.04 -.08 -.04 -.01 5 Yrs -------.02 -.06 .04 .03

1: Largest 2 3 4: Smallest

These results suggest that over the entire 10-year period, there was not a significant relationship between size and performance. Over the last five years there was a tendency for the smaller funds within the LS100 to do better than larger funds. Given the statistics for the full ten-year period, the pattern in the first five years must have been reversed. These results provide no support for the thesis that the larger LS100 funds are likely to outperform the smaller ones. If anything, the evidence is mildly supportive of the opposite thesis. Economies of scale may well give larger funds comparative advantages over smaller ones up to a point, but that point may be reached at a size
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LS100 Subsets

below that of the smallest LS100 fund.

Portfolios Based on Prior Average Selection Returns


The table below shows the average selection returns over each of the periods for the "Quartile 1" portfolios based on three different selection criteria. In each case, the 25 funds with the largest prior average selection returns were selected each year. The first row shows the results obtained when the funds were chosen each year on the basis of their average selection returns in the prior 12 months. The second row shows the results when the criterion was the funds' average selection returns in the prior 24 months. The last row shows the results obtained when the criterion was the average selection returns over the prior 36 months. 10 Yrs ------.07 .04 .03 5 Yrs ------.07 .03 -.02

12 Prior Months 24 Prior Months 36 Prior Months

This set of experiments suggest that the most recent prior performance (12 months) may be the most relevant for predicting future performance. Taken alone, the results show that this method worked as well in the last 5 years as over the entire period. However, the average performance of the LS100 was better in the latter five years. Relative to the average performance of the 100 funds, the quartile 1 funds' performance declined. For example, the funds selected on the basis of the prior 12 months' selection returns outperformed the LS100 by 0.11 percent per month for the overall period, but only .08 percent per month in the latter five years: 10 Yrs: 5 Yrs: .07 - (-.04) = .11 .07 - (-.01) = .08

To further illustrate the value of the prior 12 months' average selection returns as a predictor of future performance, we show below the average selection returns for each of the four quartile portfolios over each of our ex post measurement periods. 10 Yrs ------.07 -.08 -.06 -.11 5 Yrs ------.07 -.01 -.05 -.04

1 (Best) 2 3 4 (Worst)

The progression from quartile 1 through quartile 4 is fairly regular, lending added credence to the earlier results. Note, however, that the spread between the performance of the best and worst quartiles was somewhat lower in the last five years than it was for the overall ten-year period: 10 Yrs: .07 - (-.11) = .18

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LS100 Subsets

5 Yrs:

.07 - (-.04) = .11

Portfolios based on Prior Selection Sharpe Ratios


We next examine the performance of the top-quartile portfolios selected on the basis of the Sharpe Ratios of prior selection returns. The table below shows the average selection returns over each of the periods for strategies in which funds were chosen based on the Sharpe Ratios of selection returns. The first row shows results obtained when 12 months of prior selection returns were used, the next row when 24 months were used, and the last row when 36 months were used. 10 Yrs ------.06 .02 .04 5 Yrs ------.06 .01 -.02

12 Prior Months 24 Prior Months 36 Prior Months

The results are similar but slightly inferior to those found when funds were selected on the basis of prior average selection returns. As before, the shorter the period used for prediction purposes, the better.

Ex Post Sharpe Ratios


Thus far we have utilized only ex post average selection returns as a measure of the actual performance of each of the strategies analyzed. For completeness, we turn now to the ex post Sharpe Ratio of the strategies' selection returns. Specifically, we consider only the Sharpe Ratios for the aggregate portfolios, not the Sharpe Ratios for the individual funds. Each of the next two tables shows the ex post selection return Sharpe Ratios for six strategies, defined by the selection criterion (prior average selection ratio or prior selection return Sharpe Ratio) and the period (12, 24 or 36 months) over with the measures utilized for the selection were computed. Selection return Sharpe ratios for the entire ten-year period were as follows: Prior Sharpe Ratio ------.17 .04 .08

12 Prior Months 24 Prior Months 36 Prior Months

Prior Average ------.15 .07 .06

while those for the last five years covered were:

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LS100 Subsets

12 Prior Months 24 Prior Months 36 Prior Months

Prior Average ------.14 .05 -.04

Prior Sharpe Ratio ------.16 .02 -.04

The selection return Sharpe Ratio predicted the future selection return Sharpe Ratio better than did the historic average selection return, although the differences were relatively slight. As before, the shortest historic period was the best and both predictors did a better job for the last five years than for the overall period.

Implications
While these results offer at best presumptive evidence on the subject of predicting future winners, some tentative implications may be offered. For predicting future performance, relatively recent prior performance appears to be more relevant than longerterm performance. Both the average of the last 12 month's selection returns and the Sharpe Ratio of those returns provided useful information about future performance over the period analyzed. The average selection return from a strategy based on prior average selection returns was slightly better than that of one based on the Sharpe Ratio of prior selection returns. On the other hand, the ex post Sharpe Ratio of selection returns was higher for a strategy based on the prior Sharpe ratio of such returns. When making predictions, it appears to be slightly better to use a past value of the measure being predicted rather than an alternative measure. During the periods analyzed, strategies based on both average prior selection returns and those based on the Sharpe Ratio of prior selection returns produced portfolios of funds that outperformed their styles. This was the case for both the full ten-year period and the last five years of that period. A fortiori, such strategies outperformed the LS100 funds, taken as a whole. These results can be seen in the next two figures, which show the cumulative monthly selection returns (uncompounded) for four strategies. In the graph below, the MnQ1 and MnQ4 curves show the performance of the first (best) and fourth (worst) quartiles of 25 funds each year, ranked on prior 12-month mean (average) selection returns. The curve labeled "All" shows the performance of the full set of 100 funds. The curve labeled "Passive" reflects the results associated with an index fund with overall costs of 0.20% per year. It is included as an indication of a reasonable performance for a fund that engages in no active management and minimizes expenses accordingly.

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LS100 Subsets

The next graph shows the same results for the LS100 ("All") and the passive alternative, along with the first and fourth quartiles ranked on the Sharpe Ratios of prior 12-month selection returns.

Do winners repeat? If so, can Style Analysis help find winners in advance? If the last ten years are indicative of the next ten years, one might be tempted to answer both questions in the affirmative. However, closer examination of the record of the last two or three years could lead to at least a neutral position on the issues. Either way, the evidence is far from conclusive, statistically or economically. Perhaps the only safe conclusion is that there is little support for the thesis that within this group of funds, past losers "are due" and likely to
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LS100 Subsets

outperform past winners. Data Source Micropal, Inc. For more information, please call 617-451-1585

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Risk Disclosure by Mutual Funds

Financial Economists Roundtable


Statement on Risk Disclosure by Mutual Funds
September 18, 1996

The Need for Information about Mutual Fund Risks


The growth in the U.S. mutual fund industry in recent years has been explosive. Individuals invest in such funds directly and through retirement funds such as 401(k) plans. With broader use comes the need for investors and their advisors to have more and better information concerning the nature of the investments these funds undertake. To help achieve this goal, in March 1995 the U.S. Securities and Exchange Commission (SEC) issued a Concept Release and Request for Comments on "Improving Descriptions of Risk by Mutual Funds and Other Investment Companies". Interest was great - 3,600 individual investors submitted comment letters and the Investment Company Institute (an industry trade association) surveyed an additional 600 fund shareholders on the subject. In May1996, Arthur Levitt, the Chairman of the Commission, stated that "... at least for the time being, we do not need to mandate a specific risk measure..." but that funds would be asked to select names more closely related to their investment practice and that a bar graph showing historic annual returns should be included in a fund's prospectus, along with "...a brief, plain English risk summary."

Financial Economists Roundtable Views and Recommendations


At its annual meeting in July, 1996, the Financial Economists Roundtable examined the issue of mutual fund disclosure and reached the following conclusions: 1. Current disclosure practices in the mutual fund industry are inadequate. Investors and their advisors need more information to help them assess the risks associated with investment in mutual funds. 2. Since the impact of a single mutual fund on an investor's overall financial situation may be complex, a one-dimensional measure is often inadequate. For this reason, fund risk disclosure should go beyond the reporting of historic return variability. Investors and their advisors need information that can enable them to assess sources of future risk; in many
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Risk Disclosure by Mutual Funds

cases, history may not be the best guide to the future. 3. To better communicate the sources of risk associated with mutual fund investments, fund managers should provide estimates of the principal risk factors that are likely to influence fund returns in the future. Specifically, fund managers should describe and quantify the expected relationship between their fund's future returns and relevant security market indexes as well as the likely extent of divergence of their returns from such indexes and the probable sources of such divergence. In subsequent periods, actual fund returns should be compared with the portfolio of market indexes previously selected by a fund. It is important that fund managers both provide estimates of exposures to key risk factors in advance and subsequently report returns relative to those same exposures. 4. Management predictions of future actions and outcomes are, of necessity, subject to error. Thus the SEC must provide an adequate safe harbor for such predictions so that managers can provide honest estimates without fear of later litigation. 5. We hope that individual investors and sponsors of retirement plans that use mutual funds will demand that fund managers provide the above information, thereby avoiding the constraints and costs of mandated disclosure.

The Need for Disclosure of Future Risk


The Roundtable concurs with the SEC's conclusion that disclosure of a specific risk measure need not be mandated. However, the Roundtable believes that investors and their advisors need more information to help them assess the risks of mutual funds and other investment companies. By its very nature, risk concerns the uncertain future. While investors know (or can know) what happened to a fund's returns in the past, their primary need is to predict the likely range of a fund's returns in the future. The greater is this range, the more risky are a fund's prospects. Investments in funds are risky because they are exposed to economic forces or factors for which the future is uncertain. Some of these are unique to individual funds, but many are common to many funds. Thus, a U.S. stock fund will typically move to a greater or lesser extent with the overall U.S. stock market. A fund's risk depends on how closely its return is coupled with given indexes, the riskiness of each index, and how closely the indexes tend to move together. A fund manager can communicate the nature of exposures to major risk factors of this sort by specifying a portfolio of security market indexes that, averaged over the next two to four years. is likely to have exposures similar to those of the fund. Thus, a growth stock fund might specify that a U.S. growth stock index would be an appropriate benchmark for this purpose. Another fund might select a combination of
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Risk Disclosure by Mutual Funds

indexes, with 5% in a money market index, 75% in a value stock index, and 20% in a non-U.S. stock index. The Roundtable recommends that each fund manager provide a well-defined index or portfolio of indexes so that investors can be informed of the fund's likely future exposures to major sectors of the security markets. Since disclosures of this nature will, of necessity, describe management's intentions and predictions concerning future actions and outcomes, the SEC should provide an adequate safe harbor by specific reference under Rule 175 so that funds can provide honest best estimates without fear of later shareholder litigation. Investors must ultimately be responsible for understanding or making predictions about the risks associated with major market sectors, as well as the extent to which sectors are likely to move with one another. Much of this information is common to many funds and thus can be most efficiently provided to investors by third parties such as financial planners and database providers. In contrast, the manager of a mutual fund is in the best possible position to predict his or her intended future investment strategy and to choose a benchmark portfolio of indexes that best describes that strategy. In some respects this proposal resembles the SEC requirement that each fund compare its historic returns with those of a broad-based index, preferably one provided by a third-party. However, there are three major differences. First, in many cases, funds can provide better information if they use narrow-based indices. Second, where relevant, funds should use portfolios of indexes. Third, and most importantly, a fund should select a benchmark of indexes representative of future investment strategy whether or not this benchmark was representative of the fund's past strategy. Many narrow-based indices could be used for this purpose. Some examples are:
q q q q q q q q q q q q q

Cash equivalents (for example, short-term U.S. Treasury Bills) Intermediate-term government bonds Long-term government bonds Corporate bonds Mortgage-related securities Large value stocks Large growth stocks Medium-capitalized stocks Small-capitalized stocks Non-US Bonds European stocks Pacific stocks Emerging Market stocks

There is at least one index readily and cheaply available for each of these, and many are already tracked by index mutual funds.

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Risk Disclosure by Mutual Funds

Risk not Related to Principal Factors


Not all risk arises from exposures to major factors. A fund's returns will typically be more risky than those of its selected portfolio of indexes, for one or both of two possible reasons. First, the fund may concentrate its holdings within a sector and hence be less diversified than the corresponding security index. Second, it may rotate its holdings around the long-term average positions represented in the portfolio of indexes. While it would be useful to formally quantify the non-factor risk arising from one or both of these activities, this may be difficult to do with precision. However, fund managers should provide a narrative account of the likely divergence of their fund's returns from those of the selected portfolio of indexes and the extent to which such divergence is likely to be due to (1) concentrated holdings and (2) rotation among asset classes.

Performance Evaluation
The Roundtable recommends that subsequent disclosures by funds provide historical comparisons of returns with the returns that could have been obtained had investments in the selected portfolio of indexes been made instead. Thus, in all subsequent periods, the fund's returns would be compared with returns on the portfolio of indexes selected by the fund management in advance of that period. To emphasize the risk arising from its operations, the fund should show the difference between its return and that of a portfolio of indexes for each year for which the information is available.

Reporting Historic Variability


In many instances the total variation in a fund's returns may not adequately measure its risk for a specific investor. A fully relevant measure of risk will take into account all the investor's assets and liabilities. For example, an investor making payments on a fixed-rate mortgage will view the sensitivity of a bond fund to change in interest rates differently than will an investor with no such liabilities. Similarly, an investor with existing holdings in a U.S. stock fund will be more concerned with the sensitivity of a stock fund to changes in the level of the U.S. stock market than will one with only holdings in other countries. It is for these reasons that the Roundtable has advocated a focus on the exposures of funds to principal risk factors.

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Risk Disclosure by Mutual Funds

Despite these caveats, the historic variability of returns still provides useful information for many investors. Thus, the Roundtable does not oppose the presentation of information on historic returns for the benchmark portfolio of indexes selected by a fund for the forthcoming period. However, it advocates that any chart based on the previous returns on such a portfolio show the difference in the portfolio's return each year from the average portfolio return over the years portrayed in the chart. Such a presentation emphasizes the effects of risk rather than on historic average returns. Both theory and empirical evidence indicate that history is a much better predictor of future risk than of future average return.

The Need for more Information on Portfolio Holdings


These recommendations are not intended to minimize the importance of third-party studies of past mutual fund performance. Such analyses require high-quality data, some of which can only be provided by fund management. There is one area in particular where the data provided by mutual funds is deficient for this purpose. Funds are now required to report their portfolio holdings after-the-fact once every six months, on a delayed basis to protect proprietary information. To increase the usefulness of studies of mutual fund performance, analysts should ultimately have access to monthly portfolio holdings. To facilitate this, the Roundtable recommends that the SEC mandate that funds include holdings at the end of each of the prior six months when filing their bi-annual reports.

FER Members Signing Statement


(Affiliations shown for identification purposes only)
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Rashad Abdel-Khalik, University of Florida Edward I. Altman, New York University George J. Benston, Emory University Gerald O. Bierwag, Florida International University Marshall E. Blume, University of Pennsylvania Richard Brealey, London Business School Willard T. Carleton, University of Arizona Andew Chen, Southern Methodist University Franklin R. Edwards, Columbia University Robert Eisenbeis, Federal Reserve Bank of Atlanta Edwin Elton, New York University Lawrence Fisher, Rutgers University Martin J. Gruber, New York University

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Risk Disclosure by Mutual Funds


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Nils Hakansson, University of California at Berkeley Edward J. Kane, Boston College George G. Kaufman, Loyola University Chicago Alan Kraus, University of British Columbia Hayne Leland, University of California at Berkeley Haim Levy, Hebrew University of Jerusalem Kenneth E. Scott, Stanford University William F. Sharpe, Stanford University Seymour Smidt, Cornell University Hans Stoll, Vanderbilt University Robert A. Taggart, Boston College Seha Tinic, Koc University (Turkey) James Van Horne, Stanford University Roman L. Weil, University of Chicago Richard West, New York University J. Fred Weston, University of California at Los Angeles

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Financial Economists Roundtable

Financial Economists Roundtable


Description and Statement of Purpose 1993 Statement on Registration Requirements for Foreign Securities 1994 Statement on Derivatives Markets and Finacial Risk 1995 Statement on The Structure of the Nasdaq Stock Market 1995 Statement on Accounting Disclosure About Derivative Financial Instruments 1996 Statement on Risk Disclosure by Mutual Funds 1997 Statement on Social Security 1998 Statement on Institutional Investors and Corporate Governance

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Social Security

Financial Economists Roundtable


Statement on Social Security
March 31, 1998

The following statement on Social Security was discussed at FERs annual meeting in July 1997 and released on March 31, 1998. For further information on this statement, contact: Stewart C. Myers, MIT and The Brattle Group, (617) 864-7900

The Financial Economists Roundtable met in July 1997 to consider long-run problems facing the Social Security system. The goal was not necessarily to endorse any particular proposal for Social Security reform, but to explore how the principles of modern finance can clarify the current debate. The Roundtable reached definite conclusions on the following points: Investing part of the Social Security Trust Fund in common stocks does not help solve the basic problems facing the current, pay-as-you-go Social Security system. A reformed Social Security system should be partly funded through individual retirement accounts. But it should preserve a safety net, that is, a minimum benefit for all participants, financed on a pay-as-you-go basis. Individual retirement accounts should be invested in well-diversified portfolios of securities, including common stocks. But the moneys worth ratios reported in the Report of the Advisory Council on Social Security exaggerate the value of investing in common stocks. Individual retirement accounts should be fully owned by workers, just as they own IRAs and 401K plans. Prudent and low-cost management is essential. Competition between private and public management could be
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Social Security

healthy.

Introduction
Unlike private pension plans, Social Security is not funded; it is a pay-as-you-go system. The payroll taxes paid by each generation of workers are not invested to cover that generations retirement. Instead the taxes are used to pay benefits to workers who have already retired. The young pay the old, and when the young become old, they in turn are paid by the next generation. Payroll taxes will exceed benefit payments for the next few years. These surpluses will flow to the OASDI (Old Age, Survivors and Disability Insurance) Trust Fund. The Trust Fund is not intended to fund future Social Security liabilities. At its projected peak in about 2020, the Trust Fund will cover less than three years of benefit payments. The Social Security system faces two serious problems. First, pay-as-you-go will not work in the long run at current tax rates and benefit levels. Projected annual benefits will exceed taxes before 2015, and the Trust Fund will be exhausted by about 2030. Projected annual and cumulative deficits become steadily worse through at least 2075. The projected deficits are created by several economic and demographic trends. For example, the ratio of young workers entering the workforce to older workers retiring from it will decrease, and once retired, workers will live longer and therefore collect more Social Security benefits. Second, pay-as-you-go systems do not encourage saving. Young workers invest payroll taxes in exchange for a promise of Social Security payments at retirement, but no net aggregate saving takes place, because the taxes flow to current retirees. The Advisory Council on Social Security has put forth three proposals for reform: Maintenance of Benefits (MB) would shave benefits, eventually increase payroll tax rates and (seriously consider) investing 40 percent of the OASDI Trust Fund in common stocks instead of Treasury bonds. The assumed higher return on stocks in the Trust Fund is used to reduce or delay planned increases in taxes or future reductions in benefits. Individual Accounts (IA) would shave benefits and also create mandatory investment accounts for all participants, financed with an additional 1.6% payroll tax. The accounts would be invested in government-managed stock and bond index funds. As annuities from the accounts become available for retirement, there would be offsetting reductions in pay-as-you-go benefits.
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Social Security

Personal Security Accounts (PSA) would divert 5% of the payroll tax to accounts placed with private investment companies. The rest of the payroll tax would finance a flat monthly benefit of $410 in 1998 dollars. The transition to the new system would be spread over 72 years, financed with an additional1.52% payroll tax and by Federal borrowing. The Roundtable concentrated on these three proposals, not to endorse or refute any one of them, nor to rule out other proposals, but to focus discussion on the financial issues in Social Security reform.

Individual accounts invested in common stocks


If Social Security participants acquire individual accounts, as in the IA and PSA plans, the accounts should be invested in well-diversified portfolios. Most portfolios would include common stocks as well as fixed-income securities. The additional risks of investing in common stocks -- compared, say, to investment just in Treasury bonds -- are offset by higher expected rates of return. But it is wrong to project the higher expected returns without accounting for the additional risk. The Advisory Council Report makes this mistake. The Report says that the IA and PSA plans give participants greater moneys worth ratios than the MB plan, that is, more valuable benefits relative to payroll taxes paid. In fact, these misstated ratios make the IA and PSA plans look much better than they really are, relative to the MB plan. The moneys worth ratios calculated for the IA and PSA plans look good mainly because the Report projects relatively high rates of return from investments in the stock market and then discounts projected future benefits at a lower Treasury bond rate. The resulting moneys-worth ratios are therefore overstated. Future benefits that depend on the performance of the stock market should not be discounted at a Treasury bond rate. Finance theory and practice require that discount rates include risk premiums sufficient to compensate for investment risks incurred. Replacing a safe investment with common stocks increases expected return, but does not increase present value once risk is accounted for. In short, the moneys-worth ratios in the Advisory Council Report are incorrect and unreliable. They overstate the value of investing in common stocks.

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Social Security

Investing the OASDI Trust Fund in common stocks


Although the MB plan has no individual accounts, its proponents contemplate investing 40% of the OASDI Trust Fund in common stocks. This allows more favorable actuarial assumptions and delays the need for a future payroll tax increase or a further cut in benefits. But this is a cosmetic improvement only. What are the actual effects of investing part of the Trust Fund in common stocks, other things constant? The Trust Fund is now invested in Treasury bonds. If the Trust Fund buys $1 billion of common stocks from private investors, the Treasury will have to issue an additional $1 billion of bonds to private investors. The Federal government would be borrowing to buy equities, that is, swapping bonds for stocks. There would be no change in the funds received or paid out by the Federal government, and aggregate saving would not be increased. The secondary effects of Trust Fund investment in equities are difficult to forecast. Purchases of stocks by the Trust Fund, and sale of additional bonds by the Treasury, may push stock prices up a little relative to bond prices. Therefore expected rates of return on equities may fall slightly, relative to long-term interest rates, making risk capital relatively less expensive. However, the Roundtable believes that any such changes will be small and probably imperceptible. Trust Fund investment in equities may also shift risks between current and future generations. Suppose, for example, that the stock market does much worse than projected. (Given the markets volatility, this outcome can not be ruled out, even in the long run.) If the benefits formula is not changed, the shortfall in projected return has to be made up by future workers (as taxpayers in a pay-as-you-go system). But of course benefits might also be reduced. On the other hand, if the stock market does exceptionally well, future payroll taxes could be lower. But in this case, the political will to hold the line on benefits will weaken. Thus risk would probably be shared by future workers (as taxpayers) and current workers when they retire.

An improved Social Security system


An improved Social Security system should: Move to a partially funded system, gradually eliminating part of the unfunded deficit of the current pay-as-you-go system. Funding should be accomplished through mandatory individual retirement accounts. Promote saving and assure that individual accounts are invested prudently and managed efficiently.

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Social Security

Preserve a safety net, that is, a minimum retirement benefit for all participants, financed on a pay-as-you-go basis. Moving to a partially funded system requires transition financing to maintain benefits for retired or nearly retired workers. Otherwise the shift of payroll taxes to individual accounts will create a dollar-fordollar shortfall in the Federal budget, and aggregate saving will not increase. It is not clear that the transition costs should be covered by increased payroll taxes; this forces younger workers to pay for current retirees benefits and also for their own future retirement. A broader-based tax should be considered. The PSA plan is generally consistent with the goals just stated. The Roundtable does not endorse PSA specifically, but it is better than the IA or MB plans as a framework or prototype for change. The PSA plan moves towards partial funding through individual accounts, preserves a guaranteed monthly payment for all participants, and provides transition financing (although the financing comes from an additional payroll tax, not a broader-based tax). The IA plan also creates individual accounts funded by an additional 1.6% payroll tax. Annuities supported by the IA account balances would gradually replace part of the benefits from the existing payas-you-go system. The IA plan moves toward a partially funded system, but much more slowly and cautiously than the PSA plan. Also, it is not clear whether participants would truly own their accounts. For example, the IA proposal does not say what happens to a participants account if he or she dies before normal retirement. Does the balance revert to the government? The MB plan contemplates minor changes to the present system and is not a significant improvement.

Management of individual accounts


Partial funding of Social Security requires a savings program designed to accumulate assets to cover part of retirement benefits. Saving would be mandatory for all workers covered by the system, and many participants would have few other financial assets. Therefore, excessively risky investment strategies would be unacceptable. Securities would be held in index funds or other widely diversified portfolios. Portfolios would be balanced, with investment in fixed-income securities as well as stocks. Participants would be allowed to move to safer portfolios, for example by investing less in stocks and more in fixedincome securities, as they approach retirement. The PSA plan calls for private management of individual retirement accounts, with few restrictions on investment. Some participants would choose excessively risky portfolios and/or end up paying high investment management fees. The IA plan calls for the government to pool the accounts and invest in index funds, perhaps subcontracting management to a small number of investment companies. In this

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Social Security

case diversification would be assured and costs would be very low. The Roundtable believes that mandatory individual retirement accounts should be restricted to widely diversified portfolios. Excessive costs or fees for investment management should be avoided. Given these constraints, the differences between government and private management of workers retirement accounts would not be marked. Each would require oversight by an independent agency or regulatory authority to assure that workers investments go to widely diversified and efficiently managed portfolios. The Roundtable reached no specific conclusions about how this oversight should be implemented. A government-managed system would not necessarily be more or less simpler or less cost-effective. Keeping track of collections, transfers and cumulative balances might be more complex in a privately managed system, partly because workers would have greater choice. On the other hand, a governmentmanaged system would require firewalls to prevent political interference in investment management. The Roundtable did not evaluate any detailed proposals for the administration and management of individual retirement accounts. However, it believes that a combination of private and public management could be healthy. For example, a workers initial contributions might be directed to publicly supervised index funds invested in bonds and stocks; this would minimize investment management expenses on small accounts. But the worker could be given the option to switch to a privately managed portfolio once a minimum account balance is reached. Whatever the arrangements for administration and investment management, workers should own their investment accounts. The account balances should be available to a deceased workers heirs. Upon retirement there should be a choice of payout options, including inflation-indexed annuities.

FER Members Signing Statement


(Affiliations shown for identification purposes only)

Rashad Abdel-Khalik, University of Florida Edward I. Altman, New York University George J. Benston, Emory University Gerald O. Bierwag, Florida International University Marshall E. Blume, University of Pennsylvania Richard Brealey, London Business School (U.K.)
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Social Security

Willard T. Carleton, University of Arizona Andrew Chen, Southern Methodist University Franklin R. Edwards, Columbia University Robert Eisenbeis, Federal Reserve Bank of Atlanta Edwin Elton, New York University Lawrence Fisher, Rutgers University Martin J. Gruber, New York University Edward J. Kane, Boston College George G. Kaufman, Loyola University Chicago Alan Kraus, University of British Columbia Robert Litzenberger, University of Pennsylvania Dennis E. Logue, Dartmouth College John J. McConnel, Purdue University Stewart C. Myers, Massachusetts Institute of Technology Anthony M. Santomero, University of Pennsylvania Kenneth E. Scott, Stanford University William F. Sharpe, Stanford University Seymour Smidt, Cornell University Hans Stoll, Vanderbilt University Seha Tini, Ko University (Turkey) James Van Horne, Stanford University Ingo Walter, New York University Roman L. Weil, University of Chicago Richard West, New York University J. Fred Weston, University of California at Los Angeles

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Bob Boomer

Bob Boomer

Background It had been a good day for Bob Boomer. He had celebrated his fiftieth birthday with a few beers with some of his programmer friends at the Los Altos Bar and Grill, dropped in at Fry's in Palo Alto to check out some new software, then gone back to his apartment in Cupertino to read over material related to the benefits for which he had just become eligible. Bob had been hired a year earlier as a software engineer by the William David Company (WD), a major player in the computer industry. His skills in C++ had made him attractive to WD, and he was delighted to be in a firm with both a solid position in the industry and a reputation for openness and concern for its employees. The word in Silicon Valley was that no good employee would ever be laid off by WD. Bobs gross salary before any deductions was $100,000 per year. He expected that his salary would increase at roughly the rate of inflation until he chose to retire.

Financial Condition Bob's financial situation was adequate but not what it might have been. Two divorces had taken their toll, financially and otherwise. Prior to a year ago he had devoted all his time and much of his money to a start-up that had turned out badly. As a result, he had no savings other than approximately $10,000 in the bank and a Certificate of Deposit worth $10,000 that would come due at the end of the month. Bob's major tangible assets were his new Jeep Grand Cherokee, for which he had paid $36,000 in cash a month earlier and his year-old 28 foot Bayliner cabin cruiser, for which he had paid $55,000. His expenses were typical for a programmer in Silicon Valley. His rented a rather luxurious one-bedroom apartment for $2,000 per month. He liked to eat out, but preferred Armadillo Willy's ribs to Madalena's haute cuisine. He had resolved to never marry again. For recreation he liked to play Doom on the internet and talk with his friends about java applets at Starbuck's. He seldom attended operas or concerts. Now that he was eligible for vacations he planned to spend some time in Cabo San Lucas, a resort in Mexico only three hours away by plane. In addition to the usual recurring payments, he paid $150 per month for his boat slip at Peninsula Marina.

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Bob Boomer

The William David Plans WD provided two retirement plans: the Basic Retirement Plan (BRP) and the Supplemental Retirement Plan (SRP). The former was a traditional defined-benefit plan in which the amount ultimately received by the participant was not a function of investment returns, while the latter was a defined contribution plan in which the amount received by the participant depended on investment performance.

The Basic Retirement Plan The cost of the Basic Retirement Plan was borne entirely by WD. The plan guaranteed a minimum retirement benefit in the form of monthly income at age 65 according to the following formula: (1.5% times Average Monthly Salary in Final Year) less $40 times Years of Credited Service For example, if an employees final year average pay rate at age 65 were $10,000 per month, the first term would be: (0.015* $10,000) - $40 = $110 If she had 25 years of credited service, the total benefit would then be: $110 * 25 = $2,750 per month. or $33,000 per year. An employee who retired at or after age 65 could elect to receive a lifetime annuity based on this formula. One who retired at an earlier age could elect to receive payments immediately or wait until reaching any age up to 65. The amount paid would be a percentage of the benefit determined by the formula, with the percentage greater, the later the age at which payments began:

Age when annuity Percent of payments begin BRP benefit

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Bob Boomer

65 or over 64 63 62 61 60 59 58 57 56 55

100 percent 93.33 percent 86.67 percent 80.00 percent 73.33 percent 66.67 percent 63.33 percent 60.00 percent 56.67 percent 53.33 percent 50.00 percent

Instead of taking the BRP benefit in the form of an annuity, a participant could elect to receive a single lump sum calculated using a factor determined at the time by the Pension Benefit Guaranty Corporation. The relevant factor would depend on the age of the participant and current levels of interest rates. Some typical examples were: Age 55 60 65 4% 174 154 134 5% 157 141 123 6% 143 130 115 7% 131 120 107 8% 121 111 100

Thus, if the applicable interest rate were 6% and the monthly benefit were $3,000, a 65-year old participant could elect to receive a lump sum payment of 115*$3,000, or $345,000. Whether taken as annuity payments or as a lump sum, all money received from defined benefit plans such as the Basic Retirement Plan were subject to standard income tax rates (although lump sums could be rolled over to other types of investment accounts from which only the amounts withdrawn would be subject to income taxes).

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Bob Boomer

The Supplemental Retirement Plan The SRP qualified for advantageous tax treatment under section 401(k) of the U.S. Internal Revenue Code. Amounts contributed by an employee to the plan would be deducted from the employees taxable income. Moreover, no taxes would be paid on income or capital gains left in the account. However, any amounts withdrawn would be treated as ordinary income and taxed accordingly. Under the regulations in effect at the time, amounts withdrawn prior to age 59 other than for reasons of hardship would be subject to an additional tax of 10%. WD allowed participants in the SRP plan to borrow up to 50% of their account balance, but no more than $50,000. After one year with the company, employees could choose whether or not to participate in the plan The benefits office had informed Bob that he could elect to contribute up to 8% of his gross pay each month and that WD would match his contributions dollar-for-dollar up to an amount equal to 4% of his pay. At retirement, the total value of the SRP could be taken as a lump-sum payment. Alternatively, some or all of it could be rolled into an Individual Retirement Account (IRA) selected by the participant. In general, amounts received by the individual either as lump sum distributions or as subsequent withdrawals from an IRA account would be taxed at standard income tax rates. The tax laws also mandated specified minimum withdrawals after age 70 .

Investment Alternatives Participants in the SRP were allowed to allocate their contributions among the following nine investment alternatives:
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Fidelity Cash Reserves Fidelity Intermediate Bond Fund Fidelity Market Index Fidelity Growth and Income Fidelity Magellan Fidelity Contrafund Templeton Foreign PBHG Growth Fund WD Stock

New contributions could be allocated in any desired proportions. Participants were also allowed to change the allocations of funds in the account at any time. There were no fees associated with investment, withdrawal, or re-allocations.
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Bob Boomer

Each of the funds was also available for direct investment by anyone, although "retail investors" were sometimes charged "front-end load" fees ranging from 3% to over 5% which were not required for investment via the SRP. WD stock could also be purchased directly. It had performed very well recently, as had most stocks in the technology sector. Bob had been told that due to a conservative financial structure, WD shares were considered to be no more vulnerable to a market decline than those of the average U.S. corporation. Bob had looked for information about the funds on the World Wide Web. He found detailed information on the Fidelity funds at Fidelity's mutual fund site. In addition, he found that he could obtain a great deal of information about all the funds with the exception of Fidelity Cash Reserves at the Morningstar site, after registering (for which there was no charge), using the following ticker symbols: Fund Fidelity Market Index Fidelity Magellan Fidelity Contrafund Templeton Foreign PBHG Growth Ticker FSMKX FMAGX FCNTX PBHGX TEMFX

Fidelity Intermediate Bond FTHRX Fidelity Growth and Income FGRIX

A friend had also suggested that he check out the Advisor Software Site to get further information concerning the "style" of each of the funds and the recent performance of each one, relative to that of an unmanaged portfolio with a similar style.

Social Security One of the great unknowns was the future viability of the Social Security system. If the current schedule of benefit payments were maintained, Bob would be eligible for a significant annuity. The actual magnitude would depend both on the age at which he elected to begin receiving payments and the rate of inflation. According to one article that he had read, the income per year for someone in his generation if there were no further inflation would be roughly: Age 62 Income $ 12,000

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Bob Boomer

63 64 65 66 67

$ 13,000 $ 14,000 $ 15,000 $ 16,500 $ 18,000

The actual amount was scheduled to increase with inflation. The article indicated that to determine the amount paid in any future year, the "zero-inflation amount" (above) should be multiplied by the ratio of the estimated Consumer Price Index at the time to its current level. The article indicated that it would be very difficult for the society to make good on these obligations for Bobs generation, since the ratio of active workers to those receiving social security payments would fall significantly as the "baby boomers" moved into retirement. Despite this concern, little was being said by politicians about this problem. The received wisdom was that social security was "sacred" and thus not subject to debate.

Retirement Goals Bob enjoyed his job at WD and expected to work there for the rest of his career. He hoped to retire in his sixties -- preferably in his early sixties. Given advances in communications technology he was certain that fast internet connections would soon be available via satellite almost everywhere. He figured that a comfortable house near the beach in Cabo San Lucas, a state-of-the art computer, internet access and some money for entertainment would be all that he would need to live out the rest of his days with gusto. At current price levels, he estimated that he could accomplish this with $60,000 per year before taxes. Since the economy in Cabo San Lucas was virtually dollar-based, he figured that the actual cost would move more or less one-to-one with inflation in the U.S..

Retirement Calculators Bob had assumed that he could find material on the World Wide Web that would help him analyze his situation. After a short period with the usual search engines, he turned up five promising sites:
q q

The T. Rowe Price Retirement Page The Vanguard Retirement Resource Center

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Bob Boomer
q q

The Fidelity Retirement Planning Calculator The Quicken Retirement Planner

However, these seemed to be somewhat limited in scope. At the suggestion of a friend, he had also identified a worksheet produced by an academic economist:
q

W. F. Sharpe's Retirement Planning Worksheet

Investment Projections All the retirement planning software that Bob had discovered had required the user to input projections for the return (and, in one case, the risk) of an investment strategy. This presented a serious problem. He found some historic data one of the pages provided at the T. Rowe Price site. This helped, but covered periods of different lengths and Bob was unclear concerning the most relevant for making projections concerning future returns. Fortunately, one of his neighbors had recently spent a great deal of time (and money) with a financial planner. She said that the planner had made the following estimates for an "average year": Inflation Stocks 3% 10 %

Short-term Investments 5 %

The planner had pointed out that short-term investments tended to track inflation quite closely, but that the difference between the return on stocks and inflation could vary considerably from year to year. While in an average year the "real return" on stocks was projected to be 7% (10% - 3%), in any given year, the actual real return might be very different. The planner's estimate was that in two years out of three, the real return on stocks would fall in a range from -8% (=7%-15%) to 22% (=7%+15%).

Decisions Bob felt that it was time to make two major decisions:(1) how much to contribute to the SRP and (2) how to allocate his contributions among the available funds. It was a beautiful evening. He poured a glass of Kendall Jackson sauvignon blanc, made certain that the batteries on his computer and wireless modem were fully charged, and headed for the spa. He looked forward to enjoying the stars above and the lights of Silicon Valley below while working on his future. He figured that the better the decisions he made, the sooner would he be on the beach in Cabo San Lucas, sipping a cerveza and listening to the mariachis.
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Bob Boomer

This case was written by Prof. William F. Sharpe, STANCO 25 Professor of Finance, Stanford University. Current version: July 13, 1997

Appendix: List of Web Sites

Site Advisor Software Site Fidelity's mutual fund site The Fidelity Retirement Planning Calculator Morningstar site The Quicken Retirement Planner T. Rowe Price site. The T. Rowe Price Retirement Page The Vanguard Retirement Center W. F. Sharpe's Retirement Planning Worksheet

URL http://www.fundstyle.com http://personal12.fidelity.com/products/funds

http://personal.fidelity.com/fidbin/retire_image?00 http://www.morningstar.net/Cover/Invest.html http://www.quicken.com/retirement/planner http://www.troweprice.com/retirement/historical.html http://www.troweprice.com/retirement/index.html http://magestic.vanguard.com/RRC/DA

http://sharpe.stanford.edu/ws_ret.htm

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Bob Boomer

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Financial Planning in Fantasyland

Financial Planning in Fantasyland


William F. Sharpe STANCO 25 Professor Finance, Stanford University
Note: this paper is an expanded version of a dinner speech presented at a conference sponsored by the University of California, Davis Graduate School of Management on October 17, 1997

There is a world-wide trend away from defined benefit pension plans, in which workers make no decisions about savings and investment, to defined contribution plans, in which they make such decisions. For example, twenty years ago, 70% of U.S. corporate retirement assets were in defined benefit plans; the proportion is now 50% and falling, as the following figure shows..

This sea change in retirement savings is creating an unprecedented need for ordinary human beings to make informed decisions about investing their retirement savings -- a task for which most are currently ill-equipped. Most participants in defined contribution plans don't know what they are doing and desperately need help. Since such help must be provided at low cost, we are seeing a plethora of computer-based procedures for such "financial planning". One assumes that the approaches typically implemented in such software reflect the traditional practice of human financial planners, but of course it is difficult to know what goes on between two consenting adults when a financial planner meets a client in the privacy of the planner's office.

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I have been studying software provided by major mutual fund and software companies and have found that it reflects remarkably few of the lessons learned after decades of the development of financial theory and its implementation by and for large institutional investors. Participants in defined contribution plans need economic science, but what they are getting at present is bookkeeping and pseudo-science. Here is an example of the kind of information that drives such analyses. Current Age Current Savings Annual Savings (today's $) Retirement Age Years in Retirement Investment Return (%) Inflation (%) 50 $ 100,000 $ 12,000 65 20 10.5 % 3.5 %

Annual Retirement Spending (today's $) $ 70,000

In some cases, questions of mortality are left to the user. In others, the age at death is provided by the software, presumably from a mortality table. But it is always a single number. One dies right on schedule. So much for actuarial science. Note that the investment return is specified by the user, although most software provides some historic perspective as background for the decision. Imagine complaining about a stomach ache only to have the doctor respond: "Well, do you think it is indigestion, an ulcer or cancer?". If there is an investment expert lurking behind the software, it is one reluctant to give opinions. Also note that the investment return is summarized with one number. So much for Markowitz's notion of risk. The implications of these inputs are shown in a graph of one's savings account, produced in living color by virtually all the software packages. Here is an example:

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Financial Planning in Fantasyland

Prior to retirement the account grows regularly, due to new contributions and the unvarying rate of return on assets. After retirement the account eventually begins to diminish as spending overtakes the rate of return, which remains resolutely constant. Eventually one of two things happens. Either you die (right on schedule) with money in the bank or you run out of money before you die. This case above is one of the happier ones. The user has a bit left at death.In such instances, the software will usually issue a message such as: CONGRATULATIONS You have a surplus and will meet or exceed your goal or: CONGRATULATIONS Your plan works or the like. Such messages are usually delivered in green to indicate that everything is a go. In many cases, however, the situation may be ugly. Here is a case in point:

This poor soul will run out of money before the appointed date with the grim reaper. The software will issue a message such as: YOU HAVE A SHORTFALL or: WARNING Your plan does not work

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Financial Planning in Fantasyland

Such messages are usually delivered in red, indicating the need to stop and reconsider. When there is a shortfall, the software packages will generally suggest changes in one or more of four key inputs. To improve the situation, the user is urged to:
q q q q

save more, retire later, spend less, or increase investment return

The first three choices are, of course, rather painful. But the last one seems easy. Why not choose investments with a higher rate of return? That will clearly improve things. And the software makes it easy to determine the magnitude of the improvement. What we have here is a return/return tradeoff, rather than the risk/return tradeoff that our textbooks describe. So much for portfolio theory. To be fair, the software will probably point out that higher returning investments may bring higher "short-term risk". But there is no sign of this in the savings graph. Moreover, such risk has no effect on the deliverance or withholding of congratulations. One is left with the impression that a high-risk investment may go down every so often, but that it will kindly go up subsequently by a large enough amount to get the account back on its appointed track -- mean-reversion with a vengeance. Of course, one must eventually invest in order to achieve return, and the software packages generally provide advice on this front, although it is sometimes limited to allocation among major asset classes. Here are two examples:

Diagrams of this sort are rather like dinner plates, with the sections indicating proportions of three major food groups. Typically, 6 to 10 such standard menus are offered. At one end is the all-cash, or granola diet, which provides small pleasure but is unlikely to cause much in the way of gastric distress. At the other end is the all-stock, or classic French diet, which will taste delicious but may cause a heart attack or two. While the pain (risk) is sometimes indicated only the pleasure (return) affects the savings account projections.

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One might imagine that asset allocations suggested in such software packages conform to the prescriptions of Markowitz, representing points along an efficient risk/return frontier, with each one optimal for a different degree of risk tolerance. However, this seems unlikely. In this case the "moderate" portfolio has 20% in cash and equal parts of bonds and stocks. This would suggest that a 50/50 bond/stock portfolio has the greatest excess return Sharpe ratio. But if this is the case, why is the "conservative" portfolio not a combination with equal parts of bonds and stocks and more cash rather than a mix with the same amount of cash and three times as much in bonds as in stocks. Here is another example:

As one goes from the "aggressive" to the "moderate" and on to the "conservative" portfolio, the amount invested in stocks declines and the amount invested in cash increases. So far so good. But note what happens to the bond portion. It increases, then decreases. Markowitz showed that in regions of the efficient frontier for which a given set of constraints is binding, every portfolio can be constructed using a linear combination of any other two. Here, there is no way that the moderate portfolio can be constructed by allocating funds between the aggressive and conservative portfolios. The principles that guided the dietitians constructing these menus were not the ones typically taught in business schools. However important asset allocation may be, ultimately the investor must select specific mutual funds. For this task, software packages tend to either leave the user in a sea of thousands of funds or provide a crude taxonomy involving a few broad categories (such a "growth and income") with all funds in a given category considered equivalent. The latter approach flies in the face of numerous studies that have found the standard fund classifications to be inaccurate in almost every case and intentionally misleading in some. At this point it is useful to recount the key ingredients of portfolio theory. In the diagram below, each point in blue plots the risk and expected return for a specific portfolio composed in a more or less traditional way from 1 to 18 different asset classes. The points in red represent portfolios that are efficient in the sense of Markowitz. Collectively, they form the efficient frontier of risk/return opportunities. For any given level of risk, the efficient portfolio is the one with the greatest expected return. Estimation of the risk and return of a portfolio and determination of the set of efficient portfolios requires knowledge of financial markets and hence is properly the task of an expert investment advisor. The curves in green in the diagram represent the attitudes of a particular investor towards risk and return. This investor

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considers all points on a given green curve to be equally desirable -- that is, he or she is indifferent among them. Points on higher curves are preferred to points on lower curves. There are, of course, many such indifference curves, only a few of which have been shown. Note that the curves slope upward, indicating that the investor will only be willing to take on more risk if there is the prospect for greater expected return. The shape of the curves reflects the investor's degree of tolerance for risk. Ultimately, only the investor knows his or her risk tolerance. The goal, of course, is to find the portfolio that will be best for the investor in question. Formally, this lies at the point on the efficient frontier at which one of the investor's indifference curves just touches the frontier -- shown by the yellow point in the figure. To determine this, the information known to the investment advisor must be brought together with the information known to the investor. There are two ways to do this. First, the investment advisor can help the investor understand the implications of each of a number of alternative efficient portfolios, letting the investor choose among them. This is almost universally done in institutional investment practice. However, to do this the investment advisor must admit that there is risk and help the investor understand the implications of both risk and return. Since the typical software package fails to quantify the efficient investment opportunity set in meaningful risk and return terms, a different other approach is taken. The investor is asked a series of questions that attempt to elicit information about his or her preferences (the green curves in the figure). Then the software suggests a portfolio that seems appropriate. Unfortunately, such questions often leave a great deal to be desired. Two types of questions recur.First there are those that try to assess the respondent's willingness to take risk in other contexts -- for example: "Do you like to jump out of airplanes?". The presumption is that those who answer in the affirmative are prime candidates for all-stock portfolios. The second type of question probes the respondent's current investment positions -- for example: "True or False: I have a lot of stocks and am comfortable with the risk." Not surprisingly, those who answer such an inquiry in the affirmative are counseled to have a stock-heavy portfolio. There are other types of questions, such as those that ask about short-term needs for cash, and so on. There may or may not be some sort of science behind such procedures but it seems unlikely that the leap from answers to such questions to a recommended portfolio is a sound one.

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Enough bashing of software that is, for all its substantive failings, often aesthetically pleasing and fun to use. It is time to address the two obvious questions. First, why this state of affairs? Second, what might be done instead? I think there are two major reasons for this situation. First, there is a perfectly well-placed concern that ordinary human beings just can't understand and process uncertainty. It is thought that probability distributions may be fine in the MBA classroom, but not in the factory. At the very least, it will be a challenge to educate large numbers of people to think probabilistically. Second, there are the ever-present legal and regulatory constraints. Many believe that it is safer to give no advice than to give good advice. Just as the threat of medical malpractice suits may severely constrain even the most dedicated physician, the threat of fiduciary suits may constrain the most dedicated investment advisor, whether operating in person or via software. To take a key example, it should be the case that a plan sponsor is more likely to be sued for providing little advice or overly simplistic advice than for providing realistic projections that take uncertainty into account. If this is not the case, we need to change public policy so that it will be. Finally, what should be done? Here the answer is reasonably obvious. We need to devise software that recognizes that investment returns are not certain, that conveys risk/return tradeoffs in ways that are relevant and understandable by the user
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and that projects mutual fund characteristics as carefully as possible. There is ample experience on this front from institutional practice, in particular pension fund asset allocation studies. But such studies typically cost tens to hundreds of thousands of dollars. We need to bring such technology to individuals for a tiny fraction of that cost. A number of people, myself included, believe that with today's technology this is possible. Time will tell.

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Revisiting the Capital Asset Pricing Model

Revisiting The Capital Asset Pricing Model


by Jonathan Burton
Reprinted with permission from Dow Jones Asset Manager May/June 1998, pp. 20-28
For pictures and captions, click here

Modern Portfolio Theory was not yet adolescent in 1960 when William F. Sharpe, a 26-year-old researcher at the RAND Corporation, a think tank in Los Angeles, introduced himself to a fellow economist named Harry Markowitz.. Neither of them knew it then, but that casual knock on Markowitz's office door would forever change how investors valued securities. Sharpe, then a Ph.D. candidate at the University of California, Los Angeles, needed a doctoral dissertation topic. He had read "Portfolio Selection," Markowitz's seminal work on risk and returnfirst published in 1952 and updated in 1959that presented a so-called efficient frontier of optimal investment. While advocating a diversified portfolio to reduce risk, Markowitz stopped short of developing a practical means to assess how various holdings operate together, or correlate, though the question had occurred to him. Sharpe accepted Markowitz's suggestion that he investigate Portfolio Theory as a thesis project. By connecting a portfolio to a single risk factor, he greatly simplified Markowitz's work. Sharpe has committed himself ever since to making finance more accessible to both professionals and individuals. From this research, Sharpe independently developed a heretical notion of investment risk and reward, a sophisticated reasoning that has become known as the Capital Asset Pricing Model, or the CAPM. The CAPM rattled investment professionals in the 1960s, and its commanding importance still reverberates today. In 1990, Sharpe's role in developing the CAPM was recognized by the Nobel Prize committee.
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Sharpe shared the Nobel Memorial Prize in Economic Sciences that year with Markowitz and Merton Miller, the University of Chicago economist. Every investment carries two distinct risks, the CAPM explains. One is the risk of being in the market, which Sharpe called systematic risk. This risk, later dubbed "beta," cannot be diversified away. The otherunsystematic riskis specific to a company's fortunes. Since this uncertainty can be mitigated through appropriate diversification, Sharpe figured that a portfolio's expected return hinges solely on its betaits relationship to the overall market. The CAPM helps measure portfolio risk and the return an investor can expect for taking that risk. More than three decades have passed since the CAPM's introduction, and Sharpe has not stood still. A professor of finance at the Stanford University Graduate School of Business since 1970, he has crafted several financial tools that portfolio managers and individuals use routinely to better comprehend investment risk, including returns-based style analysis, which assists investors in determining whether a portfolio manager is sticking to his stated investment objective. The Sharpe ratio evaluates the level of risk a fund accepts vs. the return it delivers. Sharpe's latest project is characteristically ambitious, combining his desire to educate a mass audience about risk with his longtime love of computers. Technology is democratizing finance, and Sharpe is helping to push this powerful revolution forward. Through Financial Engines, Sharpe and his partners will bring professional investment advice and analysis to individuals over the Internet.

What do you think of the talk that beta is dead? The CAPM is not dead. Anyone who believes markets are so screwy that expected returns are not related to the risk of having a bad time, which is what beta represents, must have a very harsh view of reality. "Is beta dead?" is really focused on whether or not individual stocks have higher expected returns if they have higher betas relative to the market. It would be irresponsible to assume that is not true. That doesn't mean we can confirm the data. We don't see expected returns; we see realized returns. We don't see exante measures of beta; we see realized beta. What makes investments interesting and exciting is that you have lots of noise in the data. So it's hard to definitively answer these questions.

Would you approach a study of market risk differently today than you did back in the early 1960s? It's funny how people tend to misunderstand the CAPM's academic, theoretical and scientific process. The CAPM was a very simple, very strong set of assumptions that got a nice, clean, pretty result. And then almost immediately, we all said, let's bring more complexity into it to try to get closer to the real
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world. People went onmyself and othersto what I call "extended" capital asset pricing models, in which expected return is a function of beta, taxes, liquidity, dividend yield, and other things people might care about. Did the CAPM evolve? Of course. Are the results more complicated shall just expected return is a linear function of beta relative to the Standard & Poor's 500-Stock Index? Of course. But the fundamental idea remains that there's no reason to expect reward just for bearing risk. Otherwise, you'd make a lot of money in Las Vegas. If there's reward for risk, it's got to be special. There's got to be some economics behind it or else the world is a very crazy place. I don't think differently about those basic ideas at all.

What about Harry Markowitz's contribution to all of this? Markowitz came along, and there was light. Markowitz said a portfolio has expected return and risk. Expected return is related to the expected return of the securities, but risk is more complicated. Risk is related to the risks of the individual components as well as the correlations. That makes risk a complicated feature, and one that human beings have trouble processing. You can put estimates of risk/return correlation into a computer and find efficient portfolios. In this way, you can get more return for a given risk and less risk for a given return, and that's efficiency a la Markowitz.

What stands out in your mind when you think about Markowitz's contribution? I liked the parsimony, the beauty, of it. I was and am a computer nut. I loved the mathematics. It was simple but elegant. It had all of the aesthetic qualities that a model builder likes. Investment texts in the pre- Markowitz era were simplistic: Don't put all your eggs in one basket, or put them in a basket and watch it closely. There was little quantification. To this day, people recommend a compartmentalized approach. You have one pot for your college fund, another for your retirement fund, another for your unemployment fund. People's tendencies when they deal with these issues often lead to suboptimal solutions because they don't take covariance into account. Correlation is important. You want to think about how things move together.

Tell us about your relationship with Markowitz. Harry was my unofficial dissertation advisor. In 1960, he and I were both at the RAND Corporation. My official advisor at the University of California at Los Angeles suggested I work with Harry, but Harry
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wasn't on the UCLA faculty. I introduced myself to him and said I was a great fan of his work.

With Markowitz's encouragement, you delved into market correlation, streamlining Portfolio Theory with the use of a single-factor model. This became part of your dissertation, published in 1963 as "A Simplified Model of Portfolio Analysis." I did my dissertation under a strongly simplified assumption that only one factor caused correlation. The result I got was in that setting, prices would adjust until expected returns were higher for securities that had higher betas, where beta was the coefficient with "the factor." Portfolio Theory focused on the actions of a single investor with an optimal portfolio. You wondered what would happen to risk and return if everyone followed Markowitz and built efficient portfolios. I said what if everyone was optimizing? They've all got their copies of Markowitz and they're doing what he says. Then some people decide they want to hold more IBM, but there aren't enough shares to satisfy demand. So they put price pressure on IBM and up it goes, at which point they have to change their estimates of risk and return, because now they're paying more for the stock. That process of upward and downward pressure on prices continues until prices reach an equilibrium and everyone collectively wants to hold what's available. At that point, what can you say about the relationship between risk and return? The answer is that expected return is proportionate to beta relative to the market portfolio. In a paper I finished in 1962 that was published in 1964, I found you didn't have to assume only one factor. That basic result comes through in a much more general setting. There could be five factors, or 20 factors, or as many factors as there are securities. In a Markowitz framework, where people care about the expected return of their portfolios and the risk as measured by standard deviation the results held. That paper was called "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions Of Risk." Eugene Fama called it the Capital Asset Pricing Model. That's where the name came from. The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in one security as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing badly in bad times. Beta is a measure of that. Securities or asset classes with high betas tend to do worse in bad times than those with low betas.

Perhaps you never imagined that the CAPM would become a linchpin of investment theory, but did
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you believe it was something big? I did. I didn't know how important it would be, but I figured it was probably more important than anything else I was likely to do. I had presented it at the University of Chicago in January 1962, and it had a good reaction there. They offered me a job. That was a good sign. I submitted the article to The Journal of Finance in 1962. It was rejected. Then I asked for another referee, and the journal changed editors. It was published in 1964. It came out and I figured OK, this is it. I'm waiting. I sat by the phone. The phone didn't ring. Weeks passed and months passed, and I thought, rats, this is almost certainly the best paper I'm ever going to write, and nobody cares. It was kind of disappointing. I just didn't realize how long it took people to read journals, so it was a while before reaction started coming in.

What does the CAPM owe to finance research that came immediately before? The CAPM comes out of two things: Markowitz, who showed how to create an efficient frontier, and James Tobin, who in a 1958 paper said if you hold risky securities and are able to borrowbuying stocks on marginor lendbuying risk-free assets and you do so at the same rate, then the efficient frontier is a single portfolio of risky securities plus borrowing and lending, and that dominates any other combination. Tobin's Separation Theorem says you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there's only one portfolio plus borrowing and lending, it's got to be the market. Both the CAPM and index funds come from that. You can't beat the average; net of costs, the returns for the average active manager are going to be worse. You don't have to do that efficient frontier stuff. If markets were perfectly efficient, you'd buy the market and then use borrowing and lending to the extent you can. Once you get into different investment horizons, there are many complications. This is a very simple setting. You get a nice, clean result. The basic philosophical results carry through in the more complex settings, although the results aren't quite as simple.

The University of Chicago's Gene Fama and Yale University's Ken French came up with the ThreeFactor Model, which states that beta matters less than either market capitalization or book-tomarket value. Do Fama and French exaggerate? All empiricists, myself included when I do empirical work, tend to exaggerate the importance of their particular empirical study. There are different time periods, different markets, different countries. You don't always get the same thing. Fama and French are looking at the question: Using historical manifestations of these ex-ante constructs, can we confirm that expected returns are related to beta and/or
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related to book-to-price and/or related to size? Given what they did and how they did itusing realized average returns, which are not expected returnsthey found a stronger empirical correlation with book-toprice and with size than to their measure of historic beta. The size effect and the value/growth effect had been written about before, so neither of these phenomena were new What was new was that Fama and French got that very strong result at least for the period they looked atwhich, by the way, included the mid-1970s, a very good period for value stocks, which really drove up those results.

Fama and French's results were a product of the time period they examined? There's a whole industry of turning out papers showing things "wrong" and "partially wrong" with the Fama- French study. I have not been part of that industry. I would only point out that during that period in the United States, value stocks did much better than growth. In the bear market of 1973 and 1974, people thought the world was coming to an end. It didn't come to an end. Surprise. The stocks that had been beaten down came back, and they came back a lot more than some of the growth stocks. Maybe in an efficient market, small stocks would do better because they're illiquid, and people demand a premium for illiquidity That gets to be less compelling if you start thinking about mutual funds that package a bunch of small stocks and therefore make the illiquid liquid. As people figured that out, they'd put money into those funds, which would drive up the price of small stocks, and there goes the premium. For the value/growth effect, there's the behaviorist story that people overextrapolate. I have quite a bit of sympathy with that. I'm a bit of a fan of behavioral financethe psychology of marketsso I don't dismiss that argument out of hand. Since the studies about the size effect were published, small stocks have not done better than large stocks on average. Since the publicity about the value effect, value stocks haven't done as well as before around the world. So there's always the possibility that whatever these things were may have gone away, and that the publication of these studies may have helped them go away. It's too early to tell. It's a short data period. One would not want to infer too much, except that rushing to embrace those strategies has not turned out to be a very good idea, recently, certainly in the United States.

Empiricism is integral to investment theory. Do you discount such methodology? I wouldn't discount it. I do it, and we all look carefully at the results. But it's been my experience that if you don't like the result of an empirical study, just wait until somebody uses a different period or a different country or a different part of the market. In the data it's hard to find a strong, statistically significant relationship between measured betas and average returns of individual stocks in a given
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market. On the other hand it's easy to build a model of a perfectly efficient market in which you could have just that trouble in any period. The noise could hide it. The optimal situation involves theory that proceeds from sensible assumptions, is carefully and logically constructed, and is broadly consistent with the data. You want to avoid empirical results that have no basis in theory and blindly say, "It seemed to have worked in the past, so it will work in the future." That's especially true of anything that involves a way to get something for nothing. You're not likely to get something for nothing as long as you've got investors looking to get something for nothing.

Fama and French claim the Three Factor Model is an extension of the CAPM. Would you agree? To the extent that the Fama-French study is a richer way of measuring the probability of doing badly in bad times, then there's nothing inconsistent with the Capital Asset Pricing Model. But there's a lot of confusion and inconsistency in how some people take the Fama-French results to market and advocate a big value tilt and a big small tilt in your portfolio. If those are just measures of an unrealized but futurelooking beta, then you shouldn't have those tilts unless you happen to be one of those people who doesn't care how badly you do when times are bad. We do care when times are bad. Otherwise, there shouldn't be a risk premium for anything.

What about the Arbitrage Pricing Theory, which was originally proposed by Steve Ross at Yale? Is the APT stronger than the CAPM? Yes and No. The APT assumes that relatively few factors generate correlation, and says the expected return on a security or an asset class ought to be a function of its exposure to those relatively few factors. That's perfectly consistent with the Capital Asset Pricing Model. But the APT stops there and says the expected return you get for exposure to factor three could be anything. The CAPM says no if factor three does badly in bad times, the expected return for exposure to that factor ought to be high. If that factor is a random event that doesn't correlate with whether or not times are bad, then the expected return should be zero. The APT is stronger in that it makes some very strong assumptions about the return-generating process, and it's weaker because it doesn't tell you very much about the expected return on those factors. The CAPM and its extended versions offer some notion of how people with preferences determine prices in the market. The CAPM tells you more. The CAPM does not require that there be three factors or five factors. There could be a million. Whatever number of factors there may be, the expected return of a security will be related to its exposure to those factors.

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Ross has said the APT came from dissatisfaction with the CAPM's assumptions. You can't actually build a portfolio if you stop at the APT. You've got to figure out the factors and what the returns are for exposure to each factor. Some advocates of the APT have said one should just estimate expected returns empirically. I have argued that's very dangerous because historic average returns can differ monumentally from expected returns. You need a factor model to reduce the dimensions, whether it's a three- factor model or a five-factor model or a 14 asset-class factor model, which is what I tend to use. The APT says if in fact, returns are generated by a factor model, then without making any strong assumptions in addition to the modelwhich is strong to begin withyou can't assign numeric values to the expected returns associated with the factors. The CAPM goes further, putting some discipline and consistency into the process of assigning those expected returns.

So the great factor debate rages on. I'd be the last to argue that only one factor drives market correlation. There are not as many factors as some people think, but there's certainly more than one. To measure the state of the debate, look at textbooks. Textbooks still have the Capital Asset Pricing Model because that's a very fundamental economic argument.

You've devoted much of your career to the study and understanding of market risk. Are today's investors focused enough on the downside? Investment decisions are moving to individuals who are ill-prepared to make them. These are complicated issues. To say, here are 8,000 mutual funds, or even here are 10, do what's right, is not very helpful. The software versions and some of the human versions of the advice that people are getting often seem to ignore risk. They're bookkeeping schemes in which you earn 9% every year like clockwork. You die right on schedule. There's no uncertainty at all. Making a decision as to stocks vs. bonds vs. cash and about how much to save, without even acknowledging uncertaintylet alone trying to estimate itseems to me the height of folly.

You've acknowledged your fascination with computers. What about your latest venture, Financial Engines, which will be available over the Internet? We're working to help people understand the downside possibilities of different strategies, as well as the upside. There are two dangers that arise when people are ill-informed. One is that they won't realize what

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they've done. So when times are bad, they'll be very disappointed. If you just take somebody's current investments and project return without any notion of risk, you give them a wildly distorted view of what their future might hold. It may be the best point estimate if you've done it carefully, but they have no notion of how good it can get or how bad it can get. So when and if it gets bad, they're not only likely to be desperately disappointed if they're already retired, they're also likely to do the wrong thing if they haven't retired. In classrooms for decades, we've presented investments as a risk/return tradeoff.. Now, people are being presented investments as a return/return trade-off. There ought to be a law against that. Instead, we can help people understand the range of outcomes associated with different investments and help them find combinations of investments that are optimal.

How will the Internet impact the financial advisory business? I don't think the Internet is the death knell for financial planning, but it certainly will affect it. There may be a migration to higher-net-worth individuals, or advisors will charge less and service more clients be cause they have better tools. At Financial Engines, we are focusing on investors who don't get any good advice. They get tips from their supervisor or relatives. These people really can't afford a financial advisor. The Internet is going to be potent and powerful for them. But that's not displacing advisors; it's bringing good advice to those who don't have it. An upper level will always have human financial planners because, as a percentage of their assets, planners aren't very expensive. Even at that level, software is going to be increasingly important. The real issue is what happens in the middle. Almost everyone will get more computer and Internet input. There's going to be more of that and less of human beings in the mix. You can't afford to pay 3% of your money every year for advice, no matter how good it is.

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Revisiting the Capital Asset Pricing Model - Pictures

Revsititing The Capital Asset Pricing Model


by Jonathan Burton Pictures and Captions

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The Distribution Builder: A Tool for Choosing Among Equal-cost Probability Distributions

The Distribution Builder: A Tool for Inferring Investor Preferences


William F. Sharpe, Daniel G. Goldstein and Philip W. Blythe*
This version: October 10, 2000

Abstract
This paper describes the Distribution Builder, an interactive tool that can elicit information about an investor's preferences. Such information can, in turn, be used when making decisions about investment alternatives over time for that investor. The approach can also be employed when conducting surveys designed to obtain data on the cross-section of investor preferences. Hopefully, such data can provide insights that can lead to more realistic models of equilibrium in capital markets. The approach asks an investor to choose among alternative probability distributions for end-of-period wealth, where only distributions with similar overall costs are allowed. Importantly, the cost of any distribution is consistent with a model of equilibrium pricing in capital markets. We show how such a model can be calibrated and how information about an investor's marginal utility of wealth can be inferred from his or her choice of a distribution.

Introduction
Models in Financial Economics are frequently built on assumptions about the preferences of investors. For example, the original Capital Asset Pricing Model1 followed the approach developed by Markowitz2, in which each investor is assumed to wish to maximize a linear function of the mean and variance of portfolio return. Moreover, investors are assumed to differ in their willingness to substitute mean return for variance of return. Given a world of such investors, the CAPM derives equilibrium conditions for
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security prices and the relationships among risks, correlations and returns. Its key implications for optimal portfolio holdings are that the (wealth-weighted) average investor should hold all securities (the market portfolio) while investors with less (more) tolerance for risk should invest less (more) in the market portfolio and more (less) in a riskless security. Other equilibrium asset pricing models use more detailed models of investor preferences. Many start from explicit assumptions about the relationship between an investors utility and wealth or consumption. For example, a multi-period model of equilibrium may characterize an investors preferences in a manner that involves both a measure of risk tolerance and another relating to time preference3. As with simpler models, in equilibrium the wealth-weighted average investor should hold the market portfolio while others should adopt different strategies, depending on their relative degrees of risk tolerance and timepreference. More recent models utilize utility functions with more parameters and hence obtain results that imply more diversity in optimal portfolio holdings4. Most asset pricing models focus on the prices of assets in equilibrium and the resulting relationships among risks, returns and correlations of returns. For such purposes the use of relatively simple characterizations of investor preferences may be perfectly reasonable. However, to explain actual investor holdings or to advise investors concerning optimal strategies it may be necessary to adopt a richer characterization of investor preferences or, at the very least, to have a better understanding of actual preferences so that a parsimonious characterization of such preferences can be utilized. Not surprisingly, when choosing a form of utility function theorists have taken into account not only plausibility but also analytic tractability. This has led to "traditional assumptions" in one area that differ from those in another. For example, many life-cycle models of investor behavior assume that investor preferences exhibit constant relative risk aversion5. On the other hand, many models that focus on information assume that investor preferences have constant absolute risk aversion6. Any given investor could have one or the other, a function that exhibits one kind of behavior in one range of outcomes and the other in another range, or an entirely different type of function. But it cannot be the case that every investor has both functions at once. To understand at least some phenomena and to offer investors the best possible advice, it is desirable to know more about the actual preferences of individuals. There are two ways to approach this subject. The first, common in the finance literature, is to make assumptions about preferences, imply equilibrium implications, then evaluate the degree of consistency of the implications with empirical data7. The second, common in the literature in cognitive psychology and behavioral finance, is to present subjects with alternative choices and infer preferences from the resulting selections. Prominent in the latter tradition is the work of Kahneman and Tversky8, which showed that individuals in experimental settings make choices that are inconsistent with some of the standard properties of the utility functions and axioms of choice used in most theories in Financial Economics. One of the key findings from the psychological studies of choice under uncertainty is the importance of framing. Subjects presented with alternatives that are the same in objective terms will often make
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different selections if the alternatives are described in one way rather than another9. This makes it imperative that attempts to elicit an investors true preferences involve choices among alternative outcomes that are as similar as possible to those available in actual capital markets, with the alternatives stated in terms that are relevant for the individual in question. This paper describes a method designed to aid in this process. We introduce a tool called the distribution builder that allows an individual to examine different probability distributions of future wealth and choose a preferred distribution from among all alternatives with equal cost. An important features is the requirement that, in order to make the choice set realistic, the cost of each distribution is consistent with an equilibrium model of asset pricing in capital markets . Finally, the nature of the distribution is presented in a manner designed to be easily understood by those not familiar with probabilistic analyses. We envision two major uses for this tool. The first is normative in nature. Once an individual has chosen a distribution, it is possible to determine an investment strategy through time that will provide that distribution. With this information a third party could provide advice or implementation to help the investor meet his or her goals. The second application relates to positive models of asset pricing and investor behavior. Once an individual has chosen a distribution using the tool it is possible to make inferences concerning his or her utility function. Given experimental data of this type from a number of individuals it should be possible to better select a set of parsimonious assumptions about investor preferences for building equilibrium capital market models. As an illustration of these two types of application, consider investments such as equity index-linked notes that offer "downside protection" and "upside potential". An investor who purchases such an instrument may not fully understand the trade-offs involved in choosing the associated distribution over one that would result from a more traditional strategy such as a combination of an equity index fund and a riskless asset. The distribution builder can help make such trade-offs clear and allow an investor to make a more informed choice among alternative strategies. Turning to considerations of equilibrium we know that in order for markets to clear, a minority of investors should adopt such strategies with an equal minority (in value terms) adopting strategies with the opposite characteristics10. However, theory alone cannot provide information concerning the sizes of such minorities. In equilibrium, when investors fully understand the trade-offs, should 45% purchase downside protection, 45% provide it and only 10% adopt more traditional investment strategies, or are the percentages 1%, 1% and 98%, or even 0%, 0% and 100% (as in models such as the CAPM)? The answer will ultimately depend on the cross-sectional distribution of investor preferences. Widespread experimentation with tools such as the distribution builder should make it possible to better assess the characteristics of investors in a given market. The plan of the paper is as follows. Section 1 shows how a distribution builder presents a probability distribution in terms easily understood and manipulated by users. It also describes the role of the budget constraint in limiting possible choices.
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Section 2 describes a method used to compute the least cost of a distribution, given a set of ArrowDebreu prices for possible future states of the world, where each state is equally probable. Section 3 shows how attributes of a user's utility function can be inferred from his or her choice of distribution, given the underlying Arrow-Debreu prices. Section 4 shows how a simple binomial pricing model can be used both to compute the required Arrow-Debreu prices and to determine a specific dynamic strategy that will provide a chosen distribution. Section 5 provides a summary and conclusions as well as suggestions for further research.

1. The User Interface


A Distribution Builder lets people build and explore different probability distributions of a future source of utility, such as wealth or retirement income, under the constraints of a fixed budget. Figure 1 shows a typical user interface. The main parts of the tool are the large square playing area, a given number of "people" (here, 64), the reserve row (along the bottom of the playing area), and the budget meter. In this case the source of utility is income per year after retirement, expressed as a percentage of income in the year prior to retirement. Here, the user is told that the tool can help make decisions about the likely ranges of retirement income. Using the mouse, the user can place the people in different rows, forming patterns against the vertical axis. Thinking of the number of people in a row divided by the total number of people as a probability, it can be seen that each pattern is equivalent to a probability distribution over levels of wealth. When the user begins interacting with the tool, all the people are in the reserve area and the budget meter (explained below) does not display a value. The user is told that she is represented by one of the people, but that all people look identical and there is no way to tell in advance which person she is. Given this information, the user is instructed to use the tool to create patterns that she would happily have apply to her own retirement income. The user can then place all the people on the playing field and arrange them into patterns against the income percentages on the vertical axis. Each distribution that can be made with the Distribution Builder has an associated cost that is displayed on the budget meter. This cost is not the expected value of the probability distribution, but rather the amount of a hypothetical 100 unit budget that would be required to achieve that distribution of wealth using the cheapest possible dynamic investment strategy. When using the Distribution Builder, the user cannot select a final pattern that does not use 100 units of the budget. In the application shown in Figure 1 the most conservative distribution that uses up the budget is achieved by placing all the people in the 65% row (which corresponds to investing all funds in a risk-free account). From this point, a little downside risk is rewarded with even greater upside possibilities. For instance Figure 1 shows a case in which (1) 4 people were moved from the risk-free 65% row to the 35% row and (2) 12 people were moved from the 65% row to the 200% row nonetheless leaving a small part
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of the budget unused. For some purposes, the use of the tool ends when the user has selected his or her preferred feasible distribution. However, in some contexts it proves useful to include a second stage that simulates the realization of a specific outcome in order to help the user better understand the nature of probabilities. In the example shown in Figure 1, once the user decides on a desirable pattern, she can submit it to learn which of the people she is, and experience the process of learning how her retirement investment turned out. In this mode, after the user submits a distribution, the people begin to disappear from the board one by one until the only the only one left is the one representing the participant. This discrete representation of probability, in which the participant can envision herself as one of a number (here, 64) of people, should appeal to humans preferential understanding of probabilities as frequencies11.

2. Pricing a Probability Distribution


A key feature of the Distribution Builder is the pricing of probability distributions in a manner consistent with equilibrium in capital markets. We assume that the investor will choose combinations of broad asset classes and hence can achieve higher expected returns by taking on market-wide risk. To represent such trade-offs we utilize an Arrow-Debreu framework and procedures of the type developed by Dybvig12. A method for determing the underlying state prices is described in section 4. Here we focus on the use of such prices. Consider an investor who is concerned only with the distribution of wealth at a specified horizon date H. We assume that her utility is a function solely of wealth at that date. To simplify the analysis we assume that there are N mutually exclusive and exhaustive states of the world at the horizon date, and that each of the states has a probability of taking place equal to 1/N. The investor's ex ante measure of the desirability of a probability distribution is its expected utility, computed by weighting the utility of each possible outcome by its probability. The investor has a given budget B and wishes to obtain a probability distribution of wealth that will maximize her expected utility without exceeding her budget. We assume that there is a market in which one can obtain claims on wealth in the states and that the market is sufficiently complete that it is possible to arrange to obtain any given amount of wealth in one state and none in any other. The cost of obtaining $1 in state i is pi. At least some prices are different, but we allow for cases in which two or more states have the same price. Without loss of generality, states will be numbered in order of increasing prices. Thus pi<=pi+1 for all i. The vector of these Arrowfile:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/qpaper.html (5 of 17) [15/10/2001 10:51:47]

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Debreu state prices, [p1, p2, ..., pN] will be denoted p. Consider an investor who desires a distribution of wealth D in which there is probability na/N of receiving wealth wa, probability nb/N of receiving wealth wb, and so on, where na, nb,... are integers. We may represent such a distribution by a vector of N wealth values in which na values are equal to wa, nb are equal to wb and so on. For reasons that will become clear, we choose to arrange these values in order of decreasing wealth values. Thus wi>=wi+1 for all i. The vector of wealth values, [w1,w2,...,wN] associated with distribution D will be denoted w. Given our convention, there is a one-to-one mapping between the distribution D and the wealth vector w in the sense that for any distribution D there is a given wealth vector w and for any wealth vector w there is a given distribution D. To obtain a set of payoffs with a given distribution D it is only necessary to assign each of the N wealth values in w to one of the N states of the world. We will call such an assignment an investment strategy. To determine the cost of any strategy one simply multiplies the price in each state times the wealth to be obtained in that state and sums the resulting products for all the states. Clearly, there will be many possible ways to obtain a given distribution D and their costs may differ. We assume that the investor prefers to obtain a given distribution D using the strategy with the lowest cost. The goal is to find such a strategy and compute its cost. In this section we show how to compute the cost of such a strategy, in section 4 we discuss a procedure that can derive actual investment rules to achieve a desired strategy. Consider an investment strategy in which wi is assigned to state i, recalling that the states have been numbered in order of increasing prices and that the desired wealth values have been arranged in order of decreasing wealth. The cost of this strategy will be C = p'w. Importantly, there is no other investment strategy that will provide the distribution represented by w at a lower cost, although there may be others with the same cost. To see why C = p'w is the lowest cost for which the distribution represented in w can be obtained, consider the conditions that would make a strategy not least-cost. Assume that for two states i and j, pi<pj and wi<wj. The cost associated with obtaining wi and wj is piwi+pjwj. But this can be reduced by switching the two wealth levels, so that wj (the larger value) is obtained in state i (the cheaper state) and wi (the smaller value) is obtained in state j (the more expensive state). Hence any strategy that allows for this kind of re-arrangement cannot be least-cost. Now consider the manner in which the desired distribution was mapped onto states in our procedure. Since prices are non-decreasing in state number and wealth is non-increasing, there will be no cases in which any such re-arrangement can be used to lower total cost. Hence our procedure will always provide an investment strategy that is least cost.

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Unless prices are strictly increasing in state number and wealth levels strictly decreasing, there may be alternative investment strategies that are least-cost, but under the assumption that utility is not statedependent, the investor will be indifferent among all such strategies. Clearly, a necessary condition for solving the investor's problem is the choice of a least-cost investment strategy. The design of the distribution builder restricts the investor's attention to such strategies. In this sense the investor is provided with investment expertise, allowing her to avoid strategies that are clearly suboptimal.

3. Inferring Attributes of a User's Utility Function


Implicitly, the user of the Distribution Builder is presented with a set of N Arrow-Debreu state prices and asked to choose a wealth for each one. If the goal is to determine an optimal investment strategy for the user this may be sufficient information. However, if other choices are to be made for the individual or if the information is to be used for calibrating models of equilibrium it is useful to interpret the resulting set of choices as consistent with the maximization of the expected value of a utility function of wealth and to infer some of the attributes of that function. Here, following Dybvig, we show how attributes of a user's utility function can be inferred from the distribution chosen. Let u(w) represent the user's utility u as a function of wealth, w. The goal is to maximize the expected value of u(w) subject to the constraint that p'w=B. Assume that the investor's utility function is smooth13. Let i be the probability of state i. To maximize u(w) subject to the budget constraint requires the satisfaction of the first order conditions that: iu'(wi) = kpi for each state i where u'(wi) is the marginal utility14 of wi and k is a constant. Since we have assumed that every state is equally probable, this can be written as: pi = u'(wi) for each state i where = (1/N)/k.

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Thus under the assumed conditions we may interpret pi, the price of state i, as a constant times the user's marginal utility for the wealth wi selected for that state. Thus the chosen distribution provides points on the investor's utility curve. To illustrate, consider an investor with a power utility function (which exhibits constant relative risk aversion)15. Such a function has the form: u(w) = w(1-g)/(1-g ) giving a marginal utility of wealth of: u'(w) = w -g Taking logarithms of both sides and writing the relationship for a specific state i gives: ln(u'(wi)) = -g ln(wi) As we have shown, the first order condition implies that: pi = u'(wi) which can be written as: ln(pi) = ln( ) + ln(u'(wi)) Combining the two equations gives: ln(pi) = ln( ) - g ln(wi) We thus conclude that a user who maximizes the expected utility of wealth and who has a power utility function will select a distribution for which there is a linear relationship between ln(pi) and ln(wi), with the slope of the line equal to the negative of the exponent g in the underlying utility function. There is, of course, no reason to believe that all users have power utility functions, nor that they will choose distributions that maximize the expected utility of this or any other utility function. Indeed, the relationship between p and w can be examined to assess the degree to which the user's choice conforms to maximization of any specified type of utility function. Nonetheless, given the prominence of the power utility function in the literature on lifetime consumption and investment planning, it seems especially relevant to investigate the extent to which the relationship between ln(p) and ln(w) for a user's choices can be approximated by a linear function.
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Other questions can also be addressed by examining the relationship between p and w. For example, the maximization of a smooth utility function with a continuous first derivative requires that there be a oneto-one mapping between state prices and the associated levels of wealth. A kink in a user's utility function may be revealed by the choice of the same wealth in states with two or more different prices. While the results that can be obtained with a Distribution Builder are limited in scope, they may well shed some light on investor preferences light that is badly needed for both positive and normative applications.

4. Using a Binomial Process to Generate Prices and to Determine Strategies


Thus far we have not indicated the way in which the set of state prices p utilized in an experiment might be chosen. In doing so, the goal is to utilize a set of prices that presents the user with trade-offs similar to those associated with actual investment markets. This section shows how a simple return-generating process can be used to generate a set of Arrow-Debreu prices and to also provide the rules for an investment strategy that can provide the chosen distribution at least cost.

4a. Characteristics of the Return-generating Process A simple way to generate a set of Arrow-Debreu prices rests on the assumption that stock market returns follow a binomial process16 in which there are two possible states of the world in each of a number of periods. We assume that the investor is allowed to allocate his or her assets between the stock market and a riskless security in each of H periods and that there are no transactions costs associated with any reallocation between these assets from period to period. To make the process even simpler, we assume that both the riskless rate of interest and the distribution of returns on the stock market are constant from period to period. In other words, we assume that returns are independent and identically distributed (I.I.D). In any period, if the state of the world is that the market is up, $1 invested in the riskless asset will grow to have a value of $vr, and $1 invested in the stock market will grow to have a value of $vu. If the state of the world is that the market is down, $1 invested in the riskless asset will still grow to have a value of
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$vr, but $1 invested in the stock market will fall to a value of $vd. Finally, we assume that the two states of the world (up and down) are equally probable.

4b. Computing Arrow-Debreu Prices Consider an investor who wishes to have $1 at the end of a period if and only if the market is up. Assume that she may take either a long or a short position in one or both assets. Then, it will be possible to find a strategy using the two investments that will produce the desired payments. One only needs to solve the set of simultaneous equations: xrvr + xsvu = 1 xrvr + xsvd = 0 where xr represents the dollars invested in the riskless asset and xs the dollars invested in the stock market. The cost of the resulting strategy (xr+xs) is the cost today of achieving a payment of $1 at the end of one period if and only if the state of the world is up. We denote this pu (the price of $1 if the state is up). Replacing the right-hand side of the simultaneous equations with 0 and 1 provides the strategy that will provide $1 if and only if the state is down. Its cost will be denoted pd (the price of $1 if the state is down). To illustrate, assume that a period is one year and that all returns are in real terms. Let vr=1.02, vu=1.22 and vd=0.92. Then pu = 0.3268 and pd = 0.6536. These are the state prices implicit in an economy in which the real rate of interest is 2%, the expected real return on the stock market is 5%, and the standard deviation of the real return on the stock market is 15% -- values not unlike those frequently used for projections made by academics and investment professionals17. Our simple one-period market is complete in the sense that the available securities allow the purchase of any set of outcomes over states at known prices. In such a market it is reasonable to assume that there are no possibilities for arbitrage (the ability to find an investment strategy that costs nothing to undertake, will provide positive income in one or more states and will provide negative income in no states). If the market is indeed arbitrage-free, each security will sell for an amount equal to the sum of the products of its payoff in each state times its state-price. Now consider a multi-period setting in which there are H periods, each of which has the same distribution of outcomes. The simple two-branch tree process is now a substantial tree. There will be 2H different paths through the tree and hence potentially different wealth levels for different investment strategies. Let N (=2H) be the number of such paths. We seek pi, the cost today of obtaining $1 at the horizon if and only if path i is realized.
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In this case the price for a path can be determined directly once the number of "up" branches along the path has been specified. Let nui be the number of such branches along path i and ndi (=H-nui) the number of down branches. If there are no multi-period arbitrage opportunities, the cost of receiving $ if and only if the path occurs will be:
nu nd pi = pu i pd i

since this will be cost of obtaining the payoff by using one-period investments as the path develops. The relationship may be written in terms of the number of up branches on the path:
nu (H-ndi) pi = pu i pd

or as:
nu pi = pdH (pu / pd) i

In our example, pu<pd, hence the parenthesized ratio is less than one, indicating that the price of a path will be smaller, the greater the number of up markets along the path. Note that all paths with the same number of up branches will have the same price. Thus, although there will be 2H different paths, there will be only H+1 different prices (this follows from our assumption that the binomial process is I.I.D.). To maintain generality, we consider each path a different "state of the world" at the horizon, so that the number of states (N) will equal 2H. Recall that we wish to number states so that pi increases with i. To do this requires only that we number the states in order of decreasing nui, so that nui>=nui+1 for all i. Thus state number 1 will represent a path in which the market goes up every period, states 2 through H+1 will represent paths in which the market goes up in one period and down in the other periods, and so on. Note that the assignment of numbers to paths is not unique. This implies that more than one investment strategy may provide a given distribution of terminal wealth for the same least cost amount.

4c. Finding a Dynamic Strategy The Distribution Builder allows a user to construct any distribution. It is then priced using Arrow-Debreu prices. Eventually the user chooses a distribution which uses up her entire budget -- a distribution that is presumed to be preferred to all other feasible distributions. As indicated earlier, for some purposes this is all that is needed. In other cases it may be important to find an actual strategy that can provide the chosen
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distribution. Such a strategy will specify an initial mix of stocks and the riskless asset and a set of rules for changing this mix, depending on the path followed by the stock market up to each date until the horizon is reached. Given a distribution D and a least cost implementation w, it is possible to determine the precise dynamic strategy that will produce the vector w. This can be done in one stage by solving a large linear programming problem18. Alternatively, the solution can be obtained by folding back the tree from its terminal nodes19. For each pair of terminal nodes with the same predecessor, the required amounts invested in the riskless asset and stocks can be found by solving the two simultaneous equations in two unknowns using the desired terminal wealth levels as the right-hand side. This provides the amount of money required at each of the nodes for period H-1. Once this has been done for all pairs of terminal nodes, the procedure can be repeated for the each of the pairs ending in period H-1, using the amounts determined in the prior step. The process is then repeated until the initial node is reached. The amount of money required at time 1 will, of course, equal p'w, which can be computed directly, as we have shown. However, the added information provides a complete set of instructions for allocation between cash and stocks at each node in the tree, and thus constitutes a detailed dynamic strategy. The dynamic strategy required to obtain a chosen distribution may be simple or complex. In the current setting, in which returns are I.I.D., a constant mix strategy (with the same percentages invested in the two assets at all times and circumstances) will be optimal if an investor's preferences can be represented by a power utility function. As we have shown, such preferences will lead to the choice of a distribution for which there is a linear relationship between ln(p) and ln(w). Departures from such a relationship are especially interesting since they will generally imply a preference for outcomes that will require strategies that are truly dynamic, requiring changes in allocations of funds among major asset classes as the investor's wealth changes20.

5. Summary and Suggestions for Further Research


We have described an approach that can be used in either experimental or practical applications. In either case, the goal is to obtain information about an individual's preferences based on his or her choice from alternative distributions of outcomes with the same cost. Key to the procedure is its focus on realistic alternatives that reflect the manner in which capital markets can evolve. Our goal has been to illustrate the approach with a relatively simple example in the hope that others will apply and extend it. To conclude we briefly outline some possible avenues for further research followed by a few caveats.
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Our example employed 64 people in order to utilize a binomial model of asset price behavior. One could of course use a larger number of periods in the return-generating process, expanding the number of people to 128, 256 or any power of two, thereby providing the user with more degrees of freedom. Alternatively, one could employ a discrete approximation to a continuous distribution of Arrow-Debreu prices21. Among other things, the latter approach would allow for a presentation involving 100 people, which would have the advantage of equating the number of people associated with an outcome with the probability of that outcome. While it may prove convenient to assume that stock prices are independent and identically distributed (I.I.D.), there is no need to do so. For example, prices could be assumed to follow a binomial process in which the expected stock return, variance of stock return and/or riskless rate of interest could be dependent on prior events. More complex stochastic processes22 could also be utilized, as long as sufficient instruments exist to span the set of outcomes so that Arrow-Debreu prices can be calculated. While the approach is rich in possibilities, it is not without limitations. Our example required the user to focus on a single outcome (income in retirement). One can envision variations that would utilize two outcomes (for example, savings per year prior to retirement and wealth at retirement)23 but extensions designed to estimate characteristics of a user's full multi-period utility function would require restrictions on the assumed nature of user preferences. Finally, there are serious questions about the ability of a user to fully understand the trade-offs presented by the Distribution Builder. In some cases understanding might be better if the underlying Arrow-Debreu prices were presented explicitly. In other cases, a user might need to engage in several experiments before fully understanding the nature of the available alternatives. Hopefully, behaviorists will be able to perform experiments that can lead to presentations that more efficiently obtain information about users' true preferences.

Footnotes
* William F. Sharpe is STANCO 25 Professor of Finance, Emeritus at Stanford University and Chairman, Financial Engines, Inc.. Daniel G. Goldstein is Director, Products Division at the Fatwire Corporation. Much of this work was performed when Goldstein and Blythe were associated with the Center for Adaptive Behavior and Cognition at the Max Planck Institute in Berlin. An early version of this paper was presented at the Third International Stockholm Seminar on Risk Behaviour and Risk Management in June, 1999.

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1. Sharpe, 1964 2. Markowitz, 1952 3. See, for example, Hong and Wang, 2000 4. See, for example, Epstein and Zin, 1989 and Constantinides, 1990 5. See, for example, Barberis, 2000 6. See, for example, Hong and Wang, 2000 7. For an overview, see Campbell, 2000 8. Kahneman and Tversky, 1979 9. For a discussion of this and other aspects of interest in this context, see Shefrin, 1999 10. For a formal model, see Brennan and Solanki, 1981 11. For a discussion, see Gigerenzer, 1994. 12. The basic concept of state-prices was developed in Arrow, 1964 and Debreu, 1959. The computation of the least-cost of a distribution is presented in Dybvig, 1988. 13. More precisely, that the first derivative is continuous. 14. that is, the derivative of u(w) with respect to w at w=wi. 15. For a discussion of the properties of this and other forms of utility functions, see Huang and Litzenberger, 1988 16. initially developed in Sharpe, 1978 and greatly expanded in Cox, Ross and Rubenstein, 1979 17. See Welch 1999 18. See, for example, Sharpe, 2000

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19. See, for example, Sharpe, Alexander and Bailey, 1999, pp. 616-622. 20. For a related discussion, see Perold and Sharpe, 1988 21. For example, in the limit (as the number of periods H goes to infinity), the Arrow-Debreu prices for an IID process converge to a lognormal distribution. 22. such as trinomial processes in which there are three possible states of the world in each period. 23. For example, the user could be presented with a grid in which one outcome is plotted on the horizontal axis and the other on the vertical axis. The user could then place people on cells in the grid.

References
Arrow, Kenneth J. "The Role of Securities in the Optimal Allocation of Risk-bearing," Review of Economic Studies, April 1964, pp. 91-96 Barberis, Nicholas, "Investing for the Long Run when Returns are Predictable," Journal of Finance, Vol. 55, no. 1 (February 2000), 225-264. Brennan, M.J. and R. Solanki, "Optimal Portfolio Insurance," Journal of Financial and Quantitative Analysis, 16, no. 3 (September 1981): 279-300. Campbell, John Y., "Asset Pricing at the Millennium," Journal of Finance, Vol. 55, no. 4 (2000) 15151568. Constantinides, George, "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy 94, (1990) 842-862. Cox, John C., Stephen A. Ross and Mark Rubinstein, "Option Pricing: A Simplified Approach," Journal of Financial Economics, 7, no. 3 (September 1979), 229-263. Debreu, Gerard, Theory of Value, The Cowles Foundation Monograph 17, 1959 Dybvig, Philip H., "Inefficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market," The Review of Financial Studies, (1988), Volume 1, Number 1, 67-88.
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The Distribution Builder: A Tool for Choosing Among Equal-cost Probability Distributions

Epstein, Lawrence and Stanley Zin, "Substitution, Risk Aversion and the Temporal Behaviour of Consumption and Asset Returns, A Theoretical Framework," Econometrica 57, (1989) 937-969. Gigerenzer, Gerd, 1994, Why the distinction between single-event probabilities and frequencies is relevant to psychology (and vice versa). In George Wright and Peter Ayton, Eds., Subjective probability (Wiley, New York). Hong, Harrison and Jiang Wang, "Trading and Returns under Periodic Market Closures," The Journal of Finance, Vol. 55, no. 1 (February 2000), 297-354. Huang, Chi-fu and Robert Litzenberger, Foundations for Financial Economics, Prentice-Hall (1988). Kahneman, Daniel and Amos Tversky, "Prospect Theory: An Analysis of Choices Involving Risk," Econometrica, 47 (1979), 263-291. Markowitz, Harry, "Portfolio Selection," Journal of Finance 7 (1952) 77-91. Perold, Andre F., and William F. Sharpe, 1988, "Dynamic Strategies for Asset Allocation", Financial Analysts' Journal, Jan/Feb, 16-27. Sharpe, William F., Investments, 1st Edition, Prentice-Hall, 1978. Sharpe, William F., "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," Journal of Finance, 19 (1964) 425-444. Sharpe, William F., Gordon J. Alexander and Jeffery V. Bailey, Investments, 6th Edition, Prentice-Hall, 1999. Sharpe, William F., Macro-Investment Analysis: Prices, Dynamic Strategies, 2000 www.wsharpe.com/mia/prc/mia_prc3.htm#dynamic Shefrin, Hersh, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, 1999. Welch, Ivo, "Views of Financial Economists On The Equity Premium And Other Issues," 1999, available at: http://welch.som.yale.edu/academics/#mktsurvey

Figure 1: A Distribution Builder Interface


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The Distribution Builder: A Tool for Choosing Among Equal-cost Probability Distributions

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crs.htm

Macro Investment Analysis


Stanford Graduate School of Business Professor William F. Sharpe

Available Outlines
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Finance 328: Spring 1996 Finance 328: Spring 1997 Finance 368: Spring 1998

Finance 368: Spring 1999

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Finance 328 -- 1996

Finance 328 Macro Investment Analysis


Stanford Graduate School of Business Professor William F. Sharpe Spring, 1996 NOTE: This is for information only. Many of the links shown here are no longer accurate

Overview
The official title of this course is Portfolio Management, and the course will indeed cover the subject of portfolio management. However, we take a particular view of the process, with emphasis on (1) the decisions that must be made by and/or for the ultimate investor and (2) the analytic tools and empirical evidence that can help inform such decisions. As explained in the reading material, we prefer to use the more specific title Macro Investment Analysis to reflect this focus. The course will be divided into two related, although sequential halves, called (somewhat simplistically) Theory and Practice. In the first half, principles, techniques and empirical material will be introduced through readings, lectures and discussion in a more or less linear manner. The second half of the course will be devoted to a cooperative effort to collectively simulate the operation of Stanford Financial Planners, a mythical firm dedicated to the application of the principles and techniques of Macro Investment Analysis to real investment decisions.

Grades
To complete the course you must prepare a financial plan for an investor. At any time during the latter half of the course you may be called upon to present an oral report on the portion of the plan that is required to have been completed at the time. Your overall grade will be based on the quality of your written report and any such oral reports. The larger the number of oral reports that you are called upon to present, the smaller the weight given your written report. Your contributions to class discussions will also be taken into account. In no instance, however, will your written report receive a weight of less than 70% when determining your course grade.
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Oral Reports and Class Attendance


At any time during the second half of the course, you may be called upon to give an oral report on your progress on the financial plan that you are preparing for your client, including any or all of the material scheduled to have been completed by that date. Students called upon to present such reports will be selected randomly each day using a simple algorithm. Initially, a list will be prepared on which each student's name appears ten times. A random number will be used to select a name from this list. After a student makes a presentation, one of the instances of his or her name will be removed from the list. This process will continue through the remainder of the course. However, no student's name will disappear entirely from the list. This means that you might be called upon more than ten times, although the probability is low. Each oral report will be given a regular grade (H,P+,P,P-,U) by the instructor, based on both the "degree of difficulty" and the performance of the requested task. If you are absent without authorization when called upon to present an oral report you will be assigned a U for the non-performance and the associated instance of your name will not be deleted from the list. You are entitled to one absence without cause during the quarter. To take it, you must send an email message to the instructor at least 24 hours prior to the class in question. Excused absences are rarely granted. However, if you wish to petition for one, do so by email at least 48 hours prior to the class in question.

Supplemental reading
The following books are recommended for those wishing to obtain foundation material, additional discussions, and/or another view on some of the subjects covered in the course. William F. Sharpe, Gordon J. Alexander and Jeffery V. Bailey, Investments, Fifth Edition. Englewood Cliffs, N.J.: Prentice-Hall, 1995 Mark Kritzman, The Portable Financial Analyst - What Practitioners Need to Know,. Chicago: Probus Publishing, 1995

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Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, Fifth Edition. New York: John Wiley & Sons, Inc., 1995

PART 1: Theory
At present, no printed textbook adequately covers the domain of this course. Instead, we will rely on the reading material described below. Material that is highlighted is only a click away via the web. The remainder of the material is included in the syllabus available to students registered for the course. All the web material can be accessed from either the instructor's home page:

http://gsb-www.stanford.edu/~wfsharpe/home.htm or from this page:

http://gsb-www.stanford.edu/~wfsharpe/328home.htm The instructor's goal is to provide all the material for this course on the web in a reasonably consistent and coherent form. Meanwhile, some of the subjects must be covered with material written in other forms for different audiences. To minimize confusion (the students' and also the instructor's), the latter's own publications were given a high priority in the selection process. Be assured that no royalties are involved. In the list below, highlighted readings are on the web and can be obtained directly. The remainder must be obtained on paper. The material listed for each session should be read before the date given. Those who have not read the material in advance may be confused, embarrassed and/or frustrated.

Introduction (April 3)
q q q q

Investment Approaches Financial Economics Models and Paradigms W.F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, July/August 1976, p. 4.

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W.F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, January/February 1991, pp. 7-9. J. Lakonishok, A. Shleifer, and R.W. Vishny, "The Structure and Performance of the Money Management Industry", Brookings Papers: Macroeconomics 1992, pp. 339-391.

Matrix Algebra (April 5)


q q q q

Matrices Matrix Operations MATLAB Asset Allocation with Investment Funds

Prices (April 9)
q q q q q

Time-state Claims Valuation Multiple Commodities, States and Times Interest Rates and Bond Yields Forward Prices

Probabilities (April 12)


q q q

Production, Consumption and Market Clearing Risk Premia Consumption and Investment Choices

Risk and Return (April 16)


q q q q q

Mean, Variance and Distributions Portfolio Choice Multi-period Returns Portfolio Characteristics Two-asset Portfolios

Optimization (April 19)


q

W.F. Sharpe, "An Algorithm for Portfolio Improvement," Advances in Mathematical Programming and Financial Planning, (K.D. Lawrence, J.B. Guerard, Jr., and Gary D. Reeves,

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Editors), JAI Press, Inc., 1987, pp. 155-170. W.F. Sharpe, "Practical Aspects of Portfolio Optimization," Improving the Investment Decision Process: Quantitative Assistance for the Practitioner and for the Firm, Dow-Jones Irwin (Homewood, Illinois), 1984, pp. 52-65. F. Black, F. and R. Litterman, "Global Portfolio Optimization," Financial Analysts Journal, September/October 1992, pp. 28-43.

Factor Models (April 23)


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q q

W.F. Sharpe, "Some Factors in New York Stock Exchange Security Returns, 1931- 1979," Journal of Portfolio Management, Summer 1982, pp. 5-19. W.F. Sharpe, "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. Setting the Record Straight on Style Analysis R.A. Grinold and D. Stefek, "Global Factors: Fact or Fiction?," Journal of Portfolio Management, Fall 1989, pp. 79-88.

Equilibrium (April 26)


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W.F. Sharpe, "Capital Asset Prices with and without Negative Holdings," Journal of Finance, June 1991, pp. 489-509. W.F. Sharpe, "Factor models, CAPMs, and the APT," Journal of Portfolio Management, Fall 1984, pp. 21-25. S. Benartzi and R.H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle"Quarterly Journal of Economics, February 1995, pp. 73-92. Carlo Capaul, Ian Rowley and W.F. Sharpe, "International Value and Growth Stock Returns," Financial Analyst's Journal, January/February 1993, pp. 27-36.

Dynamic Strategies (April 30)


q

W.F. Sharpe, "Integrated Asset Allocation," Financial Analysts Journal, September/October 1987, pp. 25-32. Andre Perold and W.F. Sharpe, "Dynamic Strategies for Asset Allocation", Financial Analysts Journal, January/February 1988, pp. 16-27. W.F. Sharpe, "Investor Wealth Measures and Expected Return," Quantifying the Market Risk Premium Phenomenon for Investment Decision Making, The Institute of Chartered Financial Analysts, 1990, pp. 29-37.

Currencies (May 3)
q

A.F. Perold and E.C. Schulman, "The Free Lunch in Currency Hedging: Implications for

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Investment Policy and Performance Standards," Financial Analysts Journal, May/June 1988, pp. 45-52. W.F. Sharpe, "Hedging Currency Risk in an International Portfolio," Investment Technology, Spring 1992, pp. 1-43.

Performance (May 7)
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W.F. Sharpe, "Adjusting for Risk in Portfolio Performance Measurement," Journal of Portfolio Management, Winter 1975. W.F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58.

PART 2: Practice
The second half of the course will be devoted to simulation of the activities of Stanford Financial Planners (SFP). SFP is a coalition of individual financial planners who have joined together to achieve economies of scale in database purchase and software development. Due to the exigencies of the latter activities, they somewhat grudgingly follow a common approach in some domains, while preserving independence in others. The business plan calls for SFP ultimately to have a suite of software and databases available for use on the internet following the protocols of the World Wide Web. Such material will be used by the SFP Associates and will be sufficiently general to allow direct use (for a fee) by any financial planner. The goal of the partners of SFP is to design software and databases that will provide wide latitude in terms of assumptions made, models employed, etc.. If the resultant systems are sufficiently valuable, it is possible that all the current partners of SFP will retire in one or two years, supported by the royalties from software licenses. Hence the partners consider the proper design of this material very important. Unfortunately, present reality is far from the ultimate goal. Many databases are available, but legal restrictions make it necessary for the firm's research department to provide some of the data analysis on a non-networked computer system. Some software has been written for the internet, but large gaps remain. Each student in the course will be one of the financial planners in SFP. The instructor will function as the research department. Each student will complete a financial plan for an client (investor) following guidelines set in SFP partners' meetings. At such meetings the group will discuss software, analyses
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and assumptions to be employed by the partners, and software and analytic methods that should be designed for future use and/or sale. At some such meetings, the research department may provide empirical analyses, using a computer with proprietary databases and non-internet software. Each student must prepare a financial plan for his or her client. The final written financial plan must be delivered to the instructor before Tuesday, June 11. The key parts of the financial plan are described briefly below, along with the date by which each part must be sufficiently complete to serve as the basis for an informative oral report.

Selection of a Client (April 16)


You must select a living human being for a client. He or she must be agree to provide sufficient information for you to create a useful financial plan. The client must also be willing to spend enough time to make choices that you may wish to present and to react to your suggestions. You need not disclose the identity of your client to the instructor or the class, but you will need to describe his or her financial situation, projected income, etc.. It is imperative that you inform the client that you are performing this analysis as part of an exercise for a class and that your recommendations have not been approved by Stanford University, the Stanford Graduate School of Business or the instructor in the course. You might wish to make the analogy of obtaining a haircut at a Barbers' College (or better yet: an appendectomy at a Medical School).

Current Balance Sheet (May 10)


You need to complete a balance sheet showing estimates of the values of the client's assets, liabilities and net worth. Each item should be an estimate of the value that the future cash flows (contingent or not) would command if they were traded in financial markets. While earnings from human capital and the costs of meeting future needs will generally be treated directly, as future cash flows, it is instructive to estimate the values of at least some of the associated assets and liabilities.

Current Investments (May 14)


This should be a detailed inventory of the investments in market-valued assets and any associated liabilities. Whenever possible, information that will help determine the investments' exposures to movements in major asset classes should also be obtained.

Planned Future Savings and Spending (May 17)


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While estimates of future savings (pre-retirement) and spending (post-retirement) are extremely difficult to make, they are central in most retirement planning processes. Such estimates typically must take into account predictions of future tax rates, degree of inflation, etc..

Current Asset Allocation and Level of Risk (May 21)


In this stage a set of asset classes to be utilized for the remaining analysis must be selected and the client's net exposures to each of the asset classes determined. This will typically require further analysis to estimate the exposure of each of the client's investments to one or more of the asset classes as well as an "adding up" based on the values of the various investments.

Recommended Current and Future Levels of Risk (May 24)


This task takes into account the client's current situation, planned future savings and spending, and predictions about the tradeoffs available in the capital markets of risk for expected return. The goal is to work with the client to determine the best overall level of risk, both now and in future years. The resulting policy may involve a constant level of risk, a level that changes with time, or even a level that changes depending on the results obtained in earlier years.

Recommended Changes in Asset Allocation (May 28)


This provides a possible implementation of the chosen level for the current year using passive investments in asset classes or surrogates for such classes.

Recommended Changes in Investments (June 4)


The final task is to recommend a set of investment vehicles that will provide the asset allocation recommended in the previous phase. Possible choices include (but are not limited to) index mutual funds, active mutual funds, asset allocation funds, closed-end funds, and financial derivatives.

Final Report (June 11)


The final report will have two sections. The first section is designed for the client; it should be written in a manner that he or she can easily understand. The second section is designed for the other partners in the firm and should contain information concerning the approach taken in the plan, the assumptions made, supporting analysis, intermediate results (where relevant), and so on. It should be written in a manner that the instructor can understand.

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Changes
This page may change from time to time. It is expected that you will check it periodically. Ignorance of its latest content is not an excuse for lack of preparation.

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Finance 328 -- 1997

Finance 328 Macro Investment Analysis


Stanford Graduate School of Business Professor William F. Sharpe Spring, 1997 NOTE: This is for information only. Many of the links shown here are no longer accurate

NOTE This course is designed for students with access to the World Wide Web. Some material requires the use of a Netscape 3.0 (or above) browser and will not be accessible with other browsers.

Overview
The official title of this course is Portfolio Management, and the course will indeed cover the subject of portfolio management. However, we take a particular view of the process, with emphasis on (1) the decisions that must be made by and/or for the ultimate investor and (2) the analytic tools and empirical evidence that can help inform such decisions. As explained in the reading material, we prefer to use the more specific title Macro Investment Analysis to reflect this focus.

Teams
By the end of the second class, you will be expected to join a team of from three to five members. All exercises will be submitted by teams, and your grade will depend in large part on the quality of the work of your team. You are free to join with any other 2 to 4 members of the class for this purpose. You should make certain that at least one member of the team is reasonably facile with word processing and

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can move information to and from a web browser page.

Team Lists
Before class 3 a designated member of each team should send an email to the instructor listing:
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team password team members r names r email addresses

Please send this email to: wfsharpe@leland.stanford.edu

Team Sites
Each team will be required to complete assigned exercises according to a firm schedule. To facilitate this, each team will be given a site on the instructor's web server. For example, the address of the site for team 1 will be: http://www-sharpe.stanford.edu/1 Access to each such site will require the team password that you choose. Do not give this password to anyone who is not a member of your team! All the material on your site is confidential and for the use only of your team. This includes your team's answers to the exercises. Under the honor code you are required to maintain this confidentiality both during and after the class, except as needed for oral presentations in class sessions. Once your account is set up, you may access it with any browser. After you provide the correct name (Team1, etc.) and password, you will get an index of the pages on the site. For each exercise there will (eventually) be two files. For example:
q q

EX1-2A.xls: Exercise 1, team 2, questions plus the answers that you have submitted EX1-2G,xls: Exercise 1, team 2, questions plus the answers that you have submitted, plus the instructor's comments and the grade for the exercise

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Worksheets
Several of the exercises require the use of Worksheets prepared by the instructor. Independently, these may also prove helpful as aids to learning the material for the course. References to specific worksheets will be found in this course outline, in some of the reading material, and in some of the exercises.

Oral Reports and Excused Absences


The instructor will maintain a list of names of members of the class chosen randomly (with replacement). From time to time he will select the next person from the list to make an oral presentation to the class on some or all of the associated team's answers to the most recent exercise. This may be very short or relatively long, depending on the subject in question. For purposes of the presentation, the team's answer (e.g. EX1-2A) may be accessed in class. The presentation will be graded and used (if very good or very bad) to alter the person's course grade from that eventually assigned to the team in question. An unexcused absence when called upon will be considered an extremely bad performance and may severely prejudice your grade in the course. You are entitled to one excused absence during the quarter. To obtain one, simply email the instructor (at wfsharpe@leland.stanford.edu) at least 24 hours before the class -- you need not give a reason. Excused absences will be given only under the most dire circumstances. If you wish to try to receive one, email the instructor at least 48 hours prior to the class. Unless you get an email from the instructor specifically authorizing the absence, it is unexcused.

Grades
Grades will be given to each team based on overall performance on the exercises. Each individual on the team will receive the team grade modified to account for the individual's performance(s) on any oral report(s).

Supplemental reading
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The following books are recommended for those wishing to obtain foundation material, additional discussions, and/or another view on some of the subjects covered in the course.
q

Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, Fifth Edition. New York: John Wiley & Sons, Inc., 1995 Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management, Probus Publishing, Chicago, Ill., 1995 Mark Kritzman, The Portable Financial Analyst - What Practitioners Need to Know,. Chicago: Probus Publishing, 1995 William F. Sharpe, Gordon J. Alexander and Jeffery V. Bailey, Investments, Fifth Edition. Englewood Cliffs, N.J.: Prentice-Hall, 1995

Interesting Web Sites


Web sites that are particularly germane for specific topics are listed later. The following sites are of general interest vis-a-vis the subject of the course. ****** TO COME ***************

Course News
From time to time there will be news of interest (or at least relevance) for all the members of the course. Be certain to check the Course News Page from time to time. You may wish to bookmark it for easy access.

Course Site
Some material will be found on the course site. Its address is: http://www-sharpe.stanford.edu/328

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This is a password-protected site. If asked, give your team name as your id and your team password.. Under the honor code, you are expected to keep this password confidential and to not divulge it to anyone not registered for the class.

Course Material
At present, no printed textbook adequately covers the domain of this course. Instead, we will rely on the reading material described below. Material that is highlighted is only a click away via the web. The remainder of the material is included in the syllabus available to students registered for the course. All the web material can be accessed from the instructor's site: http://www-sharpe.stanford.edu The instructor's goal is to provide all the material for this course on the web in a reasonably consistent and coherent form. Meanwhile, some of the subjects must be covered with material written in other forms for different audiences. To minimize confusion (the students' and also the instructor's), the latter's own publications were given a high priority in the selection process. Be assured that no royalties are involved. In the list below, highlighted readings are on the web and can be obtained directly. The remainder must be obtained on paper. The material listed for each session should be read before the date given. Those who have not read the material in advance may be confused, embarrassed and/or frustrated. Due dates for exercises are shown. With the exception of Exercise 1, each team must retrieve its exercises from its own web directory on the instructor's server.

Exercises

Each of the following exercises is contained in an Excel Workbook. To configure your Netscape
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browser to deliver these files directly to Excel, choose Options, General Preferences, Helpers from the main menu. Check to see if Application/x-excel is included in the list that is displayed. If not, select "Create New Type" with Mime Type = application and mime-subtype = x-excel. It is a good idea to list the extension xls as well. Then select "Launch the application" and type in the address of your Excel.exe file (or browse to find it). To submit an excercise, insert your answers in the appropriate places, then email the resulting Excel workbook as an attachment in an email to the instructor. Exercise 1: Prices and Probabilities
q q

uses material through class session 4 submit via email before class session 6

Exercise 2: Derivative Securities


q q

uses material through class session 4 submit via email before class session 8

Exercise 3: Risks, returns and optimization


q q

uses material through class session 6 submit via email before class session 9

Exercise 4: Equilibrium
q q

uses material through class session 8 submit via email before class session 11

Exercise 5: Dynamic Strategies


q q

uses material through class session 9 submit via email before class session 13

Exercise 6: Performance Analysis


q q

uses material through class session 13 submit via email before class session 15

Exercise 7: Style Analysis

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q q

uses material through class session 13 submit via email before class session 17

Exercise 8: Retirement Planning


q q

uses material through class session 14 submit via email before class session 19

Course Material
1. Introduction (April 2) Required Reading (before class)
q q q q

Investment Approaches Financial Economics Models and Paradigms W.F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, July/August 1976, p. 4. W.F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, January/February 1991, pp. 7-9.

2. Matrix Algebra (April 4) Required Reading (before class)


q q q q

Matrices Matrix Operations MATLAB Asset Allocation with Investment Funds

3. Prices (April 8) Required Reading (before class)

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q q q q q

Time-state Claims Valuation Multiple Commodities, States and Times Interest Rates and Bond Yields Forward Prices

4. Probabilities (April 11) Required Reading (before class)


q q q

Production, Consumption and Market Clearing Risk Premia Consumption and Investment Choices

5. Risk and Return (April 15) Required Reading (before class)


q q q q q

Mean, Variance and Distributions Portfolio Choice Multi-period Returns Portfolio Characteristics Two-asset Portfolios

6. Optimization (April 18) Exercise 1 due (submit before class) Required Reading (before class)
q q

Optimization: The Gradient Method The Optimization Worksheet

7. Factor Models (April 22) Required Reading (before class)

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q q

Factor models -- copies of overheads W.F. Sharpe, "Some Factors in New York Stock Exchange Security Returns, 19311979," Journal of Portfolio Management, Summer 1982, pp. 5-19.

8. Equilibrium (April 25) Exercise 2 due (submit before class) Required Reading (before class)
q q

Equilibrium - preliminary W.F. Sharpe, "Capital Asset Prices with and without Negative Holdings," Journal of Finance, June 1991, pp. 489-509. W.F. Sharpe, "Factor models, CAPMs, and the APT," Journal of Portfolio Management, Fall 1984, pp. 21-25.

9. Dynamic Strategies (April 29) Exercise 3 due (submit before class) Required Reading (before class)
q

W.F. Sharpe, "Integrated Asset Allocation," Financial Analysts Journal, September/October 1987, pp. 25-32. Andre Perold and W.F. Sharpe, "Dynamic Strategies for Asset Allocation", Financial Analysts Journal, January/February 1988, pp. 16-27. W.F. Sharpe, "Investor Wealth Measures and Expected Return," Quantifying the Market Risk Premium Phenomenon for Investment Decision Making, The Institute of Chartered Financial Analysts, 1990, pp. 29-37.

10. International Investment (May 2) Required Reading (before class)


q

A.F. Perold and E.C. Schulman, "The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards," Financial Analysts Journal, May/June 1988, pp. 45-52. W.F. Sharpe, "Hedging Currency Risk in an International Portfolio," Investment Technology, Spring 1992, pp. 1-43.

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q

Patrick Odier and Bruno Solnik, "Lessons for International Asset Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77.

11. Behavioral Finance and Market Anomalies (May 6) Exercise 4 due (submit before class) Required Reading (before class)
q

S. Benartzi and R.H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle"Quarterly Journal of Economics, February 1995, pp. 73-92. Carlo Capaul, Ian Rowley and W.F. Sharpe, "International Value and Growth Stock Returns," Financial Analyst's Journal, January/February 1993, pp. 27-36.

12. Performance Analysis (May 9) Required Reading (before class)


q

W.F. Sharpe, "Adjusting for Risk in Portfolio Performance Measurement," Journal of Portfolio Management, Winter 1975. W.F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58.

13. Style Analysis (May 13) Exercise 5 due (submit before class) Required Reading (before class)
q

q q

"The AT&T Pension Fund", Graduate School of Business, Stanford University Case S-F-243. 1992 W.F. Sharpe, "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. Setting the Record Straight on Style Analysis R.A. Grinold and D. Stefek, "Global Factors: Fact or Fiction?," Journal of Portfolio Management, Fall 1989, pp. 79-88. Morningstar's Performance Measures

14. Financial Planning (May 16)


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Required Reading (before class)


q

The Bob Boomer Case

15. Global Tactical Asset Allocation: Mellon Capital Management (May 20) Exercise 6 due (submit before class) Speakers
q

Charlie Jacklin is Director of Asset Allocation Strategies for Mellon Capital Management Corporation. He is responsible for overseeing domestic, international and global asset allocation strategies. He also engages in research related to the asset allocation process and is a member of the investment management and research committees. In addition, he is the primary client service officer for a number of asset allocation clients. Prior to joining Mellon Capital, Charlie was on the finance faculty of Stanford University's Graduate School of Business. At Stanford, he taught a variety of finance courses in the M.B.A., Sloan, and Ph.D. programs and did extensive research in finance and investments. In addition, he has been an instructor for the Stanford - London Business School International Investment Management Program, the Stanford Financial Management Program, and the Pacific Coast Banking School. For the academic year 1990 - 91, Charlie served as Senior Staff Economist for Financial Markets and Banking for the President's Council of Economic Advisers in Washington, D.C. Prior to joining Stanford in 1987, Charlie spent three years on the finance faculty at the University of Chicago's Graduate School of Business. From 1978 to 1980, as a management consultant with Ernst & Ernst, he provided financial planning and risk management consulting services to a variety of clients, primarily from the financial services industry. Charlie received his Ph.D. in Finance from Stanford University in 1985, an M.B.A. from the University of Illinois in 1978, and a B.S. in Mathematics, cum laude, from the University of Maryland in 1976. Charlie has published a number of papers on finance and investments in academic research journals, including the Review of Financial Studies, the Journal of Political Economy, and the Journal of Monetary Economics.

Required Reading (before class)


q

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16. Active Investment Management: Rosenberg Institutional Equity Management (May 23) Speaker
q

Kenneth Reid earned both a B.A. degree (1973) and an M.D.S. (1975) from Georgia State University, Atlanta. In 1982, he earned a Ph.D. from the University of California, Berkeley, where he was awarded the American Bankers Association Fellowship. From 1981 until June 1986, Mr. Reid worked as a consultant at BARRA in Berkeley, California. His responsibilities included estimating multiplefactor risk models, designing and evaluating active management strategies, and serving as an internal consultant on econometric matters in finance. Mr. Reid is a General Partner and Director of Research at Rosenberg Institutional Equity Management. His work is focused on the design and estimation of the valuation models and he has primary responsibility for analyzing the empirical evidence that validates and supports the day-to-day recommendations of the models. Patterns of short-term price behavior discussed by Mr. Reid as part of his Ph.D. dissertation have been refined and incorporated into RIEM's valuation and trading systems.

Required Reading (before class)


q

RIEM Web site

17. Endowments: Stanford Management Company (May 27) Exercise 7 due (submit before class) Speakers
q

Anne Casscells is the Managing Director of Investment Policy Research at Stanford Management Company. SMC is the investment arm of Stanford University, overseeing over $4 billion in endowment and other assets. Her responsibilities include asset allocation, spending policy, foreign exchange, tactical asset allocation, inflation hedging, arbitrage and distressed securities. Prior to joining Stanford she was a Vice President in the fixed income division of Goldman Sachs where she worked from 1985 to 1995. She holds an MBA from the Graduate School of Business at Stanford University and a BA from Yale University . Laurie Hoagland was appointed President and CEO of Stanford Management

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Company, Stanford University's $5 billion investment and real estate organization, in July 1991. For the previous 11 years, Mr. Hoagland had been a co-founder and partner in the investment management firm of Anderson, Hoagland and Company in St. Louis. He has also held positions as Vice President and Treasurer of Cummins Engine Company, Vice President and Portfolio Manager of the Irwin Management Company in Columbus, Indiana. Laurie was a director and a member of the Investment Committee of the Board of Pensions of the Presbyterian Church from 1981 to 1992 and currently serves on the Board of the Louisville Presbyterian Theological Seminary. He is a member of the Finance Committee of the Rockefeller Foundation and the Investment Committee of the Hewlett Foundation. Mr. Hoagland graduated from Stanford University with an AB in Economics in 1958, as a Marshall scholar received a BA in Philosophy, Politics and Economics from Oxford University in 1960,and earned an MBA from Harvard in 1962.

Required Reading (before class)


q q q

Harvard Management Company 1994 The Yale Endowment 1996 Extracts from the Stanford University Annual Financial Report 1996

18. Defined Benefit Pension Plans: California Public Employees' Retirement System (May 30) Speakers
q

Bob L. Boldt is the Senior Investment Officer, Global Public Market Investments, of the California Public Employees' Retirement System (CalPERS). He is responsible for the management of more than $100 billion of CalPERS assets invested in equity and debt markets around the world. Mr. Boldt has more than 20 years of investment management experience. Prior to joining CalPERS, Mr. Boldt held senior management positions at the Northern Trust Company, the American National Bank of Chicago, Concord Capital Management, and Scudder, Stevens & Clark. He has written extensively on investment topics and is a former recipient of the Graham and Dodd Award from the Financial Analysts Federation. Mr. Boldt earned an undergraduate degree in engineering and an MBA from the University of Texas at Austin. He is a Chartered Financial Analyst. CalPERS is the nation's largest public pension fund and the third largest in the world. The System provides retirement and health benefits to more than one million employees and their families. Patricia Pinkos is a Principal Investment Officer, Internal Equities, for the California Public Employees' Retirement System (CalPERS). Her responsibilities

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include management of the $40 billion domestic equity index fund and special projects related to asset allocation formulation and implementation. She formerly managed the Manager Relations unit for CalPERS, which oversees external managers in the area of active domestic equity, international equity and fixed income and currency overlay. Prior to joining CalPERS in 1987, she had her own business advising individuals and small pension funds on financial planning issues. She holds an MBA from Golden Gate University and a BA from the University of Michigan in mathematics. She is a Chartered Financial Analyst.

Required Reading (before class)


q

CalPers Web Site

19. Defined Contribution Pension Plans: Hewlett-Packard (June 3) Exercise 8 due (submit before class) Speaker
q

Elizabeth Obershaw is Director, Benefit Fund Investments at Hewlett-Packard, with investment management responsibility for HPs U.S. retirement and employee welfare plans, which currently represent over $3 billion in assets. In this capacity, Ms. Obershaw and her staff are responsible for determining asset allocation policies, selecting investment managers, and managing a $500 million in-house equity portfolio. The plans investments are broadly diversified and include U.S. large and small capitalization stocks, international stocks, venture capital and other private equities, U.S. fixed income, global fixed income and real estate. Later in 1997, her group will also assume responsibility for structuring the investment options in HPs 401(k) program. Ms. Obershaw received a BA in Economics from the University of California at Los Angeles in 1981 and an MBA from the Stanford University Graduate School of Business in 1983.

Required Reading (before class)


q

The Bob Boomer Case

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Changes
This page may change from time to time. It is expected that you will check it periodically. Ignorance of its latest content is not an excuse for lack of preparation.

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F328 Course News

Finance 328 Course News


April 8, 1997 All team subdirectories have been set up. To access your directory (say, team 4): http://www-sharpe.stanford.edu/4 Give the id: team4 (all lower case, no blanks) and your team password Note: passwords are all lower case Note also: I have assigned passwords for teams 14 and 15. Please see me to find out what they are. If asked, do the same when you wish to access the subdirectory for the course. It is http://www-sharpe.stanford.edu/328

April 8, 1997 The spreadsheet used in session 3 (which will be used also in session 4) is now available on the course directory: http://www-sharpe.stanford.edu/328 When you select it, Netscape will ask you if you wish to save the file. Do so. Then you can retrieve it from your disk using Excel.

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April 8, 1997 Please check the team list to insure that you are listed with the correct team and that your email address is present and correct. Please email me any changes at: wfsharpe@leland.stanford.edu

April 13, 1997 Good News: The reading assignment for session 6 (April 16) has changed. You don't have to read the formerly referenced articles. Bad News: The reading assignment for session 6 (April 16) has changed. You have to read the new web material and study the accompanying optimization worksheet.

April 19, 1997 Exercises 1 through 5 have been converted to Excel workbooks. Please insert your answers in the appropriate spots in a workbook, then send it to me (as an attachment in an email) before the time specified in the course outline. I will put a copy in your directory as EXn_mA.xls where n is the exercise number and m is the team number. When I have graded it, I will put another copy as EXn_mG.xls.

April 22, 1997 The "slides" for today's lecture are available: select factors.

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April 28, 1997 The "slides" for dynamic asset allocation are available: select dynamic strategies

May 1, 1997 The "slides" for currency issues are available: select currency

May 5, 1997 Some problems have arisen with the optimization worksheet due to a relatively large epsilon for the termination condition. The net effect is that the procedure may stop too far short of a global optimum. I have modified the worksheet to increase its precision (at the cost of slower run-time) and to allow you to specify any other cutoff. The current version (dated May 5) should perform much better for some of the analyses in exercise 4.

May 6, 1997 New slides for the yen/dollar exchange rate, style returns and for international diversification

May 9, 1997 New slides for the performance measurement and further results on Morningstar ratings

May 18, 1997

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Exercise 3 has been graded. See your site for the results. The grade distribution follows: PP H 1 6 3 14

P+ 4

May 23, 1997 Exercise 4 has been graded. See your site for the results. The grade distribution follows: PP H 0 7 1 14

P+ 6

May 26, 1997 Exercise 5 has been graded. See your site for the results. The grade distribution follows: P1

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P P+ H

9 2 1 14

H+ 1

Note: H+ is a highly unusual grade, but there was a highly unusual answer. It will be given 1.5 points (H = 1.0).

May 27, 1997 Exercise 6 has been graded. See your site for the results. The grade distribution follows: U P H 3 5 2 14

P+ 4

May 27, 1997 Grades to date. GPA's based on 6 exercises ( U = -1, P- = -0.3; P = 0; P+ = 0.5; H = 1.0; H+ = 1.5 ), to two decimal places 0.50 1

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0.37 0.33 0.28 0.25 0.20 0.17 0.12 0.08 0.00

1 1 3 1 1 2 1 1 1

-0.02 1

June 1, 1997 Exercise 7 has been graded. See your site for the results. The grade distribution follows: PP H 3 6 1 14

P+ 4

June 1, 1997 Grades to date. GPA's based on 7 exercises ( U = -1, P- = -0.3; P = 0; P+ = 0.5; H = 1.0; H+ = 1.5 ), to two decimal places
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0.50 0.43 0.31 0.29 0.24 0.20 0.17 0.14 0.13 0.10

1 1 2 1 1 1 1 2 1 2

-0.04 1

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Finance 368 -- 1998

Finance 368 Macro Investment Analysis


Stanford Graduate School of Business Professor William F. Sharpe Spring, 1998 GSB Room 83, 10:00 - 11:30 NOTE: This is for information only. Many of the links shown here are no longer accurate

Overview
The title of this course is Macro Investment Analysis. It can be considered an expanded course on portfolio management. However, we take a particular view of the portfolio management process, with emphasis on (1) the decisions that must be made by and/or for the ultimate investor and (2) the analytic tools and empirical evidence that can help inform such decisions.

Relationship to other courses


In previous years, much of the material in this course was taught under the title Portfolio Management as Finance 328. Starting in 1998 the more traditional content of a portfolio management course is being taught as Finance 328, with the non-traditional material included in Finance 368. Since 1998 is a transition year, there will be considerable overlap between the two courses. In this year, F328 is not a prerequisite for F368. Students who took F328 in Spring 1997 should not take F368 this year. Students who took F328 in Winter 1998 are welcome to take F368 this year but warned that there will be considerable repetition of material. It is intended that in the academic year 1998-1999, F368 will be restructured to be a genuine follow-on to F328. At that time, successful completion of F328 or the attainment of equivalent knowledge will become a prerequisite to enrollment in F368.

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Worksheets
Several of the sessions will utilize Worksheets prepared by the instructor. These may also prove helpful as aids to learning the material for the course. References to specific worksheets will be found in this course outline and in some of the reading material.

Examinations
There will be a midterm and a final. The final will receive 150% of the weight assigned the midterm. Midterm:
q q q q

Wednesday, May 6, 9:00 - 12:00 GSB 70 and 71 pick up and turn in examination in room 70 To see the examination and answers, click here

Final:
q q q

Saturday June 6, 1:00 - 5:00 GSB 70 and 71 pick up and turn in examination in room 70

Attendance
Attendance will be taken at every session in which there is a guest speaker. Any unexcused absence in one of these sessions will result in a lower grade for the course. To apply for an excused absence, email the instructor at least 48 hours prior to the class in question.

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Grades
Grades will be based on examination scores with the possibility of adjustment by the instructor based on discussions in class. In the event of unexcused absences from a session in which there is a guest speakers the grade will be decremented.

Office Hours
Informal office hours will be held in the classroom (GSB 83) after class, from 11:30 until 12:00 (as needed). Appointments for longer consultations in the instructor's office (Littlefield 381) can also be made at that time.

Supplemental reading
The following books are recommended for those wishing to obtain foundation material, additional discussions, and/or another view on some of the subjects covered in the course.
q

Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, Fifth Edition. New York: John Wiley & Sons, Inc., 1995 Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management, Probus Publishing, Chicago, Ill., 1995 Mark Kritzman, The Portable Financial Analyst - What Practitioners Need to Know,. Chicago: Probus Publishing, 1995 William F. Sharpe, Gordon J. Alexander and Jeffery V. Bailey, Investments, Fifth Edition. Englewood Cliffs, N.J.: Prentice-Hall, 1995

Course Material
At present, no printed textbook adequately covers the domain of this course. Instead, we will rely on the reading material described below. Material that is highlighted is only a click away via the web. The remainder of the material is included in the syllabus available to students registered for the course. All the web material can be accessed from either of the instructor's sites:
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http://www-sharpe.stanford.edu http://www-leland.stanford.edu/~wfsharpe The instructor's goal is to provide all the material for this course on the web in a reasonably consistent and coherent form. Meanwhile, some of the subjects must be covered with material written in other forms for different audiences. To minimize confusion (the students' and also the instructor's), the latter's own publications were given a high priority in the selection process. Be assured that no royalties are involved. In the list below, highlighted readings are on the web and can be obtained directly. The remainder must be obtained on paper. The material listed for each session should be read before the date given. Those who have not read the material in advance may be confused, embarrassed and/or frustrated.

Course Material

1. Introduction (Tuesday March 31) Required Reading (before class)


q q q q

Investment Approaches Financial Economics Models and Paradigms W.F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, July/August 1976, p. 4. W.F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, January/February 1991, pp. 7-9.

Video
q

Beyond Wall Street, The Art of Investing: Episode 4: Indexing

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2. Matrix Algebra (Thursday April 2) Required Reading (before class)


q q q q

Matrices Matrix Operations MATLAB Asset Allocation with Investment Funds

3. Prices and Probabilities (Monday April 6) Required Reading (before class)


q q q q q q q q

Time-state Claims Valuation Multiple Commodities, States and Times Interest Rates and Bond Yields Forward Prices Production, Consumption and Market Clearing Risk Premia Consumption and Investment Choices

4. Risk and Return (Thursday April 9) Required Reading (before class)


q q q q q

Mean, Variance and Distributions Portfolio Choice Multi-period Returns Portfolio Characteristics Two-asset Portfolios

Video
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Beyond Wall Street, The Art of Investing: Episode 8: Managing Investment Risk

5. Optimization (Monday April 13) Required Reading (before class)


q q q

Optimization: The Gradient Method Optimal Portfolios without Bounds on Holdings The Optimization Worksheet

6. Factor Models and Style Analysis (Thursday April 16) Required Reading (before class)
q q

q q

Factor models -- copies of overheads W.F. Sharpe, "Some Factors in New York Stock Exchange Security Returns, 19311979," Journal of Portfolio Management, Summer 1982, pp. 5-19. W.F. Sharpe, "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. Setting the Record Straight on Style Analysis R.A. Grinold and D. Stefek, "Global Factors: Fact or Fiction?," Journal of Portfolio Management, Fall 1989, pp. 79-88. Morningstar's Risk-adjusted Ratings

7. Equilibrium (Monday April 20) Required Reading (before class)


q q

Equilibrium - preliminary W.F. Sharpe, "Capital Asset Prices with and without Negative Holdings," Journal of Finance, June 1991, pp. 489-509. W.F. Sharpe, "Factor models, CAPMs, and the APT," Journal of Portfolio

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Management, Fall 1984, pp. 21-25. S. Benartzi and R.H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle"Quarterly Journal of Economics, February 1995, pp. 73-92.

8. International Investment (Thursday April 23) Required Reading (before class)


q

A.F. Perold and E.C. Schulman, "The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards," Financial Analysts Journal, May/June 1988, pp. 45-52. W.F. Sharpe, "Hedging Currency Risk in an International Portfolio," Investment Technology, Spring 1992, pp. 1-43. Patrick Odier and Bruno Solnik, "Lessons for International Asset Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77. Carlo Capaul, Ian Rowley and W.F. Sharpe, "International Value and Growth Stock Returns," Financial Analyst's Journal, January/February 1993, pp. 27-36.

Video
q

Beyond Wall Street, The Art of Investing: Episode 3: Quantitative Investing

9. Asset Allocation: Stanford Management Company (Monday April 27) Speakers


q

Anne Casscells is the Managing Director of Investment Policy Research at Stanford Management Company. SMC is the investment arm of Stanford University, overseeing over $4 billion in endowment and other assets. Her responsibilities include asset allocation, spending policy, foreign exchange, tactical asset allocation, inflation hedging, arbitrage and distressed securities. Prior to joining Stanford she was a Vice President in the fixed income division of Goldman Sachs where she worked from 1985 to 1995. She holds an MBA from the Graduate School of Business at Stanford University and a BA from Yale University .

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q

Laurie Hoagland was appointed President and CEO of Stanford Management Company, Stanford University's $5 billion investment and real estate organization, in July 1991. For the previous 11 years, Mr. Hoagland had been a co-founder and partner in the investment management firm of Anderson, Hoagland and Company in St. Louis. He has also held positions as Vice President and Treasurer of Cummins Engine Company, Vice President and Portfolio Manager of the Irwin Management Company in Columbus, Indiana. Laurie was a director and a member of the Investment Committee of the Board of Pensions of the Presbyterian Church from 1981 to 1992 and currently serves on the Board of the Louisville Presbyterian Theological Seminary. He is a member of the Finance Committee of the Rockefeller Foundation and the Investment Committee of the Hewlett Foundation. Mr. Hoagland graduated from Stanford University with an AB in Economics in 1958, as a Marshall scholar received a BA in Philosophy, Politics and Economics from Oxford University in 1960,and earned an MBA from Harvard in 1962.

Required Reading (before class)


q q q

Harvard Management Company 1994 The Yale Endowment 1996 Extracts from the Stanford University Annual Financial Report 1996

Luncheon:
q q

Scott Utzinger Ali Abbas

10. Active International Investment Management: Rosenberg Institutional Equity Management (Thursday April 30) Speaker
q

Tom Mead

Required Reading (before class)


q

RIEM Web site

Luncheon
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q q q

Ignacio Bustamente Tatiana Fernandez Alexandre Alfonsi

11. Performance Analysis (Monday May 4) Required Reading (before class)


q q

q q

Mutual Fund Performance Measurement W.F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58. Morningstar's Risk-adjusted Ratings Financial Economists' Roundtable Statement on Risk Disclosure by Mutual Funds

Video
q

Beyond Wall Street, The Art of Investing: Episode 7: Global Asset Allocation

12. Global Investment Management: United Bank of Switzerland (Thursday May 7) Speaker
q

Gary Brinson is the President and Chief Investment Officer of Brinson Partners, Inc. and Chief Investment Officer of the United Bank of Switzerland. He received is B.A. defree from Seattle University and his M.B.A. degree from Washington State University. He is a trustee of the College Retirement Equities Fund and a trustee of the Institute of Chartered Financial Analysts.

Luncheon
q q

Stephan Morgan Jeff M.

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13. Dynamic Strategies (Monday May 11) Required Reading (before class)
q

W.F. Sharpe, "Integrated Asset Allocation," Financial Analysts Journal, September/October 1987, pp. 25-32. Andre Perold and W.F. Sharpe, "Dynamic Strategies for Asset Allocation", Financial Analysts Journal, January/February 1988, pp. 16-27. W.F. Sharpe, "Investor Wealth Measures and Expected Return," Quantifying the Market Risk Premium Phenomenon for Investment Decision Making, The Institute of Chartered Financial Analysts, 1990, pp. 29-37.

14. Global Tactical Asset Allocation: Mellon Capital Management (Thursday May 14) Speaker
q

Charlie Jacklin is Chief Investment Strategist for Mellon Capital Management Corporation. He is responsible for investment strategy and research as well as business development. Previously, as Director of Asset Allocation Strategies he was responsible for portfolio management in domestic, international and global asset allocation strategies. He also engages in investment research, is the Chairman of the Investment Research Committee, and is a member of the Investment Management Committee. Prior to joining Mellon Capital, Charlie was on the finance faculty of Stanford University's Graduate School of Business. At Stanford, he taught a variety of finance courses in the M.B.A., Sloan, and Ph.D. programs and did extensive research in finance and investments. In addition, he has been an instructor for the Stanford - London Business School International Investment Management Program, the Stanford Financial Management Program, and the Pacific Coast Banking School. For the academic year 1990 - 91, Charlie served as Senior Staff Economist for Financial Markets and Banking for the President's Council of Economic Advisers in Washington, D.C. Prior to joining Stanford in 1987, Charlie spent three years on the finance faculty at the University of Chicago's Graduate School of Business. From 1978 to 1980, as a management consultant with Ernst & Ernst, he provided financial planning and risk management consulting services to a variety of clients, primarily from the financial services industry. Charlie received his Ph.D. in Finance from Stanford University in 1985, an M.B.A. from the University of Illinois in 1978, and a B.S. in Mathematics, cum laude, from the University of Maryland in 1976. Charlie has published a number of papers on

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finance and investments in academic research journals, including the Review of Financial Studies, the Journal of Political Economy, and the Journal of Monetary Economics.

Required Reading (before class)


q

Thomas B. Hazuka and Randal G. Pearson, "A Valuation Approach to Currency Hedging," Financial Analysts Journal, March/April 1994, pp. 55-59.

Luncheon
q q q

Lee Phon John Linehan Steven Fox

15. Defined Benefit Pension Plans (Monday May 18) Required Reading (before class)
q

Martin Leibowitz, "Liability Returns: A New Look at Asset Allocation," Journal of Portfolio Management, Winter 1987, pp. 11-18. William F. Sharpe and Lawrence G. Tint, "Liabilities -- A New Approach," , Journal of Portfolio Management, Winter 1990, pp. 5-10.

16. California Public Employees' Retirement System (Thursday May 21) Speakers
q

Bob L. Boldt is the Senior Investment Officer, Global Public Market Investments, of the California Public Employees' Retirement System (CalPERS). He is responsible for the management of more than $100 billion of CalPERS assets invested in equity and debt markets around the world. Mr. Boldt has more than 20 years of investment management experience. Prior to joining CalPERS, Mr. Boldt held senior management positions at the Northern Trust Company, the American National Bank of Chicago, Concord Capital Management, and Scudder, Stevens &

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Clark. He has written extensively on investment topics and is a former recipient of the Graham and Dodd Award from the Financial Analysts Federation. Mr. Boldt earned an undergraduate degree in engineering and an MBA from the University of Texas at Austin. He is a Chartered Financial Analyst. CalPERS is the nation's largest public pension fund and the third largest in the world. The System provides retirement and health benefits to more than one million employees and their families. Patricia Pinkos is a Principal Investment Officer, Internal Equities, for the California Public Employees' Retirement System (CalPERS). Her responsibilities include management of the $40 billion domestic equity index fund and special projects related to asset allocation formulation and implementation. She formerly managed the Manager Relations unit for CalPERS, which oversees external managers in the area of active domestic equity, international equity and fixed income and currency overlay. Prior to joining CalPERS in 1987, she had her own business advising individuals and small pension funds on financial planning issues. She holds an MBA from Golden Gate University and a BA from the University of Michigan in mathematics. She is a Chartered Financial Analyst.

Required Reading (before class)


q

CalPers Web Site

Luncheon
q q q

Jian Wang Ramez Tombassy Art Richardson

17. Retirement Savings and Investment (Thursday May 28) Required Reading (before class)
q q q q

Financial Planning in Fantasyland Nobel Laureate Discusses Basic Investing Decisions The Economic Report of the President, 1997: Social Security Hemant Shah, "Toward Better Regulation of Private Pension Funds" The World Bank Policy Research Working Paper #1791, June 1997 Financial Economists Roundtable Statement on Social Security

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Finance 368 -- 1998

18. Defined Contribution Pension Plans: Hewlett-Packard (Monday June 1) Speaker


q

Elizabeth Obershaw is Director, Benefit Fund Investments at Hewlett-Packard, with investment management responsibility for HPs U.S. retirement and employee welfare plans, which currently represent over $3 billion in assets. In this capacity, Ms. Obershaw and her staff are responsible for determining asset allocation policies, selecting investment managers, and managing a $500 million in-house equity portfolio. The plans investments are broadly diversified and include U.S. large and small capitalization stocks, international stocks, venture capital and other private equities, U.S. fixed income, global fixed income and real estate. Later in 1997, her group will also assume responsibility for structuring the investment options in HPs 401(k) program. Ms. Obershaw received a BA in Economics from the University of California at Los Angeles in 1981 and an MBA from the Stanford University Graduate School of Business in 1983.

Required Reading (before class)


q

The Bob Boomer Case

Luncheon
q q

Dan Lopez Paul Jones

19. 401(k) Participant Investment Decisions: Financial Engines (Wednesday June 3) Speaker
q

Jeff Maggioncalda is President and Chief Executive Officer of Financial Engines, Incorporated. His experience spans applied finance, business strategy and software development. Before joining Financial Engines, he worked for McKinsey &

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Companys high technology practice, where he analyzed such issues as the impact of the Internet on commercial banking, and the strategic use of information in the credit card industry. Previously, he conducted litigation research at Cornerstone Research, a Menlo Park, CA, consulting firm. He also assisted Intel Corp. CEO Andrew Grove on a strategic analysis of how the Internet will change the economics of the brokerage industry. Mr. Maggioncalda graduated with honors from Stanford University Graduate School of Business and also received his A.B. from Stanford, with honors in Quantitative Economics and English.

Required Reading (before class)


q

Revisiting the Capital Asset Pricing Model

Luncheon
q q

Manuel Anguita Jeff Hartley

Changes
This page may change from time to time. It is expected that you will check it periodically. Ignorance of its latest content is not an excuse for lack of preparation.

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Finance 368 Midterm

Finance 368
Spring 1998 Prof. Sharpe

Midterm Examination with Answers (and additional comments) (points shown in blue)
1. In the small country of petitpays there are only four stocks. The number of shares outstanding and last night's price per share of each are shown below:

Stock Alpha Industries Beta Telecom Gamma Technology Delta Toys

Shares 41,250 30,000 25,000 30,000

Price 40 30 12 5

Stock Alpha Industries Beta Telecom Gamma Technology Delta Toys

Shares

Price

Value

PctMkt

PctLg

PctSml

41,250

40

1,650,000

55%

65%

30,000

30

900,000

30%

35%

25,000

12

300,000

10%

67%

30,000

150,000

5%

33%

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3,000,000

Despite the small number of stocks, there are 25 mutual funds in petitpays. You have been asked to evaluate six of them. For each one, the composition of last night's portfolio is shown using relative values, based on last night's stock prices.

Stock Alpha Industries Beta Telecom Gamma Technology Delta Toys Total

Brigantine Complet Fido Quasar Rabba Westwood 64.7 35.3 0.0 0.0 100.0 55.0 30.0 10.0 5.0 100.0 75.0 25.0 0.0 0.0 0.0 0.0 50.0 50.0 57.0 29.0 8.0 6.0 0.0 0.0 66.7 33.3 100.0

100.0 100.0 100.0

1a. Which (if any) of the funds are: [1] a. Active Large Cap Fido [1] b. Active Small Cap Quasar [1] c. Enhanced Index (high R-squared) Rabba [1] d. Large Cap Index Brigantine [1] e. Small Cap Index Westwood [1] f. Market Index Complet Assume that at the close of the market today the return on the entire market was 2.5%. [4] 1b. The Wall Street Journal reports the performance of the mutual fund industry by averaging the total returns of all the funds, with each fund given the same weight. What was the resulting average return? (circle one) More than 2.5% 2.5% Less than 2.5% You can't say Why? Assuming that the 2.5% is the return on the average dollar invested in the market (or equivalently, the return on

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a market-capitalization weighted index of all stocks), this may be more, less or equal to a simple average of the returns on funds, each of which has a different market value. If funds were representative and their returns were weighted by fund size, the gross returns would equal the market-capitalization weighted average for the stocks in the market. However, even in this case, the net return would be less. And, since the reported fund average is not weighted by fund size, anything could happen.

2. The following table shows the styles of four mutual funds, expressed in terms of Cash, Bonds and Stocks.

Cash Bonds Stocks Aggressive Growth Fund Balanced Safety Fund Conservative Investors' Fund Responsible Investors' Fund 0.05 0.10 0.20 0.20 0.00 0.45 0.70 0.40 0.95 0.45 0.10 0.40

2a.Doctor Watson has just invested 20% of her money in the Aggressive Growth Fund, 30% in the Balanced Safety Fund, 25% in the Conservative Investors' Fund, and 25% in the Responsible Investors' Fund. She has come to you for advice. In particular, she wants to know her current asset allocation. In order to avoid doing this in detail over and over in the future, you have decided to construct matrices, vectors and such so that you can write the task as a simple matrix expression. Show the contents of each matrix or vector that you would use and write an expression, such as a=b*c, that could be interpreted by a programming language such as MATLAB and that would provide the answer. [2] Matrices and Vectors: b = a vector with 1 row and funds columns {1*f} b = [ 0.2000 0.3000 0.2500 0.2500 ]

c = a matrix with funds rows and assets columns {f*a} c = [ 0.0500 0.1000 0.2000 0.2000 0 0.4500 0.7000 0.4000 a = b*c 0.9500 0.4500 0.1000 0.4000

[1] Expression:

[1] How big would your answer matrix or vector be? 1 row and 3 (assets) columns [1] How would you interpret the contents of each cell? The first entry shows the proportion of Watson's fund invested in cash, the second the proportion invested in bonds, and the third the proportion invested in stocks.
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2b. Impressed with your skills, Dr. Watson recommends your services to her friend Mr. Holmes. Holmes has a modest amount of money saved and wishes to invest it. He has deduced that the appropriate asset allocation for him requires 10% in cash, 30% in bonds and 60% in stocks. Your task is to find a fund or combination of two or more of the funds that will accomplish his goal. You want to be able to do this for others in an efficient manner, so you have decided to construct matrices, vectors, and such so you can write the task as a simple matrix expression. Show the contents of each matrix and vector that you woul use: [7] There are more funds than assets in this case. Thus it should be possible to obtain a desired asset allocation with only three of them (barring degeneracy). For example, Holmes could use the first three funds

Cash Bonds Stocks Aggressive Growth Fund Balanced Safety Fund Conservative Investors' Fund 0.05 0.10 0.20 0.00 0.45 0.70 0.95 0.45 0.10

We now have a square matrix that is {f*a}. Call if cc: cc = [ 0.0500 0.1000 0.2000 0 0.4500 0.7000 0.9500 0.4500 0.1000

We seek a vector of fund holdings (bb) that is {1*f} such that: aa = bb*cc where aa = the desired asset mix in a vector that is {1*f}: aa = [ 0.1000 0.3000 0.6000 ]

[1] Write a MATLAB expression that would provide the answer: bb = aa*inv(cc) [1] How big would the answer matrix or vector be? 1*3, showing the proportions in each of the three selected funds [1] How would you interpret each cell? The first cell would indicate the proportion to invest in fund 1, the second would indicate the proportion to invest in fund 2, and the last would indicate the proportion to invest in fund 3, where the fund numbers refer to the chosen funds. [6] 2c. After you report your solution to Mr. Holmes he says "Aha -- you must have made an error, since Mr. Callan, with whom I consulted yesterday, recommended a different combination of funds and showed me that his combination gave the required asset allocation!". How do you deal with this criticism? You point out to Holmes that he doesn't understand financial economics. With more funds than assets, there will typically be
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alternative ways to get the same asset allocation. For example, using the first three funds in the procedure above gives a result, stated in tems of the four funds of: b1 = [ 0.4615 0.3077 0.2308 0 ]

while using funds 2 through 4 gives: b2 = [ 0 1.0000 -0.5000 0.5000 ]

But both portfolios offer the same asset allocation (although the latter involves a short position in one fund, and hence may not be feasible)..

3. In a highly advanced society there are two securities. One is called rf (for riskfree), the other s (for stock). There are only two possible future states of the world next year (sunny and rainy). The proceeds obtained by selling $1 worth of each of the securities next year in each of the two states are as shown below:

State sunny rainy

rf 1.04 1.04

s 1.29 0.89

You have asked a mathematican friend to invert this matrix. Uncertain about what you really want, she provides two answers:

M1 =

1.04 1.04

1.29 0.89 ] 3.1010 -2.5000

inv(M1) = [ -2.1394 2.5000 M2 = [ 1.04 1.29 1.04 0.89 ]

inv(M2) = [ -2.1394 3.1010

2.5000 -2.5000

You believe that it is as likely to be sunny as to be rainy.

3a. Given this information:

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[2] What is the expected return on stocks (s)? 1+e = .5*1.29 + .5*.89 = 1.09 expected return = 9% [3] What is the standard deviation of stocks (s)? v = .5 * ((1.29 -1.09)^2) + .5 * ((0.89 - 1.09)^2) = .04 sd = sqrt(v) = 0.20 standard deviation of return = 20% [2] What is the equity risk premium? 9% - 4% = 5% [3] What is the Sharpe Ratio for equities? SR = (9 -4) / 20 = 0.25 3b. You are running a financial intermediation firm in this country. An umbrella manufacturer asks you if you would issue a sunshine insurance policy which would pay $100 if the weather turns out to be sunny. The manufacturer is willing to pay $50, which seems to him to be a fair price. Would you write the policy? If so, how much profit would there be for you in the deal? To answer this question (and the next one), we need to find the prices for the pure securities (one for each state). If we had a portfolio of securities x {securities*1}, the payoff pattern across states would be: z = M1*x (note that M1 is {states*securities}. Thus z will be {states*1}, as desired. To find a portfolio x that will give a desired payoff pattern z, we can solve: x = inv(M1)*z In this case, we want z to equal [1 0]. This means that the first column of inv(M1) gives the composition of the portfolio that will provide $1 if the weather is sunny. Since each security costs $1, the total cost is simply the sum of the entries in the first column of inv(m1) times 100. Thus Cost = .3606*100 = $ 36.06 [3] So you should definitely issue the policy. [4] The profit will be $13.94.

[3] 3c. If a sunglass manufacturer came to you and asked for a rain policy on the same terms (i.e. for $50 now you would pay $100 if it rained) would you write the policy? If not, why not?
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The sum of the entries in the second column of inv(m1) indicates the cost of providing $1 if the wealther is rainy. Thus the cost of issue this insurance policy is: Cost = .6010*100 = $ 60.10 So you should tell the manufacturer to go to another insurance company (preferably one that doesn't know matrix algebra).

4. You have spent the better part of the weekend making estimates of next year's returns for two mutual funds -- A and B. You believe that Fund A has an expected return of 8% and a standard deviation of return of 10%, while Fund B has an expected return of 10% and a standard deviation of return of 15%. You estimate that the correlation between the returns of the two funds is 0.70. The risk-free rate of interest is 5%. You have two clients: X and Y. Client X has a risk tolerance of 25, while client Y has a risk tolerance of 75. [3] 4a. If you had to invest all of Client X's money in either Fund A or Fund B, which would you choose? _______ Utility = e - v/t Ua = 8 - (10^2)/25 = 4 Ub =10 - (15^2)/25 = 1 So -- choose Fund A [3] 4b. If you had to invest all of Client Y's money in either Fund A or Fund B, which would you choose? _______ Utility = e - v/t Ua = 8 - (10^2)/75 = 6.67 Ub =10 - (15^2)/75 = 7 So -- choose Fund B [5] 4c. Client X can borrow or lend at 5%. You need to help her choose between (1) a combination of Fund A plus borrowing or lending and (2) a combination of Fund B plus borrowing or lending. Which fund would you choose and how much would you advise her to borrow or lend (if any)? Given the ability to borrow or lend, the goal is to choose the fund with the largest Sharpe ratio. SRa = SRb = (8 - 5) / 10 = 0.30

(10 - 5) /15 = 0.33

Hence, choose fund B. To find the optimium amount to invest in fund B, let x equal the proportion invested in B. Then:

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Finance 368 Midterm

ep = 5 + 5*x vp = (x^2)*(15^2) = 225*(x^2) U = e - v/t = 5 + 5x - (225*(x^2)) / t To maximize utility, we set marginal utility (dU/dx) to zero: 5 So that: x = (5*t) / 450 ( 2*x*225) /t = 0

(a formula that we have derived in other contexts) For client X, t = 25, so that: x = 5*25/450 = .278 So client X should put 27.8% of her money in Fund B and the remaining 72.2% in the bank.

[2] 4d. Client Y can also borrow or lend at 5%. You need to help him choose between (1) a combination of Fund A plus borrowing or lending and (2) a combination of Fund B plus borrowing or lending. Which fund would you choose and how much would you advise him to borrow or lend (if any)? Again, the better fund is Fund B, since it has the higher Sharpe ratio. Again, x = the optimum amount to invest in fund B is equal to: (5*t) / 450

Since Client Y has a risk tolerance of 75, the optimum investment in the fund is x = (5*75)/450 = 0.8333 So he should put 83.33% of his money in Fund B and the remaining 16.67% in the bank.

[5] 4e. An investment management company has introduced a "fund of funds" that has 50% invested in Fund A and 50% in Fund B. This new fund (called, somewhat unimaginatively) Fund AB, has no additional expenses other than those associated with Funds A and B. Client X can borrow or lend at 5% and you now have to help her choose either (1) a combination of Fund A plus borrowing or lending or (2) a combination of Fund B plus borrowing or lending, or (3) a combination of Fund AB plus borrowing or lending. Which alternative would you choose?
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Fund AB has an expected return of: e = 0.5*8 + 0.5*10 = 9.0

a variance of:: v = ((0.5^2)*(10^2)) + (2*0.5*0.5*0.70*10*15) + ((.5^2)*(15^2)) = 133.75

and a standard deviation of: s = sqrt(v) = 11.565 Its Sharpe ratio is thus: SRab = (9 - 5) / 11.565 = 0.3459

Since this is greater than the Sharpe ratios of the other funds, the best alternative is (3) -- a combination of Fund AB plus borrowing or lending.

[2] 4f. Client Y can also borrow or lend at 5% and you also have to help him choose either (1) a combination of Fund A plus borrowing or lending or (2) a combination of Fund B plus borrowing or lending, or (3) a combination of Fund AB plus borrowing or lending. Which alternative would you choose? The best alternative is still (3) -- Fund AB plus borrowing or lending, although the amount borrowed or lent will differ for the two clients.

5. The President of a large endowment fund has completed a detailed analysis of the fund's investments. The fund's board has let the President select any allocation among six major asset classes as long as no more than 50% of the fund is invested in any given asset class and there are no short positions in any of the asset classes. The President has engaged a consulting firm run by several recent graduates of a prestigious MBA program to recommend an asset allocation. The table below shows the recommended allocation, the expected returns used in the analysis, and the associated "marginal utilities" of the asset classes, given the risk tolerance of the trustees of the foundation.

Allocation (%) Expected Return Marginal Utility Cash Government Bonds Corporate Bonds Stocks 0 0 10 20 5 6 7 11 5.0 5.3 5.5 5.5

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Finance 368 Midterm

Real Estate Venture Capital

20 50

9 15

5.5 6.1

[3] 5a. Assuming that all the inputs used by the consulting firm were correct, have they recommended the best possible allocation among the asset classes? If not, what changes would you recommend? The recommendation is optimal, since the marginal utilities of all the assets that are "in the solution" (between their bounds are the same (5.5), all those for assets that are at their lower bounds ("down") are less (5.0 and 5.3), and the marginal utility for the asset that is at its upper bound (Venture Capital) is more (6.1). [3] 5b. A recent change in interest rates has raised the best estimate of expected return for government bonds from 6.0% to 6.1%. What, if any, change should be made in the foundation's asset allocation? Note that the marginal utility of an asset is: mu(i) = e(i) - 2*c(i,p)/t Since only the asset's expected return has changed, the marginal utility will increase by the same amount as the increase in the expected return. This increases the Government Bond marginal utility from 5.3 to 5.4. Since this is still below the common marginal utility for the "in variables", the current asset mix is still optimal and no changes should be made.

[4] 5c. Government interest rates have fallen back to their original levels, but the President is convinced that the expected return on Real Estate is 9.5% rather than 9.0% and that Venture Capital has an expected return of 14% rather than 15%. She doesn't want to attract the attention of the board, but would like to make at least a small change in the allocation by lowering the amount invested in one asset and increasing the amount invested in another one. Would you recommend that she make such a change? If so, which one? The situation is now: Allocation (%) Expected Return Marginal Utility Cash Government Bonds Corporate Bonds Stocks Real Estate Venture Capital 0 0 10 20 20 50 5 6 7 11 9.5 14 5.0 5.3 5.5 5.5 6.0 5.1

Real Estate has the highest marginal utility and is below its upper bound, so it is the most attractive candidate for an increase. Venture capital has a lower marginal utility than any other variable that can be decreased, so it is the most attractive candidate for a decrease. Hence the best single change would involve selling Venture Capital and purchasing Real Estate with the proceeds from the sale.

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Finance 368 Midterm

6. The table below provides spaces for you to write your estimates of the style of each of 10 mutual funds. In each style box write one number, constituting your best estimate of the percentage (blanks are treated as zero and the sum for each fund should equal 100). All estimates should be forward-looking for next year. All asset classes are represented by index funds, with asset returns based on the net returns to investors in the index funds. [2] for each fund Some of the numbers below are guesses, others are relatively precise. Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Fund 6 Fund 7 Fund 8 Fund 9 Fund 10 Cash Intermediate Govt. Bonds Long-term Govt. Bonds Corporate Bonds S&P500 Value S&P500 Growth Wilshire 4500 MSCI EAFE 47.5 47.5 100 100 50 17.5 17.5 15 20 20 80 62.5 62.5 40 40 50 40 30 30 5 -25 10 60 -20 16 10 6 17 17 14 20

The descriptions of the funds follow: 1. An S&P500 stock index fund that maintains a cash margin of approximately 5%. 2. A U.S. equity fund that specializes in medium and small stocks 3. A fund that buys large growth stocks 4. A convertible bond fund 5. A fund that buys junk bonds 6. A fund that buys large stocks on margin, with $125 invested for every $100 of capital. 7. A fund that specializes in stocks of large global corporations based in the United States. 8. A balanced fund that favors high-grade bonds and large stocks of admired companies 9. A fund that holds very long-term government bonds and stocks with betas (relative to the S&P500) greater than 1. 10. A fund that invests 80% of its money in market proportions of all U.S. securities and 20% in non-U.S. equities.

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Finance 368 Midterm

Finance 368
Spring 1998 Prof. Sharpe

Midterm Examination with Answers (and additional comments) (points shown in blue)
1. In the small country of petitpays there are only four stocks. The number of shares outstanding and last night's price per share of each are shown below:

Stock Alpha Industries Beta Telecom Gamma Technology Delta Toys

Shares 41,250 30,000 25,000 30,000

Price 40 30 12 5

Stock Alpha Industries Beta Telecom

Shares

Price

Value

PctMkt

PctLg

PctSml

41,250

40

1,650,000

55%

65%

30,000

30

900,000

30%

35%

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Finance 368 Midterm

Gamma Technology Delta Toys

25,000

12

300,000

10%

67%

30,000

150,000 3,000,000

5%

33%

Despite the small number of stocks, there are 25 mutual funds in petitpays. You have been asked to evaluate six of them. For each one, the composition of last night's portfolio is shown using relative values, based on last night's stock prices.

Stock Alpha Industries Beta Telecom Gamma Technology Delta Toys Total

Brigantine Complet Fido Quasar Rabba Westwood 64.7 35.3 0.0 0.0 100.0 55.0 30.0 10.0 5.0 100.0 75.0 25.0 0.0 0.0 0.0 0.0 50.0 50.0 57.0 29.0 8.0 6.0 0.0 0.0 66.7 33.3 100.0

100.0 100.0 100.0

1a. Which (if any) of the funds are: [1] a. Active Large Cap Fido [1] b. Active Small Cap Quasar [1] c. Enhanced Index (high R-squared) Rabba [1] d. Large Cap Index Brigantine [1] e. Small Cap Index Westwood [1] f. Market Index Complet Assume that at the close of the market today the return on the entire market was 2.5%. [4] 1b. The Wall Street Journal reports the performance of the mutual fund industry by averaging the total returns of all the funds, with each fund given the same weight. What was the resulting average return? (circle one) More than 2.5% 2.5% Less than 2.5%
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You can't say Why? Assuming that the 2.5% is the return on the average dollar invested in the market (or equivalently, the return on a market-capitalization weighted index of all stocks), this may be more, less or equal to a simple average of the returns on funds, each of which has a different market value. If funds were representative and their returns were weighted by fund size, the gross returns would equal the market-capitalization weighted average for the stocks in the market. However, even in this case, the net return would be less. And, since the reported fund average is not weighted by fund size, anything could happen.

2. The following table shows the styles of four mutual funds, expressed in terms of Cash, Bonds and Stocks.

Cash Bonds Stocks Aggressive Growth Fund Balanced Safety Fund Conservative Investors' Fund Responsible Investors' Fund 0.05 0.10 0.20 0.20 0.00 0.45 0.70 0.40 0.95 0.45 0.10 0.40

2a.Doctor Watson has just invested 20% of her money in the Aggressive Growth Fund, 30% in the Balanced Safety Fund, 25% in the Conservative Investors' Fund, and 25% in the Responsible Investors' Fund. She has come to you for advice. In particular, she wants to know her current asset allocation. In order to avoid doing this in detail over and over in the future, you have decided to construct matrices, vectors and such so that you can write the task as a simple matrix expression. Show the contents of each matrix or vector that you would use and write an expression, such as a=b*c, that could be interpreted by a programming language such as MATLAB and that would provide the answer. [2] Matrices and Vectors: b = a vector with 1 row and funds columns {1*f} b = [ 0.2000 0.3000 0.2500 0.2500 ]

c = a matrix with funds rows and assets columns {f*a} c = [ 0.0500 0.1000 0.2000 0.2000 0 0.4500 0.7000 0.4000 a = b*c 0.9500 0.4500 0.1000 0.4000

[1] Expression:

[1] How big would your answer matrix or vector be? 1 row and 3 (assets) columns
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[1] How would you interpret the contents of each cell? The first entry shows the proportion of Watson's fund invested in cash, the second the proportion invested in bonds, and the third the proportion invested in stocks. 2b. Impressed with your skills, Dr. Watson recommends your services to her friend Mr. Holmes. Holmes has a modest amount of money saved and wishes to invest it. He has deduced that the appropriate asset allocation for him requires 10% in cash, 30% in bonds and 60% in stocks. Your task is to find a fund or combination of two or more of the funds that will accomplish his goal. You want to be able to do this for others in an efficient manner, so you have decided to construct matrices, vectors, and such so you can write the task as a simple matrix expression. Show the contents of each matrix and vector that you woul use: [7] There are more funds than assets in this case. Thus it should be possible to obtain a desired asset allocation with only three of them (barring degeneracy). For example, Holmes could use the first three funds

Cash Bonds Stocks Aggressive Growth Fund Balanced Safety Fund Conservative Investors' Fund 0.05 0.10 0.20 0.00 0.45 0.70 0.95 0.45 0.10

We now have a square matrix that is {f*a}. Call if cc: cc = [ 0.0500 0.1000 0.2000 0 0.4500 0.7000 0.9500 0.4500 0.1000

We seek a vector of fund holdings (bb) that is {1*f} such that: aa = bb*cc where aa = the desired asset mix in a vector that is {1*f}: aa = [ 0.1000 0.3000 0.6000 ]

[1] Write a MATLAB expression that would provide the answer: bb = aa*inv(cc) [1] How big would the answer matrix or vector be? 1*3, showing the proportions in each of the three selected funds [1] How would you interpret each cell? The first cell would indicate the proportion to invest in fund 1, the second would indicate the proportion to invest in fund 2, and the last would indicate the proportion to invest in fund 3, where the fund numbers refer to the chosen funds.

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[6] 2c. After you report your solution to Mr. Holmes he says "Aha -- you must have made an error, since Mr. Callan, with whom I consulted yesterday, recommended a different combination of funds and showed me that his combination gave the required asset allocation!". How do you deal with this criticism? You point out to Holmes that he doesn't understand financial economics. With more funds than assets, there will typically be alternative ways to get the same asset allocation. For example, using the first three funds in the procedure above gives a result, stated in tems of the four funds of: b1 = [ 0.4615 0.3077 0.2308 0 ]

while using funds 2 through 4 gives: b2 = [ 0 1.0000 -0.5000 0.5000 ]

But both portfolios offer the same asset allocation (although the latter involves a short position in one fund, and hence may not be feasible)..

3. In a highly advanced society there are two securities. One is called rf (for riskfree), the other s (for stock). There are only two possible future states of the world next year (sunny and rainy). The proceeds obtained by selling $1 worth of each of the securities next year in each of the two states are as shown below:

State sunny rainy

rf 1.04 1.04

s 1.29 0.89

You have asked a mathematican friend to invert this matrix. Uncertain about what you really want, she provides two answers:

M1 =

1.04 1.04

1.29 0.89 ] 3.1010 -2.5000

inv(M1) = [ -2.1394 2.5000 M2 = [ 1.04 1.29 1.04 0.89 ]

inv(M2) = [ -2.1394 3.1010

2.5000 -2.5000

You believe that it is as likely to be sunny as to be rainy.


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3a. Given this information: [2] What is the expected return on stocks (s)? 1+e = .5*1.29 + .5*.89 = 1.09 expected return = 9% [3] What is the standard deviation of stocks (s)? v = .5 * ((1.29 -1.09)^2) + .5 * ((0.89 - 1.09)^2) = .04 sd = sqrt(v) = 0.20 standard deviation of return = 20% [2] What is the equity risk premium? 9% - 4% = 5% [3] What is the Sharpe Ratio for equities? SR = (9 -4) / 20 = 0.25 3b. You are running a financial intermediation firm in this country. An umbrella manufacturer asks you if you would issue a sunshine insurance policy which would pay $100 if the weather turns out to be sunny. The manufacturer is willing to pay $50, which seems to him to be a fair price. Would you write the policy? If so, how much profit would there be for you in the deal? To answer this question (and the next one), we need to find the prices for the pure securities (one for each state). If we had a portfolio of securities x {securities*1}, the payoff pattern across states would be: z = M1*x (note that M1 is {states*securities}. Thus z will be {states*1}, as desired. To find a portfolio x that will give a desired payoff pattern z, we can solve: x = inv(M1)*z In this case, we want z to equal [1 0]. This means that the first column of inv(M1) gives the composition of the portfolio that will provide $1 if the weather is sunny. Since each security costs $1, the total cost is simply the sum of the entries in the first column of inv(m1) times 100. Thus Cost = .3606*100 = $ 36.06 [3] So you should definitely issue the policy. [4] The profit will be $13.94.
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[3] 3c. If a sunglass manufacturer came to you and asked for a rain policy on the same terms (i.e. for $50 now you would pay $100 if it rained) would you write the policy? If not, why not? The sum of the entries in the second column of inv(m1) indicates the cost of providing $1 if the wealther is rainy. Thus the cost of issue this insurance policy is: Cost = .6010*100 = $ 60.10 So you should tell the manufacturer to go to another insurance company (preferably one that doesn't know matrix algebra).

4. You have spent the better part of the weekend making estimates of next year's returns for two mutual funds -- A and B. You believe that Fund A has an expected return of 8% and a standard deviation of return of 10%, while Fund B has an expected return of 10% and a standard deviation of return of 15%. You estimate that the correlation between the returns of the two funds is 0.70. The risk-free rate of interest is 5%. You have two clients: X and Y. Client X has a risk tolerance of 25, while client Y has a risk tolerance of 75. [3] 4a. If you had to invest all of Client X's money in either Fund A or Fund B, which would you choose? _______ Utility = e - v/t Ua = 8 - (10^2)/25 = 4 Ub =10 - (15^2)/25 = 1 So -- choose Fund A [3] 4b. If you had to invest all of Client Y's money in either Fund A or Fund B, which would you choose? _______ Utility = e - v/t Ua = 8 - (10^2)/75 = 6.67 Ub =10 - (15^2)/75 = 7 So -- choose Fund B [5] 4c. Client X can borrow or lend at 5%. You need to help her choose between (1) a combination of Fund A plus borrowing or lending and (2) a combination of Fund B plus borrowing or lending. Which fund would you choose and how much would you advise her to borrow or lend (if any)? Given the ability to borrow or lend, the goal is to choose the fund with the largest Sharpe ratio. SRa = SRb = (8 - 5) / 10 = 0.30

(10 - 5) /15 = 0.33

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Finance 368 Midterm

Hence, choose fund B. To find the optimium amount to invest in fund B, let x equal the proportion invested in B. Then: ep = 5 + 5*x vp = (x^2)*(15^2) = 225*(x^2) U = e - v/t = 5 + 5x - (225*(x^2)) / t To maximize utility, we set marginal utility (dU/dx) to zero: 5 So that: x = (5*t) / 450 ( 2*x*225) /t = 0

(a formula that we have derived in other contexts) For client X, t = 25, so that: x = 5*25/450 = .278 So client X should put 27.8% of her money in Fund B and the remaining 72.2% in the bank.

[2] 4d. Client Y can also borrow or lend at 5%. You need to help him choose between (1) a combination of Fund A plus borrowing or lending and (2) a combination of Fund B plus borrowing or lending. Which fund would you choose and how much would you advise him to borrow or lend (if any)? Again, the better fund is Fund B, since it has the higher Sharpe ratio. Again, x = the optimum amount to invest in fund B is equal to: (5*t) / 450

Since Client Y has a risk tolerance of 75, the optimum investment in the fund is x = (5*75)/450 = 0.8333 So he should put 83.33% of his money in Fund B and the remaining 16.67% in the bank.

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Finance 368 Midterm

[5] 4e. An investment management company has introduced a "fund of funds" that has 50% invested in Fund A and 50% in Fund B. This new fund (called, somewhat unimaginatively) Fund AB, has no additional expenses other than those associated with Funds A and B. Client X can borrow or lend at 5% and you now have to help her choose either (1) a combination of Fund A plus borrowing or lending or (2) a combination of Fund B plus borrowing or lending, or (3) a combination of Fund AB plus borrowing or lending. Which alternative would you choose? Fund AB has an expected return of: e = 0.5*8 + 0.5*10 = 9.0

a variance of:: v = ((0.5^2)*(10^2)) + (2*0.5*0.5*0.70*10*15) + ((.5^2)*(15^2)) = 133.75

and a standard deviation of: s = sqrt(v) = 11.565 Its Sharpe ratio is thus: SRab = (9 - 5) / 11.565 = 0.3459

Since this is greater than the Sharpe ratios of the other funds, the best alternative is (3) -- a combination of Fund AB plus borrowing or lending.

[2] 4f. Client Y can also borrow or lend at 5% and you also have to help him choose either (1) a combination of Fund A plus borrowing or lending or (2) a combination of Fund B plus borrowing or lending, or (3) a combination of Fund AB plus borrowing or lending. Which alternative would you choose? The best alternative is still (3) -- Fund AB plus borrowing or lending, although the amount borrowed or lent will differ for the two clients.

5. The President of a large endowment fund has completed a detailed analysis of the fund's investments. The fund's board has let the President select any allocation among six major asset classes as long as no more than 50% of the fund is invested in any given asset class and there are no short positions in any of the asset classes. The President has engaged a consulting firm run by several recent graduates of a prestigious MBA program to recommend an asset allocation. The table below shows the recommended allocation, the expected returns used in the analysis, and the associated "marginal utilities" of the asset classes, given the risk tolerance of the trustees of the foundation.

Allocation (%) Expected Return Marginal Utility

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Finance 368 Midterm

Cash Government Bonds Corporate Bonds Stocks Real Estate Venture Capital

0 0 10 20 20 50

5 6 7 11 9 15

5.0 5.3 5.5 5.5 5.5 6.1

[3] 5a. Assuming that all the inputs used by the consulting firm were correct, have they recommended the best possible allocation among the asset classes? If not, what changes would you recommend? The recommendation is optimal, since the marginal utilities of all the assets that are "in the solution" (between their bounds are the same (5.5), all those for assets that are at their lower bounds ("down") are less (5.0 and 5.3), and the marginal utility for the asset that is at its upper bound (Venture Capital) is more (6.1). [3] 5b. A recent change in interest rates has raised the best estimate of expected return for government bonds from 6.0% to 6.1%. What, if any, change should be made in the foundation's asset allocation? Note that the marginal utility of an asset is: mu(i) = e(i) - 2*c(i,p)/t Since only the asset's expected return has changed, the marginal utility will increase by the same amount as the increase in the expected return. This increases the Government Bond marginal utility from 5.3 to 5.4. Since this is still below the common marginal utility for the "in variables", the current asset mix is still optimal and no changes should be made.

[4] 5c. Government interest rates have fallen back to their original levels, but the President is convinced that the expected return on Real Estate is 9.5% rather than 9.0% and that Venture Capital has an expected return of 14% rather than 15%. She doesn't want to attract the attention of the board, but would like to make at least a small change in the allocation by lowering the amount invested in one asset and increasing the amount invested in another one. Would you recommend that she make such a change? If so, which one? The situation is now: Allocation (%) Expected Return Marginal Utility Cash Government Bonds Corporate Bonds Stocks Real Estate Venture Capital 0 0 10 20 20 50 5 6 7 11 9.5 14 5.0 5.3 5.5 5.5 6.0 5.1

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Real Estate has the highest marginal utility and is below its upper bound, so it is the most attractive candidate for an increase. Venture capital has a lower marginal utility than any other variable that can be decreased, so it is the most attractive candidate for a decrease. Hence the best single change would involve selling Venture Capital and purchasing Real Estate with the proceeds from the sale.

6. The table below provides spaces for you to write your estimates of the style of each of 10 mutual funds. In each style box write one number, constituting your best estimate of the percentage (blanks are treated as zero and the sum for each fund should equal 100). All estimates should be forward-looking for next year. All asset classes are represented by index funds, with asset returns based on the net returns to investors in the index funds. [2] for each fund Some of the numbers below are guesses, others are relatively precise. Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Fund 6 Fund 7 Fund 8 Fund 9 Fund 10 Cash Intermediate Govt. Bonds Long-term Govt. Bonds Corporate Bonds S&P500 Value S&P500 Growth Wilshire 4500 MSCI EAFE 47.5 47.5 100 100 50 17.5 17.5 15 20 20 80 62.5 62.5 40 40 50 40 30 30 5 -25 10 60 -20 16 10 6 17 17 14 20

The descriptions of the funds follow: 1. An S&P500 stock index fund that maintains a cash margin of approximately 5%. 2. A U.S. equity fund that specializes in medium and small stocks 3. A fund that buys large growth stocks 4. A convertible bond fund 5. A fund that buys junk bonds 6. A fund that buys large stocks on margin, with $125 invested for every $100 of capital. 7. A fund that specializes in stocks of large global corporations based in the United States. 8. A balanced fund that favors high-grade bonds and large stocks of admired companies
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9. A fund that holds very long-term government bonds and stocks with betas (relative to the S&P500) greater than 1. 10. A fund that invests 80% of its money in market proportions of all U.S. securities and 20% in non-U.S. equities.

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Finance 368 -- 1999

Finance 368 Macro Investment Analysis


Stanford Graduate School of Business Professor William F. Sharpe Spring, 1999 GSB Room 71, 10:00 - 11:30

Overview
The title of this course is Macro Investment Analysis. It can be considered a second course on portfolio management. We take a particular view of the portfolio management process, with emphasis on (1) the decisions that must be made by and/or for the ultimate investor and (2) the analytic tools and empirical evidence that can help inform such decisions.

Official Course Description


F368. Macro-Investment Analysis This course focuses on investment decisions made by and/or for individuals, pension funds, endowments, and others and on analytic tools and empirical evidence that can help inform such decisions. It concentrates on situations in which the investment vehicles used by investors are primarily mutual funds, derivative securities, and other combinations of fundamental positions rather than individual securities such as specific stocks and bonds. In this view, investing is a multi-level process, with the investor often assisted by an analyst at the top level, a set of investment firms at a second level, and the securities of corporations and government agencies at yet lower levels. Subjects covered include: relationships between risk and return, implications of market efficiency, aspects of observed investor performance, dynamic allocation strategies, Monte Carlo simulation of investment results, and retirement planning.

Prequisites
Finance 328 (Portfolio Management) or permission of the instructor. To obtain the latter, you will need
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to have a knowledge equivalent to that in a standard investments textbook at or above the level of Fundamentals of Investments by Alexander, Bailey and Sharpe.

Worksheets
Several of the sessions will utilize Worksheets prepared by the instructor. These may also prove helpful as aids to learning the material for the course. References to specific worksheets will be found in this course outline and in some of the reading material.

Examinations
There will be a midterm and a final. The final will receive 150% of the weight assigned the midterm. Midterm:
q q q

Thursday April 29 Rooms: to be announced To see last year's examination and answers, click here.

Final:
q q

Date: to be announced Rooms: to be announced

Grades
Grades will be based on examination scores with the possibility of adjustment by the instructor based on discussions in class.

Office Hours
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Informal office hours will be held in the classroom after class, from 11:30 until 12:00 (as needed). Appointments for longer consultations in the instructor's office (Littlefield 381) can also be made at that time.

Supplemental reading
The following books are recommended for those wishing to obtain foundation material, additional discussions, and/or another view on some of the subjects covered in the course.
q

Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, Fifth Edition. New York: John Wiley & Sons, Inc., 1995 Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management, Probus Publishing, Chicago, Ill., 1995 Mark Kritzman, The Portable Financial Analyst - What Practitioners Need to Know,. Chicago: Probus Publishing, 1995 William F. Sharpe, Gordon J. Alexander and Jeffery V. Bailey, Investments, Fifth Edition. Englewood Cliffs, N.J.: Prentice-Hall, 1995

Course Material
At present, no printed textbook adequately covers the domain of this course. Instead, we will rely on the reading material described below. Material that is highlighted is only a click away via the web. The remainder of the material is included in the syllabus available to students registered for the course. All the web material can be accessed from the instructor's site. The instructor's goal is eventually to provide all the material for this course on the web in a reasonably consistent and coherent form. Meanwhile, some of the subjects must be covered with material written in other forms for different audiences. To minimize confusion (the students' and also the instructor's), the latter's own publications were given a high priority in the selection process. Be assured that no royalties are involved. In the list below, highlighted readings are on the web and can be obtained directly. The remainder must be obtained on paper. The material listed for each session should be read before the date given. Those who have not read the
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material in advance may be confused, embarrassed and/or frustrated.

Course Material

1. Introduction (Tuesday March 30) Required Reading (before class)


q q q q

Investment Approaches Financial Economics Models and Paradigms W.F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, July/August 1976, p. 4. W.F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, January/February 1991, pp. 7-9.

Video
q

Beyond Wall Street, The Art of Investing: Episode 4: Indexing

2. Matrix Algebra (Thursday April 1) Required Reading (before class)


q q q

Matrices Matrix Operations Matrix Operations in Excel

3. MATLAB (Monday April 5)

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Required Reading (before class)


q q

MATLAB Asset Allocation with Investment Funds

4. Prices - I (Thursday April 8) Required Reading (before class)


q q

Time-state Claims Valuation

5. Prices - 2 (Monday April 12) Required Reading (before class)


q q q

Multiple Commodities, States and Times Interest Rates and Bond Yields Forward Prices

6. Probabilities (Thursday April 15) Required Reading (before class)


q q q

Production, Consumption and Market Clearing Risk Premia Consumption and Investment Choices

7. Risk and Return (Monday April 19)


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Required Reading (before class)


q q q q q q q

Mean, Variance and Distributions Portfolio Choice Multi-period Returns Portfolio Characteristics Two-asset Portfolios The Weighted Statistics Worksheet The Reverse Optimization Worksheet

8. Optimization (Thursday April 22) Required Reading (before class)


q q q q

Optimization: The Gradient Method Optimal Portfolios without Bounds on Holdings The Critical Line Method The Optimization Worksheet

9. Factor Models (Monday April 26) Required Reading (before class)


q q

Factor models W.F. Sharpe, "Some Factors in New York Stock Exchange Security Returns, 19311979," Journal of Portfolio Management, Summer 1982, pp. 5-19. R.A. Grinold and D. Stefek, "Global Factors: Fact or Fiction?," Journal of Portfolio Management, Fall 1989, pp. 79-88.

10. Midterm Examination (Thursday April 29)


q

Midterm exam with answers

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11. Style Analysis (Monday May 3) Required Reading (before class)


q

q q

W.F. Sharpe, "Asset allocation: Management style and performance measurement," Journal of Portfolio Management, Winter 1992, pp. 7-19. Setting the Record Straight on Style Analysis The Style Analysis Worksheet

12. Equilibrium (Thursday May 6) Required Reading (before class)


q q

q q

Equilibrium - preliminary W.F. Sharpe, "Capital Asset Prices with and without Negative Holdings," Journal of Finance, June 1991, pp. 489-509. W.F. Sharpe, "Factor models, CAPMs, and the APT," Journal of Portfolio Management, Fall 1984, pp. 21-25. Revisiting the Capital Asset Pricing Model S. Benartzi and R.H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle"Quarterly Journal of Economics, February 1995, pp. 73-92.

13. Performance Analysis (Monday May 10) Required Reading (before class)
q q

q q q

Mutual Fund Performance Measurement W.F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58. Morningstar's Risk-adjusted Ratings Financial Economists' Roundtable Statement on Risk Disclosure by Mutual Funds The Performance Measurement Worksheet

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14. International Investment (Thursday May 13) Required Reading (before class)
q

A.F. Perold and E.C. Schulman, "The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards," Financial Analysts Journal, May/June 1988, pp. 45-52. W.F. Sharpe, "Hedging Currency Risk in an International Portfolio," Investment Technology, Spring 1992, pp. 1-43. Patrick Odier and Bruno Solnik, "Lessons for International Asset Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77. Carlo Capaul, Ian Rowley and W.F. Sharpe, "International Value and Growth Stock Returns," Financial Analyst's Journal, January/February 1993, pp. 27-36.

15. Investment Policies for Defined Benefit Pension Plans (Monday May 17) Required Reading (before class)
q

Martin Leibowitz, "Liability Returns: A New Look at Asset Allocation," Journal of Portfolio Management, Winter 1987, pp. 11-18. William F. Sharpe and Lawrence G. Tint, "Liabilities -- A New Approach," , Journal of Portfolio Management, Winter 1990, pp. 5-10.

16. Dynamic Strategies 1 (Thursday May 20) Required Reading (before class)
q

W.F. Sharpe, "Integrated Asset Allocation," Financial Analysts Journal, September/October 1987, pp. 25-32. Andre Perold and W.F. Sharpe, "Dynamic Strategies for Asset Allocation", Financial Analysts Journal, January/February 1988, pp. 16-27.

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17. Dynamic Strategies 2 (Monday May 24) Required Reading (before class)
q

W.F. Sharpe, "Investor Wealth Measures and Expected Return," Quantifying the Market Risk Premium Phenomenon for Investment Decision Making, The Institute of Chartered Financial Analysts, 1990, pp. 29-37.

18. Individual Retirement Savings and Investment, 1 (Thursday May 27) Required Reading (before class)
q

q q q q

The Economic Report of the President, 1997: Economic Challenges of an Aging Population Hemant Shah, "Toward Better Regulation of Private Pension Funds" The World Bank Policy Research Working Paper #1791, June 1997 Financial Economists Roundtable Statement on Social Security The Bob Boomer Case The Annuity Worksheet The Retirement Worksheet

19. Individual Retirement Savings and Investment, 2 (Wednesday June 2) Required Reading (before class)
q q

Financial Planning in Fantasyland Nobel Laureate Discusses Basic Investing Decisions

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Finance 368 -- 1999

Final Examination Friday June 4, 2:00 - 5:00, GSB 70 and 71


To see last year's examination, click here.

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Finance 368 Midterm

Finance 368
Spring 1999 Prof. Sharpe

Midterm Examination with answers (in blue) Each part (subquestion) is worth 4 points Not all questions are of equal difficulty The total time for the examination is 2 hours Please allocate your time efficiently
1. The Russell Frank Company, a revered consulting firm, has made the following predictions for the expected returns and risks (standard deviations) of several mutual funds over the next year:

Fund Exp Return Std Dev A B C D 5.0 7.0 10.0 8.5 0.0 10.0 20.0 15.0

1a. (4 points) Bob Jung has decided to invest all his money in one (and only one) of these funds. Without knowing anything about his preferences, can you advise him to choose a specific fund, or at least not to consider one or more funds? Use indifference curves to defend your answer. There is no dominance in this set of funds, so any one could be optimal, depending on Bob's preferences. It is possible to draw a set of indifference curves that have the standard properties (upward-sloping with increasing slopes) that put any one of the four funds on the highest feasible curve.

1b. (4 points) Becky Morgan has decided to select one fund and put all the rest of her money in the bank, which pays 5% interest with no risk. She also can borrow money from her financial aid counselor at a rate of 5%. Can you recommend a fund
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(A,B, C or D) to her or at least rule out one or more funds? Why or why not? If she is going to put any money at risk you can advise her to use fund C plus borrowing or lending. It has the highest excess return Sharpe Ratio, as shown below.

Fund Exp Return Std Dev SR A B C D 5.0 7.0 10.0 8.5 0.0 10.0 20.0 15.0 -0.20 0.25 0.23

This means that for any desired level of risk, a combination of C plus borrowing or lending will provide a higher expected return than any combination of B plus borrowing or lending or D plus borrowing or lending. Fund A (or equivalently, putting all the money in the bank) would be a possibility only if she were very risk averse, with an indifference curve at point A with a slope greater than 0.25. 1c. (4 points) Bob Fargo is considering investing in either (1) a portfolio of funds B and C or (2) putting all his money in fund D. He would like a risk equal to that of fund D. He believes that the returns on funds B and C are not perfectly positively correlated. Should he choose a portfolio of B and C or investment solely in fund D? If he should choose a portfolio of B and C, can you say whether the optimal combination will include more B or more C, or is it impossible to determine without knowing the precise value of the correlation coefficient? Fund D lies on the line connecting funds B and C. As long as the latter are not perfectly positively correlated, the plot of combinations of risk and return that can be obtained with combinations of them will lie to the left of the line segment (except at the end points). Thus for a risk of 15, it is possible to obtain a higher expected return with a portfolio of B and C than with fund D. Since the curve showing the risk and return of combinations of B and C will lie to the left of the line connecting their points, we know that a portfolio of B and C with the same expected return as D will lie to the left of point D (that is, have a lower standard deviation). Since D's expected return is half-way between that of B and C, this portfolio will have equal amounts of the two funds. To increase the standard deviation to equal that of D will require larger amounts of fund C. Thus we can say that the optimal portfolio will have more than half invested in in Fund C. To be more precise, of course, we would have to know the precise value of the correlation coefficient.

2. Merrill Chase, a well-known investment bank with a high-quality financial engineering department, has recently built a model of the bond and stock market for use in pricing and hedging derivative securities. For two-year securities they have designated six possible contingent payment states u: pay $1 at the end of year 1 if the market goes up in the first year d: pay $1 at the end of year 1 if the market goes down in the first year uu: pay $1 at the end of year 2 if the market goes up in the first year and again in the second year ud: pay $1 at the end of year 2 if the market goes up in the first year and down in the second year du: pay $1 at the end of year 2 if the market goes down in the first year and up in the second year
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Finance 368 Midterm

dd: pay $1 at the end of year 2 if the market goes down in the first year and again in the second year They have also identified six different investment decision variables: B: invest $1 in a one-year bond today, cash it out at the end of year 1; cost today = $1 S: invest $1 in a stock today, cash it out at the end of year 1; cost today = $1 Bu: invest $1 in a one-year bond next year if the market goes up in the first year; cost today = $0 Su: invest $1 in a stock next year if the market goes up in the first year; cost today = $0 Bd: invest $1 in a one-year bond next year if the market goes down in the first year; cost today = $0 Sd: invest $1 in a stock next year of the market goes down in the first year; cost today = $0 The following matrix, M, shows their assumed binomial process (blanks are zero). B u d uu ud du dd 1.04 1.04 S 1.25 0.95 1.04 1.04 1.25 0.95 1.04 1.04 1.25 .95 Bu -1 Su -1 -1 -1 Bd Sd

They believe that in each year the odds are 50/50 that the market will go up or down in each year. 2a. (4 points) What is the one-year interest rate? 4% 2b. (4 points) What is the annual interest rate, compounded annually, on a two-year zero coupon bond? 4% 2c. (4 points) A two-year bond with 4% coupon is currently selling at par. The bond pays $4 at the end of year 1 and $104 at the end of year 2. It currently sells for $100. If the market is up at the end of year 1, what will be the price of this bond? $100 2d. (4 points) Is Merrill Chase assuming that stock returns are identically and independently distributed over time? Please explain. yes 2e. (4 points) Ken Gerard is being interviewed for a position in the financial engineering department at Merrill Chase. He has been asked to evaluate a proposal for a security that would be issued by Merrill that would promise the holder $1000 in one year if and only if the market is up. His task is to consider the appropriate price to charge for such a security and the strategy required to completely hedge the firm's obligation. To begin, he has computed the inverses of two matrices, as follows: m1 = [ 1.04 1.25

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Finance 368 Midterm

1.04 0.95 ] inv(m1) = [ -3.0449 4.0064 3.3333 -3.3333 ] m2 = [ 1.04 1.04 1.25 0.95 ] inv(m2) = [ -3.0449 3.3333 4.0064 -3.3333 ]

Ken is a bit confused -- he doesn't know if he needs the inverse of m1, the inverse of m2, or neither. In any event, he must answer the question soon or run the risk of being rejected for the job. How should he proceed? What are the answers to the questions? How can he be sure? In your answer, show the dimensions of each matrix you use stated in terms of content (for example, {assets*states}). Matrix m1 is {states*assets}. If the desired portfolio, n, is {assets*1}, then the cash flows will be: c = m1*n where c is {states*1}. Here we know c = [1000 0]' and need to find n and its cost. To do this we multiply each side by the inverse of m1, giving: inv(m1)*c = n In this case: the required strategy is to invest $3,333.33 in a stock and short $3,044.90 of bonds. The net cost is thus 3,333.33 - 3,044.90, or $288.50. The latter could have been obtained more elegantly by using a vector of prices for the assets, pa = [1 1] and computing the cost as: cost = pa*n 2f. (4 points) Having successfully answered the prior questions in his interview, Ken is posed another set of questions. He is to determine the Arrow-Debreu state prices for (1) $1 if the market is up and (2) $1 if the market is down. Then he is to show that these are consistent with the one-year discount factor. Worse yet, he has only a few minutes to provide the answers. What are the two prices? Show that they are consistent with the discount factor. We already know the state price for the up-state. It is $0.2885. Similar calculations would give the second (most easily obtained by summing the two entries in the second column of inv(m1). It is $0.6731. The two state prices sum to $0.9615. The discount factor is 1/1.04, which is also $.9615. Q.E.D. 2g. (4 points) The mutual fund department of Merrill Chase would like to issue a certificate with "upside potential and downside protection". In particular, this certificate would promise the holder $1,000 two years hence if the market is up two years in a row (upside potential) and $800 otherwise (downside protection). What would be the cost of hedging such a claim? To help you make any needed calculations, we provide below the inverses of M and M'. inv(M) = [ -3.0449 3.3333 0 0 0 0 4.0064 -3.3333 0 0 0 0 -0.8783 0.9615 -3.0449 3.3333 0 0 -2.0494 2.2436 4.0064 -3.3333 0 0 1.1557 -0.9615 0 0 -3.0449 3.3333 2.6966 -2.2436 0 0 4.0064 -3.3333 ]

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Finance 368 Midterm

inv(M') = [

-3.0449 4.0064 -0.8783 -2.0494 1.1557 2.6966

3.3333 -3.3333 0.9615 2.2436 -0.9615 -2.2436

0 0 -3.0449 4.0064 0 0

0 0 3.3333 -3.3333 0 0

0 0 0 0.0000 -3.0449 4.0064

0 0 0 0 3.3333 -3.3333

The easiest way to deal with this problem is to find the state prices. Since only the first two columns (B and S) cost money today, the price for each state will simply equal the sum of the first two elements in the inverse of M. This gives ps = [ 0.2885 0.6731 0.0832 0.1942 0.1942 0.4530 ] The desired payments are c = [ 0 0 1000 800 800 800 ]' Multiplying these two vectors gives the cost: cost = 756.29 2h. (4 points) The head of the mutual fund department has found through market research and focus groups that the proposed certificate (in 2g) could easily be sold for $800 each. She asks you to determine whether or not to issue such a certificate and, if so, to provide instructions for the trading department (1) today, (2) next year if the market is up, and (3) next year if the market is down. You plan to have an assistant do all the needed calculations. He is proficient in linear algebra, MATLAB and Excel but knows nothing else. Provide the instructions he needs to find the answers in a form that he can understand and the information he needs to prepare the instructions for the trading department. We have the formulas already. Strategy n will provide cash flows c if: c = M*n To find the strategy we solve for n in n = inv(M)*c The first two entries of n indicate the dollars to be invested (shorted, if negative) in bonds and stocks today. The next two indicate the dollars to be invested (shorted, if negative) in bonds and stocks next year if the market is up. The final two indicate the dollars to be invested (shorted, if negative) in bonds and stocks next year if the market is down. 2i. (4 points) Assume that Merrill is correct in its assessment that the odds are 50/50 that the market will go up or down in each year. What is the expected growth of $1 invested in the new certificate over the two years (that is, the expected ending value per dollar invested)? What would the ending value be if $1 were invested in a two-year bond? What would it be if $1 were invested in the stock market for two periods? In which ending states would $1 invested in the certificate outperform $1 invested in the bond? The stock? What are the risk premiums or discounts associated with each of the three strategies? Does the certificate offer a risk premium? If so, why? If not, why not?
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Finance 368 Midterm

The certificate costs $756.29. It is equally likely to return $1,000, $800, $800 or $800. Thus the expected ending value is $850. This gives an expected value per dollar invested of 850/756.29, or 1.1239, for an expected two-year return of 12.39%. For the bond $1 grows to 1.04^2, or 1.0816 for an expected two-year return of 8.16%. An investment of $1 in stocks is equally likely to have an ending value of 1.25^2, 1.25*.95, 1.25*.95, or .95*.95. This gives an expected value of $1.21 for an expected two-year return of 21%. Ending values per dollar invested in stocks, bonds and the certificate are: State Bond Stock Certificate uu 1.0816 1.5625 ud 1.0816 1.1875 du 1.0816 1.1875 dd 1.0816 0.9025 1.3222 1.0578 1.0578 1.0578

So the certificate outperforms the bond in state uu and underperforms otherwise. It outperforms stocks in dd and underperforms otherwise. Since the bonds are riskless, they have no risk premium. The certificate has a risk premium of 12.39-8.16, or 4.23% (per two years). Stocks have a risk premium of 21.0-8.16, or 12.84% per two years. The certificate offers a risk premium because its highest payoff is in the state with the highest expected return (uu). Since all four states are equally likely, comparison of the state prices reveals this directly (they are 0.0832 0.1942 0.1942 and 0.4530). Thus the certificate does (relatively) badly in bad (not great) times. Presumably the reason for the high expected return in state uu is that goods are plentiful in that state with low marginal utilities for representative investors.

3. Assets R'Us (ARU) is a firm specializing in financial planning for individuals. After considerable research the firm has predicted the following for the returns in US dollars over the next year for four major asset classes: Expected Standard corr with corr with corr with corr with Return Deviation Cash USBonds USStocks NonUSStocks 4.5 5.5 10.5 10.0 0.0 5.0 15.0 20.0 0 0 0 0 0 1 0.4 0.2 0 0.4 1 0.5 0 0.2 0.5 1

Asset Cash USBonds USStocks NonUSStocks

3a. (4 points) What are the covariances of the assets with one another? Please include a table showing your results.

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Finance 368 Midterm

Asset Cash USBonds USStocks NonUSStocks

Cash 0 0 0 0

USBonds 0 25 30 20

USStocks 0 30 225 150

NonUSStocks 0 20 150 400

3b. (4 points) ARU has three clients, each of which has a numbered account. To make matters simple, each client is referenced by his or her risk tolerance. Thus the first client (client 25) has a risk tolerance of 25, the second (client 50) has a risk tolerance of 50, and the third (client 75) has a risk tolerance of 75. No client is allowed to take a short position in any asset. At present, each client has the same portfolio. The proportions invested in the three assets in this portfolio are: Asset Cash USBonds USStocks NonUSStocks Cash 0.10 0.30 0.50 0.10

What is the expected return of this portfolio? What is its variance of return? e = 8.35% v = 87.70 3c. (4 points) What is the utility of the portfolio for client 25? for client 50? for client 75? If these differ, why do they differ? If not, why not? u(25) = 4.842 u(50) = 6.596 u(75) = 7.1807 The higher risk tolerance investors do not subtract as large a risk penalty (v/rt) from expected return. Thus their certainty equivalent (or risk-adjusted return, or utility) is higher for the same portfolio. 3d. (4 points) Is this portfolio optimal for client 25? for client 50? for client 75? To answer this question we need to compute marginal utilities. The marginal utility of an asset is its expected return minus its marginal risk divided by risk tolerance. The marginal risk of an asset is two times its weighted average of its covariances with the assets, using current portfolio weights. The results of the computations are shown below.

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Finance 368 Midterm

Asset Cash USBonds USStocks NonUSStocks

Expected Return 4.50 5.50 10.50 10.00

Marginal Risk 0 49 273 242

MU(25) 4.50 3.54 -0.42 0.32

MU(50) 4.50 4.52 5.04 5.16

MU(75) 4.50 4.8467 6.8600 6.7733

The portfolio is not optimal for any client since in each case there is at least one pair of "in" assets (between their upper and lower bounds) with different marginal utilities. 3e. (4 points) If you were allowed to change the holdings in only two asset classes for client 25, and the amount of change was required to be very small, which two assets would you change, and in what manner, or would you recommend no changes? For this client, sell US Stocks (with the lowest marginal utility) and buy cash (with the highest marginal utility). 3f. (4 points) If you were allowed to change the holdings in only two asset classes for client 50, and the amount of change was required to be very small, which two assets would you change, and in what manner, or would you recommend no changes? For this client, sell cash (with the lowest marginal utility) and buy nonUS stocks (with the highest marginal utility). 3g. (4 points) If you were allowed to change the holdings in only two asset classes for client 75, and the amount of change was required to be very small, which two assets would you change, and in what manner, or would you recommend no changes? For this client, sell cash (with the lowest marginal utility) and buy US stocks (with the highest marginal utility). 3h. (4 points) If all three clients were in the office when you made your recommendations how would you explain to them any differences in your advice? For each give a rationale (in english, using no technical terms) for your conclusions. Client 25 has low tolerance for risk. You are recommending a more conservative portfolio. Client 50 has medium tolerance for risk. The current portfolio is too conservative. Foreign stocks are especially attractive because they provide better diversification than adding to the already substantial holdings in US stocks. This more than offsets their somewhat lower expected returns in this case. Client 75 has a high tolerance for risk. The current portfolio is far too conservative. While foreign stocks provide better diversification than US stocks, risk reduction is not important enough for this client to offset the higher expected returns for US stocks. 3i. (4 points) One of your colleagues has suggested the following portfolio for client 75. Compare its utility for this client with that of the current portfolio. Is this better? Could there be a better one? Please provide computations to defend your answers. Asset Cash USBonds USStocks Cash 0.00 0.00 0.8269

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Finance 368 Midterm

NonUSStocks

0.1731

The marginal utilities are as follows:

Asset Cash USBonds USStocks NonUSStocks

Expected Return 4.50 5.50 10.50 10.00

Marginal Risk 0 56.538 424.035 386.55

MU(75) 4.5000 4.7462 4.8462 4.8460

It is definitely better. The characteristics are: CHARACTERISTICS: Current ExpRet 8.350 StdDev 9.365 Utility 7.181

Proposed 10.413 14.449 7.630

Is there a better one? Possibly, but it is not likely to be much better. The two down variables (cash and bonds) have marginal utilities below those of the two in variables (US stocks and nonUS stocks). The two in variables have very similar marginal utilities, so the likely improvement is very small.

4. A small investment consulting firm in the country of Transylvania is convinced that there are two key common factors affecting stock returns. One is associated with a stock's dividend yield, the other with its historic earnings growth rate. To this end, each of the 100 stocks in the Transylvanian market has been analyzed, and assigned two numbers. The first, y(i) is the relative yield of the stock. This is an integer number that ranges from a value of 100 (for the stock with the highest yield) to 1 (for the stock with the lowest yield). The stock with the second-highest yield has a y(i) of 99, and so on. The second number g(i) indicates the stocks's relative growth rate. Here, too the numbers are integers from 100 (for the stock with the highest historic growth rate) to 1 for the stock with the lowest historic growth rate. The consulting firm has also classified each stock based on its economic activity. Every stock has been assigned to one (and only one) economic sector, either basic industries (B), consumer goods (C), finance (F), or technology (T). The firm has hired you to implement this view in a factor model of security returns. 4a. (4 points) Write the equation that will characterize your model of the return-generating process. Please define each term in sufficient detail to avoid any confusion. Six factors are needed. The first two can reflect the yield factor and growth factor, with the last four reflecting the industry factors. Let im1(i) equal 1 if security i is a member of industry 1 and zero otherwise, im2(i) equal 1 if security i is a member of indstry 2 and zero otherwise, etc. we have: r(i) = y(i)*fy + g(i)*fg + im1(i)*if1 + im2(i)*if2 + im3(i)*if3 + im4(i)*if4 + e(i)

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Here the factors are the yield factor (fy) the growth factor (fg), and industry factors 1 (if1) through 4 (if4) Alternatively, an intercept could be include (for example, a(i)) with the understanding that the expected value of e(i) is zero. 4b. (4 points) Assume that the yield factor was positive last month. Does it mean that every stock with a yield greater than the median yield outperformed every stock with a yield below the median yield? Suppose that there are two stocks in the same industry with the same historic earnings growth. Does this mean that the one with the higher yield outperformed the one with the lower yield? What, if anything, , can you say about the relative performance of high yield and low yield stocks, based on the fact that the yield factor was positive? The information that the yield factor was positive only indicates that on average, other things equal, high yield stocks outperformed low yield stocks. In fact there were undoubtedly many cases in which a high yield stock underperformed a low yield stock. This could be due to different exposures to other factors. However, even in the case in which two stocks had the same exposures to other factors (as in the second question asked), the residual returns could cause the high yield stock to underperform the low yield stock. 4c. (4 points) You have been presented with data for each of the 100 stocks for each of the preceding 60 months. For each month you have the following information for each stock: y(i): the stock's yield ranking at the beginning of the month g(i): the stock's historic growth ranking at the beginning of the month sector(i): the stock's economic sector at the beginning of the month What would you do to determine the realized values of the relevant factors in a specific month? What would you do to determine the historic covariance matrix for the factors and the historic mean returns for the factors? What would you do to determine the historic residual risks for each of the securities? Please answer in sufficient detail so that a statistician could perform the calculations needed to provide the quantitive values in question. What statistical measures might you use to see whether or not your factor model makes sense? For each month, you would perform a cross-section regression in which each stock was an observation, the stock returns (r(i)) are the dependent variable, and the six characteristics (y(i), g(i), im1(i), .. im4(i)) are the independent variables. This would give the realizations of the factors for the month and the residual return for each of the securities for that month. Having done this for each month, you would compute the covariance matrix for the 60 months of factor values, the means of the 60 factor values, and the variances of the 60 residual returns for each of the stocks. You could check the t-statistics for the cross-sectional regressions. For each factor the t-statistic should have an absolute value of, say, 2.0 in a significant number (more than 5%) of the months. You could also check the R^2 values for the overall regression in each month. These should be large enough to indicate significant explanatory power. Finally, you could check the correlations of the residal returns. These should average close to zero and there should be relatively few values that are large in absolute value. 5. Another consulting firm has decided that it is silly to worry about factors within the overall stock market since it is interested only in equity mutual funds. It has analyzed the behavior of three such funds by relating the excess return (return over the treasury bill rate) on each fund to the excess return on the overall stock market. They have termed the resultant sensitivity "stock exposure" -- thus a fund with a stock exposure of 0.80 would have an excess return 80% as great as that of the stock market on average. In addition to estimates of the fund's stock exposures, an estimate has been made for the added
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risk and return for each fund, over and above that attributable to its exposure to the stock market. The consulting firm assumes that each fund's added (residual) return is uncorrelated with the stock market and with the added (residual) return of each of the other funds. The results of this analysis are as follows: Added Risk (% standard deviation per year) 5.0 10.0 5.0

Fund A B C

Stock exposure 0.80 1.00 1.20

Added Expected Return (% per year) 1.0 2.0 1.0

Finally, the firm has made the following estimates for the stock market: Expected Excess Return (%/yr) 5.0 Std Dev of Return (%/yr) 15.0

The rate of interest on treasury bills is 4.0%. 5a. (4 points) What is the (total) expected return of fund A? Expected return equals: Treasury bill return: Stock exposure * Stock expected excess : + Added expected return:

4.0 0.80*5.0 = 4.0 = 1.0 ---------------9.0 %

5b. (4 points) What is the variance of fund C? The variance due to the stock market factors is: (1.2^2)*225 = 324 To this we add the variance of the residual return to get total variance: 324 + 25 = 349 5c. (4 points) What is the covariance of the returns on funds A and B? Here we multiply the exposure of A by the factor covariance matrix (which has only one element) and the exposure of B: 0.80*225*1.20 = 216 There is no residual term, since the residuals are assumed to be uncorrelated.

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5d. (4 points) Assume that you had to choose between advising a friend to (1) put all of her money in fund B and (2) put half her money in fund A and half in fund C. Which would you advise her to take, or might your answer depend on her preferences? The two alternatives have the same exposures to the stock market (1.00 and 1.00) and so are equivalent in terms of market (factor)-related risks and returns. B offers a residual expected return of 2.0% while AC offers only 1.0%. On the other hand, B has a residual standard deviation of 10.0 while AC has a residual standard deviation of 5.0/sqrt(2), since its variance will equal half that of each of the two components (given that they have equal risk, are uncorrelated with one another, and the portfolio has equal amounts invested in each). This implies that AC has half the expected added value of B but less than half the added risk. In terms of the Sharpe Ratio of the residual, AC is better than B. However, this is only relevant if she can separate out the factor-related components and lever or unlever the residual to a desired level of residual risk. As the question is stated, this does not appear to be possible, so the choice ultimately depends on her preferences -- a choice between a higher expected return and risk (B) and lower expected return and risk (AC).

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Finance 368 Final

Note: questions have been graded in terms of their representativeness for questions that might be asked for the Spring 1999 final, as follows:
* * * very representative ** * fairly representative not very representative

Finance 368
Spring 1998 Prof. Sharpe

Final Examination

Saturday June 6, 1998 1:00 - 5:00 P.M. GSB 70 and GSB 71 Please pick up and leave your exam in GSB 70
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Please write your answers on the examination paper. If you need more space, place additional material on the pages in the back, with a suitable reference in the appropriate space for the question. Each separately identified question (e.g. 2a, 3b, ...) is worth 2 points. The total number of points is 138. The final score on the examination will be determined by dividing the sm of the points received by 1.38. You may consult any desired written material during the examination but should not discuss the examination with anyone prior to the conclusion of the designated time.

Student Name ___________________________ (printed) I acknowledge and accept the Honor Code (signed) _________________________________

* * * 1. Bob and Myron have formed a new company called Medium-term Capital Management (MTCM). The firm will run 15 to 20 different hedge strategies and employ leverage. They claim that they
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will produce the same expected return and risk as a diversified portfolio of US stocks but that their returns will be uncorrelated with those of US stocks. You believe them. Before MTCM entered the picture, you had decided to put $500,000 of your $1,000,000 in the bank and the rest in a portfolio of US stocks. You did so on the assumption that you could earn 5% from the bank and that the US stock market had an expected return of 11% and a standard deviation of 15%. You see no reason to change those estimates. a. Of any money that you do not put in the bank, what proportion should be in MTCM (that is, MTCM as a percent of MTCM plus Stocks)? b. If you put $500,000 in the bank, $250,000 in MTCM and $250,000 in Stocks what wille the expected return on your overall portfolio? What will be its risk? c. If you wanted your portfolio to have the same risk as it did before MTCM came along, how would you allocate your assets? What would be the expected return on your portfolio? d. Assume that in choosing your initial portfolio (pre-MTCM) you had maximized ep - vp/rt, where ep is the expected portfolio return, vp is the portfolio risk, and rt is your risk tolerance. If you wanted to do so again (with the same rt), how would you allocate your assets? What would be your expected return? What would be your risk? e. Assume that the Capital Asset Pricing Model holds and that US Stocks are "the market". If Bob and Myron were willing to work for nothing, what would be your estimate of the expected return of MTCM? If the risk of their portfolio is the same as that of the US stock market, what would be your asset allocation? f. Bob and Myron want to receive a fee based on their "value added". They propose that you pay them 20% of the difference between the MTCM return and that of a pre-specified benchmark if the difference is positive, with any shortfalls credited against future fees earned. What is the lowest-expected return asset or mix of assets that would you accept as a benchmark?

* 2a. Would you expect securities that provide a good hedge against inflation to have higher expected returns, lower expected returns, or the same expected returns as others that are similar in every other respect? Why? b. Assume that you have been appointed to the board of Leland University, which spends an inordinate amount of its budget on faculty salaries. The staff has proposed investing a small percentage of the endowment in fully collateralized commodity futures. Would you expect the return on such an investment to be higher, lower, or equal to the return on Treasury bills? Would you endorse investment in
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such a "commodity play" Why or why not?

* 3. You have been analyzing two international mutual funds - the Romer International Financial Fund and Roberts Global Corporate Fund.. Both compare their returns with those of the Morgan Stanley Capital International Europe, Australia and Far East index (EAFE). Both have significantly underperformed the index over the last six years. On further examination you find that both were heavily concentrated in the stocks of Japanese corporations over this period. Digging back into earlier data you discover that Romer was heavily invested in Europe in the previous six years while Roberts was primarily in Japanese stocks at that time as well. a. Which fund probably had the better performance in the prior period? b. If you had to choose an index with which to compare Romer's future returns, would you choose EAFE, a Japanese index, or a European index? c. If you had to choose an index with which to compare Roberts' future returns, would you choose EAFE, a Japanese index, or a European index?

* * 4. On Jan 1, 2000 the exchange rate of U.S. dollars for Japanese Yen was Y100/$1. At the time the one-year interest rates were 6% in the U.S. and 2% in Japan. The level of the Nikkei 225 was 20,000 at the time. Due to continuing austerity, Japanese firms had announced that they would pay no dividends until the year 2001. a. On Jan 1, what was the yen/dollar forward rate for delivery on Dec. 31, 2000? b. On Jan. 1, 2000 what was the futures price in yen for a one-year contract for a unit of the Nikkei 225 index (that is, a price agreed upon today to be paid on Jan. 1, 20001 for delivery of a unit of the index)? c. On Jan. 1, 2001, the Nikkei 225 stood at 25,000. What was the return (in yen) for a Japanese investor who purchased stocks in the index on Jan. 1, 2000? d. On Jan. 1, 2001 the exchange rate was Y90/$1. What was the profit or loss (in dollars) for a U.S. investor who converted dollars to yen, purchased stocks in the N225 index, then sold the stocks at the end of the year and converted the proceeds to dollars? e. What was the profit or loss (in dollars) for a U.S. investor who put $200 in a U.S. bank and took a position in the Nikkei 225 futures contract in Japan, using the U.S. bank account as collateral?

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f. What was the magnitude (in dollars) of the difference between the profit for the investor in (d) and that of the investor in (e)? To what would you attribute this difference?

* * * 5. The managers in charge of the endowments of West Coast University (WCU) and East Coast University (ECU) have both recently completed asset allocation studies. They each estimate that stocks have an expected return of 10% and a standard deviation of 17% while bonds have an expected return of 7% and a standard deviation of 10%. However, they differ in their assessment of the correlation between bond and stock returns. WCU believes it will equal 0.70, while ECU believes that it will equal 0.30. a. If both WCU and ECU plan to have 60% in stocks and 40% in bonds, will their projected expected returns be the same or differ, and if the latter, which will project the greater expected return? b. If both WCU and ECU plan to have 60% in stocks and 40% in bonds, will their projected risks be the same or differ, and if the latter, which will project the greater expected return? c. If both WCU and ECU wish to have an overall risk of 14%, will their projected expected returns be the same or differ, and if the latter, which will project the greater expected return?

* * * 6. Tacoma Partners, a well-known financial planning firm, has recently concluded an asset allocation study for a high net worth individual. Based on their analyses, the optimal mix of assets would be 60% in the Vanguard Total Stock Market Fund and 40% in the Vanguard Total Bond Market Fund, if only index funds were utilized. However, the planner who has conducted the analysis has recommended that the client consider investing at least some money in one or both of two actively managed funds -Convertible Opportunities Fund (COF) and Utilities R'Us (URU). Based on style analyses and projections of future performance, the planner has made the following preductions for the two funds: Exposure to Bonds Exposure to Stocks COF URU .60 .30 .40 .70 Expected Selection Return (%/yr) 0.50 1.20 Std. Dev. of Selection Return (%/yr) 5.00 10.00

The client's risk tolerance is 25. a. What is the Selection Sharpe ratio of COF? b. What is the Selection Sharpe ratio of URU?

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Finance 368 Final

c. If positions of equal dollar value are to be taken in both COF and URU, which position would have the greater selection risk? d. If optimal positions are to be taken in both COF and URU, which position should be greater in dollar terms? e. If the client has $100,000 to invest, how much should be invested in each of the four funds?

* * * 7. Darrell Finch, a well-known investment bank with a high-quality financial engineering department, has recently built a model of the bond and stock market for use in pricing and hedging derivative securities. For two-year securities they have designated six possible contingent payment states u: pay $1 at the end of year 1 if the market goes up in the first year d: pay $1 at the end of year 1 if the market goes down in the first year uu: pay $1 at the end of year 2 if the market goes up in the first year and again in the second year ud: pay $1 at the end of year 2 if the market goes up in the first year and down in the second year du: pay $1 at the end of year 2 if the market goes down in the first year and up in the second year dd: pay $1 at the end of year 2 if the market goes down in the first year and again in the second year They have also identified six different investment decision variables: B: invest $1 in a one-year bond today, cash it out at the end of year 1 S: invest $1 in a stock today, cash it out at the end of year 2 Bu: invest $1 in a one-year bond next year if the market goes up in the first year Su: invest $1 in a stock next year if the market goes up in the first year Bd: invest $1 in a one-year bond next year if the market goes down in the first year Sd: invest $1 in a stock next year of the market goes down in the first year The following matrix shows their assumed binomial process. B u d uu S Bu -1 Su -1 -1 1.06 1.19 -1 Bd Sd

1.05 1.20 1.05 1.00

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ud du dd

1.06 1.01 1.04 1.25 1.04 .95

They believe that in each year the odds are 50/50 that the market will go up or down. By investing $100 in a two-year zero coupon bond, an investor can be guaranteed to receive $109.72 at the end of two years. a. What is the return in year 1 on a 2-year zero coupon bond if the market goes up? b. What is the return in year 1 on a 2-year zero coupon bond if the market goes down? c. Is the correlation of year 1 returns for stocks and 2-year zero coupon bonds positive, negative, or zero? d. Do stock market expected returns (1) follow a random walk, (2) exhibit mean reversion or (3) exhibit the converse of mean reversion? Does the risk premium depend on investor's wealth? If so, in what way? e. Is the risk of the stock market (1) greater, (2) lower, or (3) the same after an down market as it is after an up market? Honeydew Capital Management Company has proposed a strategy that begins with $50 invested in stock and $50 invested in a one-year bond. If the market goes up, the strategy calls for rebalancing to a combination with 30% invested in stock and 70% invested in a one-year bond. If the market goes down, the strategy calls for a combination with 70% in stock and 30% in a one-year bond. Allstate Consultants has proposed a strategy that also begins with $50 invested in stock and $50 invested in a one-year bond. If the market goes up, the strategy calls for rebalancing to a combination with 70% invested in stock and 30% invested in a one-year bond. If the market goes down, the strategy calls for a combination with 30% in stock and 70% in a one-year bond. Tacoma consultants has recommended a strategy that involves putting $50 in stock and $50 in a one-year bond, then reinvesting any money received from either the bond or the stock in the same security (that is bond money in another one-year bond and any stock dividends reinvested in the stock). f. If the market goes up both years, which advice (Honeydew, Allstate or Tacoma) would have been best? Which would have been worst? g. If the market goes down both years, which advice (Honeydew, Allstate or Tacoma) would have been best? Which would have been worst? h. Could all investors follow Honeydew's advice? Allstate's? Tacoma's?

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Finance 368 Final

i. If someone wanted to get $10,000 two years hence if the market goes up two years in a row but $5,000 otherwise, could Darrell Finch issue a security with such payments? If so, how would they price and hedge it? Show the formulas that they could use to answer these questions, with the matrix shown above represented as M and any other matrices or vectors shown explicitly in your answer.

* * 8. NT Fund Management has just introduced a market neutral fund. Management claims that it will carefully match its long and short positions so that there will be no net market, sector or factor exposure. You believe them and estimate that they will beat an appropriate benchmark by an expected 200 basis points(2%) per year with a standard deviation of 500 basis points (5%). a. What is the appropriate benchmark for this fund? b. What is the fund's annual excess return Sharpe ratio? c. What is the fund's Selection Sharpe ratio? Before the introduction of the NT market neutral fund you had chosen to put all your money in an S&P500 Index fund. You estimate that this strategy has an expected annual return 600 basis points (6%) greater than that of Treasury bills with a standard deviation of 1500 basis points (15%). d. What is your risk tolerance? NT also has introduced a fund that combines a swap and investment in the NT market neutral fund. For every $100 received, this new fund (alpha alpha, or AA) invests $100 in the market neutral fund, then takes a position with a notional value of $100 in a swap in which the fund promises to pay the return on Treasury bills to the counterparty, in return for which the counterparty promises to pay the return on the S&P500 to the fund. e. What is the standard deviation of the AA fund's return? f. What is the expected excess return on the AA fund? g. If you could (1) invest all your money in the SP500 Index fund or (2) invest all your money in the AA fund, which would you choose? h. If you could borrow money to invest in the AA fund,or put money in Treasury bills and invest in the AA fund, how would you invest your money?

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* * 9. The Rhode Island Public Employees' Retirement System (RIPERS) has recently concluded an asset allocation study. After running an optimizer, using the estimated risk tolerance of the citizens of the state (50), they concluded that the best allocation among five asset classes was: Cash US Govt. Bonds US Large Cap Stocks US Small Cap Stocks Non-US Stocks 5% 35% 40% 15% 5%

At the hearings held in the state assembly, the leader of the majority party argued that this was done without taking liabilities into account. The staff agreed that this was the case and promised to do the study again with liabilities taken into account. Fortunately, RIPERS benefits had recently been frozen, with all benefits fixed at their current levels; henceforth all state contributions would be placed in a brand-new defined contribution plan. Since the old benefits were not indexed to inflation, this meant that all liabilities were fixed in dollars, with the payments subject only to mortality risks. Staff has estimated that the current value of assets is $1 billion and that the present value of liabilities, when discounted using the present values of corresponding zero-coupon government bonds, is $0.8 billion. Using Monte Carlo analyses, the staff has estimated that a 1% change in government interest rates would change the present value of the liabilities by 12%. a. What is the duration of the liabilities? b. The duration of the US Government Bond asset class is estimated to be 10. If the fund were invested totally in this asset class, would the fund's surplus be likely to increase, decrease, or stay the same if interest rates were to fall? Using Monte Carlo analysis, the staff has estimated that the present value of the liabilities is expected to increase 8% in the coming year (before any benefit payments are made after the year-end). However, the standard deviation associated with this expectation is 15%. Estimates of the correlations between each of the asset classes and the percentage changes in the liabilities, along with the risk of each asset class is shown below.

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Correlation with Standard Liability Deviation Cash US Govt. Bonds US Large Cap Stocks US Small Cap Stocks Non-US Stocks 0.00 1.00 0 18

0.40

15

0.35

20

0.10

22

c. Assume that the goal is to maximize the utility of the risk and return of the fund's surplus, expressed as a percentage of the fund's assets (for example, the current value is 20), with a risk tolerance of 50. Is the mix that was optimal when only assets were considered optimal in this context? Why or why not? d. If only a relatively small change could be made in the fund's asset allocation, with allocation to one asset increased and the allocation to another decreased, which asset would you choose for an increase and which would you choose for a decrease? For the remaining questions, assume that the fund's risk tolerance had been 100 and the initial asset allocation had been optimal from an asset-only perspective for that risk tolerance. e. Is the current asset allocation optimal, if the goal is to maximize the risk and return of the change in the fund's surplus, expressed as a percentage of the beginning assets, with the same risk tolerance (100)? f. If only a relatively small change could be made in the fund's asset allocation, with allocation to one asset increased and the allocation to another decreased, which asset would you choose for an increase and which would you choose for a decrease? g. Would the legislature be justified in being as concerned about the staff's decision to ignore liabilities if the risk tolerance had been 100 than if it had been 50? Why or why not?

* 10. Ocean Avenue Consultants has been hired by both the Delaware Public Employees' Retirement System (DELPERS) and the William David Company (WD) to advise on asset allocation. Ocean has

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decided to use the same estimates of asset risk, returns and correlations for each of its clients. Moreover, in each engagement, attention will be limited to four asset classes: Treasury bills, U.S. Treasury Inflationprotected bonds, U.S. Treasury bonds, and U.S. stocks. Both the WD pension plan and the DELPERS plan are defined benefit plans. DELPERS has a relatively old and experienced workforce, while WD has a young workforce. Both plans base pension payments on average salary during the last five years of service, and total years of service. The DELPERS plan includes indexing for inflation after retirement, while the WD plan does not. The actuaries at WD have used an actuarial rate of 4% for the valuation of the firm's liabilities, while those at DELPERS have used a rate of 8 1/4%. The yields of recently-issued Treasury bonds are 6% for regular long-term bonds and 3 1/2% for inflation-protected bonds. For each plan, the actuaries have estimated future cash payments for benefits on the assumption that everyone quits at once and that there is no inflation in the future. For each plan the reported value of the liabilities to pay benefits is calculated by discounting these future cash payments using the plan's actuarial rate. a. How would you value the liabilities of the WD plan? What discount rate would you use? Why? b.How would you value the liabilities of the DELPERS plan? What discount rate would you use? Why? c. Is the reported funded status (assets - liabilities) of the WD plan likely to be higher, lower, or the same as would be calculated by a financial economist? Why? d. Is the reported funded status of the DELPERS plan likely to be higher, lower, or the same as would be calculated by a financial economist? Why? e. If both DAPERS and WD wanted conservative (low asset/liability risk) asset mixes, would your recommendations for their optimal asset mixes be likely to be very different, different, or only slightly different? Why? f. If both DAPERS and WD wanted aggressive (high asset/liability risk) asset mixes, would your recommendations for their optimal asset mixes be likely to be very different, different, or only slightly different? Why?

* * * 11. The small country of Nissan has zero inflation and zero interest rates. For this reason it has been studied extensively by financial analysts, who treasure the simplicity of calculations concerning financial products in the country. Another appealing feature of Nissan's economy is the fact that stocks can either go up by 20% or down by 10% each year, and that the odds are 50/50 that each year will be an "up-year" or a "down year". The currency of Nissan is the Nissan Dollar ($). Mr.Buffet has $100 to invest. He would like to end up with twice as much money at the end of the year if the market is up as he will have if the market is down.

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Mr. Kaufman also has $100 to invest but he would like to end up with twice as much money at the end of the year if the market is down as he will have if it is up. Both Buffet and Kaufman have ample credit so that they can borrow all they want (at zero interest) if they wish to purchase stocks on margin. They may also take any short positions they desire and use any proceeds for other investments. a. How much will Buffet have if the market is up? If it is down? b. How much will Kaufman have if the market is up? If it is down? c. How many dollars will Buffet invest in stocks? In Bonds? What orders will he give to his broker? d. How many dollars will Kaufman invest in stocks? In Bonds? What orders will he give to his broker? e. What is Buffet's expected return? What is the standard deviation of his return? What is the beta of his portfolio relative to that of the stock market? f. What is Kaufman's expected return? What is the standard deviation of his return? What is the beta of his portfolio relative to that of the stock market? g. Are the characteristics of the two portfolios consistent with the Capital Asset Pricing Model? Why or why not? h. Is Buffet's portfolio efficient in the manner described by Markowitz? Is Kaufman's? Why or why not?

* * 12. Connie, Holden and Trent live in a country where by law the stock market can either go up by 25% or fall by 5% each year. Each of them has $100, with $60 invested in stocks and $40 in bonds. Bond return a guaranteed 5% per year. They all agree that the odds are 50/50 that the stock market will go up in the coming year. Each of them plans to retire in two years on whatever is left from their current investment portfolio. Connie has decided that if the market goes up in the coming year she will sell $10 of the stocks in her portfolio and put the proceeds into bonds; on the other hand, if the market goes down in the coming year she plans to sell $10 of the bonds in her portfolio and put the proceeds into stocks,.Holden has decided that whatever happens in the coming year, he will leave his portfolio alone. Trent has decided that if the market goes up he will sell $10 of bonds and use the proceeds to buiy stocks; on the other hand, if the market goes down he will sell $10 of stocks and use the proceeds to buy bonds. a. Which, if any, of these three investors is a contrarian? A Trend-follower? A buy-and-hold investor? b. Two years from now, what could happen? How rich would each investor be in each of the associated
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states of the world? c. If the stock market follows a random walk, what will be each investor's expected retirement wealth? d.Charlie, a well-known portfolio manager, has appeared as a guest lecturer in an investment class as a local university. He predicts that if the market goes up in the coming year there will be only a 40% chance that it will go up in the following year, but that if the market goes down in the coming year there will be a 60% chance that it will go up in the following year. If he is right, what will be each investor's expected retirement wealth? e. Tom, who has appeared in the same class, feels that while Charlie may be right in the long term, he is wrong in the shorter term. Instead, Tom predicts that if the market goes up in the coming year there will be a 60% chance that it will go up in the following year, but that if the market goes down in the coming year there will be only a 40% chance that it will go up in the following year. If he is right, what will be each investor's expected retirement wealth? f. Is there any possibility that Charlie could be right and that all three investors could agree with him and still plan to act in the manner described? If not, why not? If so, why?

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Computer Programs

Computer Programs

The material provided here is written in the Mathworks' MATLAB language. More information about the Mathworks' products can be found at the Mathworks home page. Of even greater interest to those reading this material is information on the Mathworks' financial products The material is in the form of either MATLAB functions or complete MATLAB programs. It is available for downloading and/or examination. MATLAB functions Functions written in the MATLAB language: can be read or downloaded TSI: A Time-Series Information System A system for storing and using time-series information. Includes a description and MATLAB functions for implementation.

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Matlab Functions

Matlab Functions

These functions were written primarily for illustrative purposes. Many are taken from and/or descrived in the material on principles and techniques. To my knowledge, they all work. However, few of them bother to detect errors, provide friendly advice, etc.. Moreover, I have used some inefficient computational procedures in order to make the algorithms easy to understand. In short, these functions may not be of full production quality . Despite these caveats, I have found them to be useful and thought others might also. Each function is stored in a file with a .txt extension so as (hopefully) not to confuse the server or your browser. You may need to set your helper options (under general preferences in Netscape's browser) to have files with mime type text, mime subtype plain and extension txt viewed in the browser. After viewing one of the functions, you may save it in a directory on your MATLAB path, using the same name and an .m extension. The function can then be used in any program. You can then also get its initial comment lines by issuing the command help, followed by the file name (e.g. help wcov). The functions are listed below in alphabetic order. The date of the most recent version is also shown. cnd Gets a probability from the cumulative normal distribution (Nov. 2, 1995) f_stox Gets a time series in the TSI standard format. Used in the Time-Series Information System (Jan 15, 1996) getfiles Loads files listed in a text file to the indicated file names (Nov. 20, 1995) getsmat Gets a string matrix from an ASCII file. Used in the Time-Series Information System (Jan 15, 1996) gqp Solves a standard asset allocation problem using the gradient algorithm (April 13, 1997) mkdbd Makes a database directory. Part of the Time-Series Information System (Jan 15, 1996) mkdbl Makes a database list. Part of the Time-Series Information System (Jan 15, 1996) pmats prints a matrix with titles for columns and rows
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Matlab Functions

putl Puts a line on an ASCII output file (PC version). Used in the Time-Series Information System (Jan 15, 1996) strsort Sorts a string matrix. Used in the Time-Series Information System (Jan 15, 1996) tsi Gets a tsi series. Part of the Time-Series Information System (June 19, 1996) wcov Computes a weighted covariance matrix and associated values (Nov. 2, 1995)

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function [src,nm,curr,dates,rets] = f_stox(fname); % [src,nm,curr,dates,rets] = f_stox(fname); % gets information in .tsi (time-series information) format % returns: % src: source (string) % nm: name (string) % curr: currency (3-character string) % dates: column vector of dates in yymm format % rets: column vector of returns as percents (e.g. 3.45 for 3.45%) % example: % [src,nm,curr,dates,rets] = f_stox('re') % tsi format: % line 1: source % line 2: name % line 3: currency % remaning lines: % yyyymm return % ..... % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 % make file name fname = [ 'c:\dbases\wfs\' fid = fopen(fname,'r'); % get header information src = fgetl(fid); nm = fgetl(fid); curr = fgetl(fid); curr = curr(1:3); % get data v = fscanf(fid,'%g',[2 inf]); dates = v(1,:)'; rets = v(2,:)'; fclose(fid);

fname '.TSI'];

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A Time-Series Information System

A Time-Series Information System


Overview
In many fields -- Investments among them -- time-series data are of considerable importance. Databases containing time series of returns, values, exchange rates and the like are available from a number of sources. Each such source is likely to have its own database structure and access routines. This makes it difficult to write MATLAB programs that can easily utilize data from one or, a fortiori two or more such databases. One solution to this problem is to adopt a standard database structure (such as Paradox, Access, or a SQL system) and translate each database from its native format to this common format each time a new version arrives from the source. Programs must, of course, be written or obtained to move data from source formats to the common format. And functions must be written to move data from the common format to MATLAB. While such an approach has a number of advantages, it requires considerable effort to maintain a structure of this type and may prove to be more trouble than it is worth. Moreover, it is complex and platform-dependent and far more than is needed for simple databases, especially those of one's own creation. Another issue concerns updating. Whenever possible, it is desirable that programs work with data from the original files provided by the relevant sources. For example, one may need monthly values and returns for an Investor's holdings of a particular mutual fund. These are dependent, in turn, on (1) the number of shares held by the Investor each month and cash flows into or out of the account and (2) the net asset value per share for the fund at the end of each month. It is best that these two sets of information be combined to compute returns and values whenever the latter are wanted. Otherwise a separate routine must be run each time one or the other of the two databases is changed and a file created with the resulting values. This takes more time, since every combination needs to be run whenever there is an updated set of data. It also takes more space, since intermediate computations must be stored. Finally, and worst of all, it increases the probability that information will be used that is not completely up to date or, worse yet, in error. Here we describe a system that can cope reasonably well with all these problems. Among the goals in its design were simplicity and ease of understanding. Hence we begin by describing a very simple version of the system, then proceed to more complex implementations. For ease of exposition we will call it the Time-series Information System, or TSI. This is a slightly pompous title for a relatively simple set of procedures, but the acronym makes it possible to lower the word count of this document.

A Simple TSI File


Consider an ASCII file with the following lines:
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A Time-Series Information System

Micropal XYZ Growth Fund USD 199101 1.23 199102 2.34 199103 -3.45 etc.. The first line gives the source, the second line the name, the third line the currency and the remaining lines the time series information as a set of two numbers: the date (in the form yyyymm) is followed by the value for the month. For the present discussion, assume that the file is in directory C:\DBASES\Stox and that its name is XYZGRTH..TSI.

Reading a Simple File


To read file XYZGRTH.TSI efficiently one could use the following MATLAB function: function [src,nm,curr,dates,rets] = f_stox(sid); % make file name fname = [ 'c:\dbases\stox\' sid '.TSI']; fid = fopen(fname,'r'); % get header information src = fgetl(fid); nm = fgetl(fid); curr = fgetl(fid); % get data v = fscanf(fid,'%g',[2 inf]); dates = v(1,:)'; rets = v(2,:)'; % close file fclose(fid);

In this case the file name indicates the series identifier (sid). Thus the series id for this fund in file XYZGRTH.TSI is XYZGRTH. To obtain the data for this fund one can give the MATLAB expression:

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[src,nm,curr,dates,rets] = f_stox('XYZGRTH'); This will return the source (as a character string), the name (as a character string), the currency (as a character string), the dates (as a column vector) and the returns (as a column vector). The first section of function f_stox sets up the file name and opens it with the file identifier fid. Note that the function "knows" that the series is in a file in directory C:\DBASES\XYZ and that its file name is the series id followed by .TSI. The second section of the function retrieves the source, name and currency, using the standard MATLAB function fgetl, which gets the next line from the input file. The next section reads the remaining information into a matrix with two columns using MATLAB's vectorized input capability. This is extremely fast and makes ASCII files competitive with binary files for speed as well as superior for readability and editability. The penultimate section places the two columns of the input into two separate vectors representing the dates and the corresponding returns. The final statement closes the input file. Note that no error checks are included, on the assumption that the files will have been checked (either by humans or some other program) before being entered into the system. For convenience, function f_stox is included in the mia library.

Fetch Routines
Function f_stox can be considered a fetch routine. The MATLAB statement: [src,nm,curr,dates,rets] = f_stox('XYZGRTH'); says, in effect: Please fetch (f_) me series XYZGRTH in database stox. Send back the source, name, currency, dates and returns ([src,nm,curr,dates,rets]); The format is thus: [src,nm,curr,dates,rets] = f_database(series_id)

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A Time-Series Information System

For each database, there will be a separate fetch routine. Thus if there is another database called Bonds with files in directory C:\DBASES\BONDS and ABCGOVT is a series in this database, it would be fetched with the command: [src,nm,curr,dates,rets] = f_bonds('ABCGOVT'); This can be a very powerful approach. For example, the bonds database could be very different from the stox database. For example: Micropal ABC Government Bond Fund USD 198901 199512 -1.23 4.23 -6.79 etc.. The fetch routine f_bonds must be different from f_stox in several respects. First, it must know that the bonds files are stored in directory C:\DBASES\BONDS. Next, it must know that the first and last date are given in lines four and five and that the remaining lines contain only returns. Finally, it must construct the complete dates vector so that it can be returned in the standard format. While this leads to some work for the person who must write a fetch routine, it completely hides the differences in file formats between, say, the f_stox files and the f_bonds files from the user of the system. Thus the statements [src,nm,curr,dates,rets] = f_stox('XYZGRTH'); [src,nm,curr,dates,rets] = f_bonds('ABCGOVT'); can be used with alacrity. Once the fetch routines have been written, subsequent programs can be oblivious to such nagging issues as file formats. Notice also that files can be left in their "native" format as long as one can write a fetch routine that will return the standard information.

Complex File Structures


One can go well beyond the previous examples. Files in a database might be in an idiosyncratic binary format. As long as the format is known (or can be discerned by careful examination) it should be possible to write an efficient MATLAB program that will read the file directly and return the standard information. The .TSD files in the Ibbotson Associates' databases fall in this category.
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A Time-Series Information System

In some cases there is a single file (or possibly two) that contain(s) information on many different time series in a database. Here a somewhat more complex procedure is required. When the file(s) are received, a program (written, for example, in MATLAB) is run that creates a lookup table. The fetch routine then looks up the series name in this table to find the locations (offsets) in the data table(s) at which the information about the series in question begins. It then goes to the data table(s) and retrieves the information. To do this efficiently it is helpful if the series names, while strings, contain only numeric characters so that the lookup can be performed with a simple find command. This strategy works well with some of the databases provided by Micropal. The earlier example in which information must be computed from two or more files can also be accommodated. For example, consider a fetch routine named f_invxyzr. If called with the statement: [src,nm,curr,dates,rets] = f_invxyzr('XYZGRTH'); It could go to file XYZGRTH.HLD in directory C:\DBASES\INV to find the Investor's holdings and cash flows for fund XYZGRTH and to file XYZGRTH.PRC in directory C:\DBASES\PRC to obtain the month-end prices of the fund. The information would be used to compute the desired returns which would then be returned in the normal manner. The user could, if desired, remain totally ignorant of the operations being performed by f_invxyzr. Another interesting case arises if a single file has both beginning of month values and monthly returns. For example: Micropal XYZ Growth Fund USD 199101 1500 1.23 199102 2000 2.34 199103 3000 -3.45 etc.. In this case one could write two fetch routines. For example, f_xyzv would return the values, and f_xyzr the returns. Thus one could use the statements: [src,nm,curr,dates,vals] = f_xyzv('XYZGRTH'); [src,nm,curr,dates,rets] = f_xyzr('XYZGRTH'); to obtain all the information or just one, if only one aspect were desired. Note that in every case, the dirty work is done when the fetch routine for a database is written. The user need not be concerned with what is "under the hood". Even if the same person is the user and author of

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the fetch routines, he or she can forget the contents of the latter once they have been debugged.

Database Directories
The more time series one has, the more important it is to organize them in a useful manner. The simplest way to do this involves the creation of a database directory for each database. Assume that directory C:\DBASES contains an ASCII file with the following lines: stox stox.ABCVAL stox.SPIND stox.XYZGRTH The format is very simple: row 1: columns 1-20: columns 21- : remaining rows: columns 1-20: columns 21- : STOCK MUTUAL FUNDS ABC Value Fund S&P Index Fund XYZ Growth Fund

database id database name database.series id series name

Assume that the above file is stored in C:\DBASES as stox.dbd and that for efficiency, every line in the file is of the same length (e.g. 80 characters). In most cases it will be desirable to have the entries in a database directory sorted so that the series names are in alphabetic order. Whenever one is interested in a series in the stox database, the database directory can be retrieved with the MATLAB function getsmat.m, as in: dbdir = getsmat('c:\dbases\stox.dbd'); This function is part of the mia library. It is designed to operate rapidly, and hence requires that the ascii file referenced does indeed have lines of the same length. It returns a string matrix in which each row corresponds to a line in the ascii file. One can look (directly or through a program) at rows 2:.. of dbdir to find the name of a desired series in this matrix. Say that it is XYZ Growth Fund. The full identifier is stox.XYZGRTH. To get its information we need to execute the statement:
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A Time-Series Information System

[src,nm,curr,dates,rets] = f_stox('XYZGRTH'); This statement can be constructed, then evaluated automatically. The simplest way is to give the statement: [src,nm,curr,dates,rets] = tsi('stox.XYZGRTH'); This calls the mia function tsi.m, which can be as simple as: function [src,nm,curr,dates,rets] = tsi(id); % function [src,nm,curr,dates,rets] = tsi(id); % returns information from tsi id ('database.series') eval(['[src,nm,curr,dates,rets] = ... f_' strrep(id,'.','(''') ''');']);

If desired, the statement itself can be placed directly in a program. A more complicated version of tsi.m could handle more information. To make a tsi formatted file easy to import into spreadsheet programs it is often useful to begin and end the source and name lines with standard quotation marks. To accommodate this alternative, the tsi function can be expanded to simply remove any quotation marks found in those lines. The revised version would be: function [src,nm,curr,dates,rets] = tsi(id); % function [src,nm,curr,dates,rets] = tsi(id); % returns information from tsi id ('database.series') eval(['[src,nm,curr,dates,rets] = ... f_' strrep(id,'.','(''') ''');']); src = strrep(src,'"',''); nm = strrep(nm,'"',''); Note that the details of database formats and underlying computations are now even more hidden from view. A series is now identified by its database name and series name. Whenever its information is required, it is simply requested using the tsi function. This is not really object-oriented programming, but it offers of the same advantages. One great advantage of this format is the ability to view, edit and rearrange a database directory using any standard word processor. While there is a slight cost in processing time vis-a-vis that associated with MATLAB .mat files, it seems well worth bearing for the far greater flexibility associated with a standard
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format.

Creating Database Directories


Often one has a directory with a large number of files, each containing a separate time series. To minimize effort and avoid errors of either commission or omission it is desirable to make the associated database directory automatically rather than by hand. This is usually easily done. Assume that directory C:\DBASES\XYZ has a series of files, all of which have a name of the form xxx.TSI, where xxx is the series identifier. To create a database directory in c:\dbases with a file name of xyz.dbd, call the mia function mkdbd, as in: mkdbd('xyz','xyz mutual funds','c:\dbases\xyz\','tsi'); This will find all the files with an extension of tsi in directory c:\dbases\xyz\, extract the name field from each one, then build a list, sorted alphabetically by name and place it in file c:\dbases\xyz.dbd. The first line will give the id ('xyz') and name ('xyz mutual funds') of the database. Some of these routines call others in the mia library (in particular, putl.m and strsort.m). While some of the operations in these functions are complicated, using them is not. Whenever a database directory is needed for a group of series contained in a specific directory, run mkdbd. Unix users might wish to let the Unix sort command handle the job of sorting the entries in alphabetic order (which strsort does very slowly).

The Database List


In the TSI system each database has its own directory, which lists all the series "in it". The quotation marks are used here since a database may be more virtual than real, as a database identifier is no more than the identifier for the fetch program to be used to retrieve information. The remaining ingredient needed to tie everything together is a list of all the databases. For example, assume that in directory C:\DBASES there is a file named tsi.dbl with the following string matrix:

dbl bonds stox

LIST OF DATABASES Fixed Income Mutual Funds Stock Mutual Funds

The format is also very simple:


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row 1: columns 1-20: columns 21- : remaining rows: columns 1-20: columns 21- :

database list id database list name database id database name

Here too, the use of an ASCII format provides flexibility and ease of use in almost any context. To find a series, one can start with the dbl list to find a likely database, load the associated database directory, then search through the latter to find the desired series. At this point the tsi routine can be used to obtain the associated information.

Creating Database Lists


A database list can be created automatically using the mia function mkdbl.m, as in: mkdbl('tsi','Time series Databases','c:\dbases\','dbd'); This will search for all the files in c:\dbases\ with an extension of dbd. A list will be created using the first line in each such file, with the name fields (column 20-...) sorted in alphabetic order. A first line will be added giving the list identifier ('tsi') and the list name ('Time series Databases'). The file will then be stored in C:\dbases as tsi.dbl.

Experience
The author has used this system with considerable success with databases from several sources comprising several thousand time series. In some cases it was desirable to break one large database into several pieces. Thus, while the Micropal U.S. mutual fund database includes over 5,000 funds, it was organized as a series of separate databases, for example: Equity Growth Funds, Government Bond Funds, etc.. Experience suggests that the approach offers more than adequate speed, very low probability of error, and a minimum of required recollection of file and computational details.

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/getsmat.txt

function smat = getsmat(fnm); % function smat = getsmat(fnm); % gets a string matrix from ascii file % fnm is the name of the file % smat is the string matrix % REQUIRES that the matrix have every line EXACTLY the same length % REQUIRES that each line end in ascii 13, ascii 10 (CR LF) % % example: % smat = getsmat('c:\dbases\xyz.dbd'); % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 fid = fopen(fnm,'r'); s = fscanf(fid,'%c'); fclose(fid); locr = findstr(s,setstr(13)); ncols = locr(1) - 1; nrows = length(s)/(ncols+2); ss = reshape(s,ncols+2,nrows); smat = ss'; smat = smat(:,1:ncols);

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/tsi.txt

function [src,nm,curr,dates,rets] = tsi(id); % function [src,nm,curr,dates,rets] = tsi(id); % returns information from tsi id ('database.series') % % see also: MKDBD eval(['[src,nm,curr,dates,rets]=f_' strrep(id,'.','(''') ''');']); src = strrep(src,'"',''); nm = strrep(nm,'"','');

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/mkdbd.txt

function ok = mkdbd(dbid, dbname, filedir, fileext); % function ok = mkdbd(dbid, dbname, filedir, fileext); % makes a database directory file % files are in filedir and have extenstion fileext % database directory id is dbid, name is dbname % database directory will be put in c:\dbases\dbid.dbd % files must be accessible through tsi % tsi full id is dbdid.filename % database directory format is: % id name % first line is: dbid dbname % remaining lines are: seriesid seriesname % example: % mkdbd('xyz','xyz mutual funds','c:\dbases\xyz','tsi'); % % Note: this will close ALL FILES to avoid overloading the file system % % see also: TSI, MKDBL % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 % deblank inputs if needed dbid = deblank(dbid); dbname = deblank(dbname); filedir = deblank(filedir); fileext = deblank(fileext); % add slash to filedir if needed if filedir(length(filedir)) ~= '\' filedir = [ filedir '\']; end; % delete any previous version of temp.txt fid = fopen('c:\dbases\temp.txt','r'); if fid >0 fclose(fid); delete c:\dbases\temp.txt; end; % list directory and place on temp.txt disp (' '); disp ( ' Getting Directory............................'); diary off diary c:\dbases\temp.txt stg = [ 'ls ' filedir '*.' fileext ';']; eval(stg); diary off % read temp.txt disp(' '); disp(' Getting Information........................'); fid = fopen('c:\dbases\temp.txt','r'); x = fscanf(fid,'%c'); fclose(fid); % go through directory to get information for dbd upext = ['.' fileext]; upext = upper(upext); r = x; n = 0;
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while length(r)>0 [tok,r] = strtok(r); if (length(findstr(upper(tok),upext))>0) & ... length(findstr(upper(tok),'*'))==0 sid = strtok(tok,'.'); fullid = [ dbid '.' sid]; [src,nm,curr,dates,rets] = tsi(fullid); fclose('all'); % needed to avoid overloading file system fullidx = [ fullid blanks(20)]; fullidx = fullidx(1:20); nmx = [nm blanks(60)]; nmx = nmx(1:60); ln = [ fullidx nmx]; n = n+1; if n == 1 dbd = ln; else dbd = [ dbd; ln]; end; end; end; % sort on name disp (' '); disp (' Sorting..............................'); numcols = size(dbd,2); nmmat = dbd(:,21:numcols); [slst,ii] = strsort(nmmat); dbd = dbd(ii,:); % write on file disp (' '); disp (' Saving..............................'); % open database directory file dbfl = [ 'c:\dbases\' dbid '.dbd']; fido = fopen(dbfl,'w'); % write first line dbidx = [ dbid blanks(20)]; dbidx = dbidx(1:20); dbnamex = [ dbname blanks(60)]; dbnamex = dbnamex(1:60); ln = [dbidx dbnamex ]; putl(fido,ln); % write remaining lines numrows = size(dbd,1); for i = 1:1:numrows putl(fido,dbd(i,:)); end; fclose(fido);

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function putl(fid,ln); % function putl(fid,ln); % puts a string (ln) on the file with file id fid % assumes that ln does not included backslashes % % PC VERSION % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 ln = [ln '\r\n']; fprintf(fid,ln);

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/strsort.txt

function [listrev,ii] = strsort(slist); % function [listrev,ii] = strsort(slist); % sorts a list of strings % slist: strings, one per row % listrev: list in ascending order % ii: indexes of strings from original list % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 % convert to numeric of upper case and turn on side s = abs(upper(slist))'; % entries are in columns nr = size(s,1); nc = size(s,2); ngt = zeros(nc,1); for col = 1:1:nc % make column matrix and subtract colv = s(:,col); colm = colv*ones(1,nc); % get first gt cmpgt = colm>s; [y,firstgt] = max(cmpgt); % if sum(cmpgt) == 0, it isn't gt anything testv = 99999*(sum(cmpgt)==0); firstgt = firstgt + testv; % get first lt cmplt = colm<s; [y,firstlt] = max(cmplt); % if sum(cmplt) == 0, it isn't lt anything testv = 99999*(sum(cmplt)==0); firstlt = firstlt + testv; % number it exceeds numgt = sum(firstgt<firstlt); ngt(col) = numgt; end; [y,ii] = sort(ngt); listrev = slist(ii,:);

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/mkdbl.txt

function ok = mkdbl(dbid, dbname, filedir, fileext); % function ok = mkdbl(dbid, dbname, filedir, fileext); % makes a database list file % database files are in filedir and have extenstion fileext % database list is dbid, name is dbname % database list will be put in c:\dbases\dbid.dbl % database files must have dbid, dbname in line 1 % the database list will simply be a list of the first lines of % the database files % example: % mkdbl('dbl','Time series Databases','c:\dbases\','dbd'); % % see also: TSI, MKDBD % copyright, 1996, William F. Sharpe % wfsharpe@leland.stanford.edu % this version Jan. 15, 1996 % deblank inputs if needed dbid = deblank(dbid); dbname = deblank(dbname); filedir = deblank(filedir); fileext = deblank(fileext); % add slash to filedir if needed if filedir(length(filedir)) ~= '\' filedir = [ filedir '\']; end; % delete any previous version of temp.txt fid = fopen('c:\dbases\temp.txt','r'); if fid >0 fclose(fid); delete c:\dbases\temp.txt; end; % list directory and place on temp.txt disp (' '); disp ( ' Getting Directory............................'); diary off diary c:\dbases\temp.txt stg = [ 'ls ' filedir '*.' fileext ';']; eval(stg); diary off % read temp.txt disp(' '); disp(' Getting Information........................'); fid = fopen('c:\dbases\temp.txt','r'); x = fscanf(fid,'%c'); fclose(fid); % go through directory to get information for dbd upext = ['.' fileext]; upext = upper(upext); r = x; n = 0; while length(r)>0 [tok,r] = strtok(r); if (length(findstr(upper(tok),upext))>0) & ... length(findstr(upper(tok),'*'))==0 sid = strtok(tok,'.');
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fnm = [ filedir tok]; fid = fopen(fnm,'r'); ln = fgetl(fid); fclose(fid); n = n+1; if n == 1 dbd = ln; else dbd = [ dbd; ln]; end; end; end; % sort on name disp (' '); disp (' Sorting..............................'); numcols = size(dbd,2); nmmat = dbd(:,21:numcols); [slst,ii] = strsort(nmmat); dbd = dbd(ii,:); % write on file disp (' '); disp (' Saving..............................'); % open database directory file dbfl = [ 'c:\dbases\' dbid '.dbl']; fido = fopen(dbfl,'w'); % write first line dbidx = [ dbid blanks(20)]; dbidx = dbidx(1:20); dbnamex = [ dbname blanks(60)]; dbnamex = dbnamex(1:60); ln = [dbidx dbnamex ]; putl(fido,ln); % write remaining lines numrows = size(dbd,1); for i = 1:1:numrows putl(fido,dbd(i,:)); end; fclose(fido);

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/getfiles.txt

function getfiles(libfile); % example: % getfiles('lib.txt'); % gets files included in file named as argument % named file has text files in blocks % each block starts with $start <filename> % (one space between start and file name) % each block ends with $end % this will overwrite any previous versions of the named files fidlib = fopen(libfile,'r'); if fidlib < 0 disp (['ERROR -- missing file: ' libfile]); return; end; true = 1==1; false = ~true; infile = false; while ~feof(fidlib) line = fgetl(fidlib); if length(line) > 0 if findstr(line,'$start') == 1 infile = true; starting = true; fname = line(7:length(line)); fid = fopen(fname,'w'); if fid<0 disp(['problem with:' fname]); return; end disp(['writing file: ' fname]); end; if findstr(line,'$end') == 1 fclose(fid); disp('.... done'); infile = false; end; if infile & ~starting if isstr(line) if length(line)>0 for i=1:length(line) fwrite(fid,line(i),'char'); end; end; end; fprintf(fid, '\r\n'); else starting = false; end; end; end; fclose(fidlib);

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/pmats.txt

function pmats(top,left,mat,width,places) % usage: % pmats(top,left,mat,width,places) % % print a matrix with ids on left and top % with width columns with places to right of decimal % options if width, places not given: 8.4 % required: % top: string of names separated with | (for example, 'col1|col2|col3') % if names are fewer than columns, blanks are used on the left side of the table % left: string of names separated with | (for example, 'row1|row2|row3') % if names are fewer than rows, blanks are used at the end of the table % set defaults if needed if nargin<5 places = 2; end if nargin<4 width = 8; end % find dimensions [rows,cols] = size(mat); % find terminators in top and left, pad as needed topend = findstr(top,'|'); if length(topend)<(cols+1) num = cols + 1 - length(topend); pad = setstr(ones(1,num)*abs('|')); top = [pad top]; end; leftend = findstr(left,'|'); if length(leftend)<rows num = rows - length(leftend); pad = setstr(ones(1,num)*abs('|')); left = [left pad]; end; % make end vectors topend = [0 findstr(top,'|')]; leftend = [0 findstr(left,'|')]; % set numeric format fmt = ['%' num2str(width) '.' num2str(places) 'f']; % find width for left diff = max(leftend(2:length(leftend)) - leftend(1:length(leftend)-1)); lftwidth = diff + 2; % print for j hd if top = 1:cols+1 = top(topend(j)+1:topend(j+1)-1); j == 1 hd = [ hd blanks(lftwidth)]; hd = hd(1:lftwidth); else num = max([0 width-length(hd)]); hd = [ blanks(num) hd]; hd = hd(1:width); end; fprintf(hd);

end
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fprintf('\n'); % print matrix for i = 1:rows lft = left(leftend(i)+1:leftend(i+1)-1); lft= [ lft blanks(lftwidth)]; lft = lft(1:lftwidth); fprintf(lft); for j = 1:cols fprintf(fmt,mat(i,j)); end fprintf('\n'); end

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file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/wcov.txt

function [C,sda,CC,e] = wcov(R,h); % [C,sda,CC,e] = wcov(R,h); % produces a weighted covariance matrix using a specified half-life % also produces standard deviations, correlations and expected values % variables: % R: matrix of s observations (states) on n variables % h: half-life (0 for equal weights) % C: n*n covariance matrix % sda: n*1 vector of standard deviations % CC: n*n matrix of correlation coefficients % e: n*1 vector of expected returns % % weight for observation t is 2^(t/h), scaled to sum to 1.0 % % % copyright 1995, William F. Sharpe wfsharpe@leland.stanford.edu this version Nov. 2, 1995 % if matrix has more rows than columns, transpose it if size(R,1) > size(R,2) R = R'; end; % get dimensions [n,s] = size(R); % set up weight vector if h == 0 x = zeros(1,s); else x = (1:s)/h; end; w = (2.^x); p = w/sum(w); % compute expected values e = R*p'; % compute matrix of deviations d = R - e*ones(1,s); % compute weighted covariances C = d*diag(p)*d'; % compute standard deviations sda = sqrt(diag(C)); % compute correlations (if sda = 0, corr = 0) z = sda*sda'; z = z + (z==0); CC = C./z;

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William F. Sharpe, Biography

William F. Sharpe

William F. Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business and Chairman, Financial Engines, Inc.. He joined the Stanford faculty in 1970, having previously taught at the University of Washington and the University of California at Irvine. In 1996, he co-founded Financial Engines, a firm that provides online investment advice to individuals. He was one of the originators of the Capital Asset Pricing Model, developed the Sharpe Ratio for investment performance analysis, the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns-based style analysis for evaluating the style and performance of investment funds. Dr. Sharpe has published articles in a number of professional journals, including Management Science, The Journal of Business, The Journal of Finance, The Journal of Financial Economics, The Journal of Financial and Quantitative Analysis, The Journal of Portfolio Management, and The Financial Analysts' Journal. He has also written six books, including Portfolio Theory and Capital Markets
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William F. Sharpe, Biography

(McGraw-Hill, 1970 and 2000), Asset Allocation Tools (Scientific Press, 1987), Fundamentals of Investments (with Gordon J. Alexander and Jeffrey Bailey, Prentice-Hall, 2000) and Investments (with Gordon J. Alexander and Jeffrey Bailey, Prentice-Hall, 1999). Dr. Sharpe is past President of the American Finance Association. In 1990 he received the Nobel Prize in Economic Sciences. He received his Ph.D., M.A. and B.A. in Economics from the University of California at Los Angeles. He is also the recipient of a Doctor of Humane Letters, Honoris Causa from DePaul University as well as the UCLA Medal, UCLAs highest honor. Dr. Sharpe is a trustee of the AXA Rosenberg mutual funds and serves as Chairman of the Board of Financial Engines, Incorporated. Further information can be found on the world-wide web at www.wsharpe.com and www.financialengines.com.

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William F. Sharpe's Home Page

NEW
September 2000: A paper on a method to obtain information about an investor's risk preferences

file:///G|/Ftp/Z_UPLOAD/z_New/SHARPE/new.htm [15/10/2001 10:52:05]

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