Application 4: Portfolio Optimization Javier Estrada ADFIN – Winter/2014 1. Your Results • What do the results suggest? 2. The Inputs in Portfolio Optimization • Evidence and implications 3. Two Related Issues • Country diversification v . industry diversification • Globalization and the market portfolio Your Results A few thoughts on your results Javier Estrada 4‐asset optimization IESE Business • The weights (portfolios) obviously vary substantially School depending on the goal and restrictions Barcelona Spain • Unrestricted portfolios may be ‘weird’ or in many cases impossible to implement Hence you have to specify your restrictions very precisely • GMM Easy to implement (No additional info required) Very different weights ( Very concentrated portfolio) 10‐asset optimization • The optimizer can easily be adapted to any n Nowadays optimizers are used mostly across asset classes A ‘simpler’ optimizer (and its limitation) GoXls ADFIN Winter/2014 1
Inputs – Some Important Questions Consider the standard problem of maximizing Javier Estrada risk‐adjusted returns (Sharpe ratio) IESE Business School Barcelona Spain And consider … the inputs of this problem ( E i / Cov ij / R f ) and the following questions • Do these inputs vary over time? • If so, are these changes predictable? • In general, how should these inputs be estimated? ADFIN Winter/2014 Inputs – Evidence Mean returns Javier Estrada Fluctuate widely in the short/medium term, around IESE Business a rather‐constant long‐term mean Go School Volatility Barcelona Spain Fluctuates in the short/medium term, around a rather‐constant long‐term mean Higher in down markets Go Correlations Fluctuate in the short/medium term, around a generally ‐ increasing trend (Globalization) Increasing in volatility Higher in down markets • Hence diversification is there the least when you want it and need it most Go ADFIN Winter/2014 2
Inputs – Some Further Thoughts Two important issues Javier Estrada Results (portfolios and characteristics) are very IESE Business sensitive to changes in the inputs School • Remember GIGO Barcelona GoXls Spain Can we do better than using historical averages? • Very ( very! ) tricky question • For a short‐term portfolio The empirical facts discussed may be useful • For a medium/long‐term portfolio The return of bonds is relatively easy to estimate (The current YTM) Go For the return of stocks, all bets are off (Both history and the RDM may be good starting points) ADFIN Winter/2014 Two Related Issues Country diversification v . industry diversification Javier Estrada US domestic/broad (top‐down) portfolio manager IESE Business • Concerned with being in the right sectors School • Not concerned with being in the right states (!) Barcelona Spain European broad (top‐down) portfolio manager • Used to be concerned with being in the right countries Hence the ‘country specialist’ was essential • That is no longer the case Countries have become increasingly correlated The benefits of country diversification have decreased The current concern is being in the right sectors Hence the ‘sector specialist’ is now essential Go ADFIN Winter/2014 3
Two Related Issues Globalization and the market portfolio Javier Estrada Segmented markets IESE Business • Stocks are affected mainly by local factors School The local market is the relevant benchmark Barcelona Spain Globalized markets • Stocks are affected mainly by global factors The global market is the relevant benchmark Most countries and companies are somewhere in between the two extremes • This begs the question about the relevant market portfolio to be used in the estimation of betas Local? Global? A blend? Perhaps the latter (though it is not entirely clear) ADFIN Winter/2014 Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 4
Mean Returns (1900 ‐ 2013) Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Volatility (T12M, 1900 ‐ 2013) Javier Estrada IESE Volatility in up months: 12.5% Business Volatility in down months: 13.1% School Barcelona Spain ADFIN Winter/2014 Back 5
Correlations – Europe Javier Estrada IESE Business School Barcelona Spain ADFIN Source : Freimann (1998). “Economic Integration and Country Allocation in Europe.” FAJ. Winter/2014 Correlations and Volatility Javier Estrada IESE Business School Barcelona Spain Source : Solnik, Boucrelle, and Le Fur (1996). “International Market Correlation and Volatility.” FAJ. ADFIN Winter/2014 6
Correlations – Up/Down Markets Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Source : Erb, Harvey, and Viskanta (1994). “Forecasting International Equity Correlations.” FAJ. Correlations – Up/Down Markets Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 7
Correlations – Up/Down Markets Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 The Changing Nature of Inputs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 8
The Expected Return of Bonds Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Country v . Industry Diversification Javier Estrada The Economist (Nov/11/00) IESE Business School A recent poll carried out by Barcelona Merrill Lynch found that only Spain 10% of European fund managers believe that countries matter for their investment decisions – only three years ago the figure was 50%! More than three quarters said it was crucial to be in the right sector. ADFIN Winter/2014 9
Country v . Industry Diversification Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 10
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