Total Portfolio Research Articles

How Sub-Optimal—If at All—Is Goal-Based Asset Allocation?

Following the success enjoyed by goal-based allocation over the last several years, the author investigates what the focus away from traditional finance and toward behavioral finance may be costing, if anything, in terms of traditional investment efficiency. The author starts with a review of the modern portfolio theory framework and offers a hypothesis as to how the demonstrated inability of individuals to stick to a single optimal portfolio might be interpreted. He then goes on to review the behavioral solution of a hypothetical case study and compares the outcome with a traditional optimization. His analysis suggests that, once goal based allocation is re-formulated to allow some focus on the total portfolio trade-off between risk and return, the cost in terms of theoretical sub-optimality may be viewed as trivial. He does however concede that this experiment is unlikely to close the debate between the two branches of finance, as the analysis allows each side to claim some form of victory. <b>TOPICS:</b>Portfolio theory, portfolio construction, in portfolio management, performance measurement

Behavioral Asset Allocation for Foundations and Endowments

The behavioral asset allocation framework developed for individual investors can help foundation and endowment trustees become more comfortable with uncomfortable asset classes that would help overall portfolio efficiency. Eleemosynary investment, particularly at smaller charities, is typified by convention and conservatism. The behavioral asset allocation approach helps overcome this tendency by decomposing the total portfolio into timeline-based subportfolios that look to secure the nonprofit's payouts for many years and isolates the uncomfortable assets in the longest-term subportfolios. We advance and apply the behavioral asset allocation framework in a new context, yet one relevant for high-net-worth individuals with charitable intent.

Disentangling Cognitive Bias in the Assessment of Investment Decisions: Derivation of Generalized Conditional Risk Attribution

Conventional performance measurement methods concentrate on investment outcomes rather than the underlying investment process. This paper examines the effectiveness of the investment process by considering the essential part of any investment strategy: the investment decision.As recognized by Kahneman and Tversky [1979], the essential first step is to decompose returns into gains and losses. Using a fundamental investment decision matrix broadens the analysis beyond realized gains and losses to include an assessment of missed opportunities and losses avoided. This leads to an examination of investment strategies in terms of investment success versus error. We contrast these terms with traditional return and risk measures.The second step is to decompose investment decisions into the mutually exclusive categories of risk-taking and risk-reducing. Uncertainty observed in risk-taking activities is newly created at each manager's discretion, while the uncertainty in risk-reducing activities is already defined by an investor's portfolio. The conventional performance measurement approach fails to differentiate between these two types of decisions.The contrast between passive and active management styles of risk reduction becomes apparent from the perspective of investment success and error, particularly when using currency risk management as an illustration. Active information diagrams describe a geometric approach called conditional risk attribution. An active manager's skill lies in the ability to use information to maximize investment success and therefore minimize investment error. The choice of benchmark determines the degree of visibility of an investment exposure.We also address the problem of distinguishing between an active manager's skill and the uncontrollable impact of market movements. Having adjusted for the bias in an investment environment, it becomes possible, as a final step, to measure the information content of an active manager's strategy as the balance between investment success and error within a generalized conditional risk attribution framework.The unlimited nature of risk-taking decisions is evident when they are included in the framework. However, having defined an ex ante risk-taking limit, we can assess whether the choice of active manager has resulted in an enhancement of investment success over error. This allows investors to compare risk-taking managers with risk-reducing managers in the context of overall portfolio construction. The entire analysis is framed in terms of risk budgeting to demonstrate its general application to all asset classes and consequently to enhance total portfolio returns within the predetermined loss budget.

Diversification and Persistence in Hedge Funds

We examine the current fund of hedge funds universe, and find that funds of hedge funds report holding between 1 and 200 underlying funds, and generally hold 10-30, with close to 20 on average. We regress the performance of this universe on the number of holdings and find that return is practically orthogonal to the number of underlying hedge funds held. However, when we regress risk-adjusted return measured by the ex post Sharpe ratios of funds-of-hedge funds, we do find a statistically significant positive relation over 5-year periods; this seems consistent with our findings that diversification reduces volatility. We also examine the diversification effect on total risk reduction in a variety of hedge fund strategies, and we report the total risk as a function of the number of underlying hedge funds for four strategies: Equity Long/Short, Arbitrage, Event-Driven and Distressed, and Global Macro. We find that the asymptotic level of total intra-strategy systematic risk varies across the strategies, from about 3% to about 10% annualized standard deviation, while diversification across funds within each strategy reduces total portfolio annualized standard deviation by about 40% - 50%, at 15 to 25 holdings. Finally, we examine whether there is persistence in the risks and returns of hedge funds, and find persistence in returns at up to 2-year horizons and strong persistence in total risk at up to 4 year horizons.

How Hedge Funds Fit

Hedge funds fit in an institutional investor9s portfolio only if one can evaluate how the inclusion of hedge fund strategies would improve the performance of the entire portfolio, after considering both beta and alpha characteristics. This is more challenging than it first appears because of the opaqueness and the complexity of most hedge fund strategies. The key is to identify institutional-quality hedge funds that permit a clear understanding of the normal portfolio and provide confidence in projecting a positive, pure alpha. If these conditions can be satisfied, there are two possible approaches to incorporating institutional-quality hedge funds: 1) hedge funds as an active overlay at the total portfolio level, or 2) hedge funds as portable alpha within a traditional asset class.

Passive Options-Based Investment Strategies

This article assesses the investment value of the CBOE S&amp;P 500 BuyWrite (BXM) index and its covered call investment strategy to an investor from the total portfolio perspective. Whaley [2002] finds risk-adjusted performance improvement based on the BXM index in individual comparison to the S&amp;P 500. We replicate this work with a longer history for the BXM index and with the short but meaningful history of the Rampart Investment Management investable version of the BXM. We use the Stutzer [2000] index and Leland9s [1999] alpha to assess risk-adjusted performance taking the skew and kurtosis of the covered call strategy into account. Additionally, we compare standard investor portfolios to portfolios where BXM has been substituted for large cap assets and find significant risk-adjusted performance improvement. The compound annual return of the BXM index over the almost 16-year history of this study is 12.39%, compared to 12.20% for the S&amp;P 500. Risk-adjusted performance, as measured by the Stutzer index, is 0.22 for the BXM versus 0.16 for the S&amp;P 500 (monthly). Leland9s alpha is 2.81%/year. The tracking error of the Rampart investable version of the BXM (1.27%/year) is found to be credible evidence of the investability of the BXM index. Known sources of BXM return are reviewed and behavioral factors that may have enhanced BXM performance are considered.

Another Look at the Determinants of Portfolio Performance: Return Attribution for the Individual Investor

This study examines the total return of investment portfolios composed of mutual funds and analyzes the contributions of strategic asset allocation (investment policy), tactical timing (the periodic over- or underweighting of asset classes relative to the strategic weightings), and security selection (the selection of individual mutual funds to represent asset classes). The results of Brinson, Hood and Beebower (1986) and Brinson, Singer and Beebower (1991) are confirmed using a sample free of several data limitations in their samples. Utilizing data from five model mutual fund portfolios, covering a wide range of asset class combinations over a three year period, I demonstrate that strategic asset allocation policy explains more than 90 per cent of the variation in total portfolio return, and that tactical timing decisions and security selection may also contribute significantly to the variation in total return. I expand the existing literature by performing a pooled regression, which incorporates all portfolios together (in addition to examining each portfolio individually and averaging the results, as in Brinson et al.) I further demonstrate that the results are also valid when examining risk-adjusted return: I extend the analysis to include several types of risk measure, examining the data in terms of absolute and relative variance, and conclude the analysis with an evaluation of the portfolios in terms of riskadjusted return, demonstrating that the results obtained vis-a-vis total return also apply on a risk adjusted return basis.

Manager Skill and Risk Budgeting

Risk budgeting appears to bridge the gap between two important concepts in modern portfolio management: ex ante total return-risk portfolio optimization and ex post performance measurement relative to a benchmark. The fundamental hypothesis is that a marginal increase in allowed tracking error is associated with an increase in expected alpha. Tests of this hypothesis using monthly returns for 366 mutual funds in three asset classes over 1997–2001 reveal little evidence of a relationship between realized alpha and tracking error. In a sample split according to manager skill (information ratio), however, there is a positive relationship between alpha and tracking error for skilled (high information ratio) specialty managers and a negative relationship for unskilled (low information ratio) managers. This suggests that investors who wish to practice risk budgeting share with all investors the difficulty of identifying skilled managers in advance.

How strategic is housing asset management of institutional real estate investors?

PurposeThere is a clear tendency towards more business‐like approaches in the housing sectors in many European countries. The paper attempts to identify these approaches and related techniques with Dutch institutional real estate investors.Design/methodology/approachIt has been investigated how real estate investors in The Netherlands decide about the physical and technical development and the tenure of their housing stock. In‐depth interviews have been held with several large real estate investors, which cover the majority of all dwellings in the sector.FindingsResults show that investment allocations are only partly rationalised and are not in the least based on intuition. In addition, some elements of strategic asset management prove to be less common than we had expected from the commercial nature of these elements.Research limitations/implicationsThe research concentrates on the development of the total portfolio. In future research, individual estates can be selected for case studies, in order to assess to what extent the policies on portfolio level are carried out in practice.Originality/valueThe paper presents recent evidence on the state of professionalisation in the commercial housing sector.

Information in the Idiosyncratic Volatility of Small Firms

Non-systematic volatilities of small firms are special as predictors of stock returns. They are positively related with future returns on all age and size portfolios. They dominate systematic volatility, big-firm volatility and other volatilities. And there is strong evidence that idiosyncratic risk is priced in small-firm returns. Small-firm volatility as a predictor of big-firm returns is in part a proxy for systematic volatility and consumption-wealth ratio. We rule out several hypotheses, including a liquidity premium, as potential explanations of our results, but not the idea that small-firm idiosyncratic volatility is correlated with the risk of the total investor portfolio, which includes non-equity assets.

The Enviable Dilemma

It9s not unusual for investors, fiduciaries, and trustees to find themselves with too much of a good thing: owning or overseeing a large quantity of a highly appreciated low-basis stock. In this emotional issue, investors are typically torn: hold the stock that9s made them rich and avoid the large tax bill, begin to diversify, or hedge? On average, investors haven9t gotten paid to take on the incremental risk of single stocks. But that fact alone isn9t enough to act upon? and indeed there are no singular answers. In this study the authors present an analytical framework that highlights the critical trade-offs underlying any single-stock decision, which has to factor in the investor9s unique circumstances. These include his long-term goals, risk tolerance, and total portfolio, as well as the volatility of his single stock. We use all of this information to identify courses of action to consider. This analysis can be applied to other risk-management diversification strategies, such as liquidating over time and hedging with derivatives.

The Future of Active Management

Success in the future means practicing safe, smart stock selection for a manager and safe, smart manager selection for a plan sponsor. Both need to begin with a clear idea of what beta is and what alpha is in the total portfolio; they involve very different expectations and very different risks and should be managed differently. Modern active portfolio or fund management must occur in the space of alpha versus active risk on the active efficient frontier. Successful active managers of the future, the ones the chief investment officer will want to pick, will have skill in forecasting alpha, will optimize their portfolios on the active efficient frontier, will be moving away from using the long-only constraint, and will have high breadth, good portfolio construction processes, low transaction costs, and stringent risk controls.

The Impact of Mutual Fund Family Membership on Investor Risk

Many investors confine their mutual fund holdings to a single fund family, either for simplicity or through restrictions placed by their retirement savings plan. We find evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio.

The expanding role of defined contribution plans in the USA: Benefits, restrictions and risks

As questions regarding the future of the US social security system (the nation's public retirement plan) continue to surface, interest in employer-sponsored retirement plans as well as other retirement investment options increases. But the restrictions and rules associated with various defined benefit plans such as 401(k), 403(b) and 457 plans can be confusing, and these plans are not without risks. This paper explores these plans and explains the need to view retirement savings in a total portfolio context.

Goals-Based Investing

This article examines opportunities to improve wealth management by combining traditional finance theory with the observations of behavioral finance. Areas of focus include risk measurement, risk profiling, and methods for managing behavioral biases. In the area of risk measurement, the author stresses the importance of capturing investor preferences and goals and proposes several measures that are consistent with this objective. The author also critiques common risk profiling techniques, advocating separate risk tolerance estimates for separate goals rather than an overall risk tolerance for each investor, noting that the total portfolio framework of traditional finance is inconsistent with investors9 tendencies towards mental accounting. A better result may be achieved by linking individual strategies to a specific goal or goals. The author describes a process for implementing his recommendations through examples, considering the challenges of investing to meet current lifestyle expenses and investing for a fixed planning horizon. The article closes with a call to align investment strategy development with common investor goals, arguing that this will promote consistency between the investment principles of the practitioner and the perspective of the individual investor.

Production from Multiple Horizons: Budget Constraints and Minimum Involvement

For a given oilfield in which a company can invest to drill untapped horizons for profit, the influences of value, cost, success probability and corporate risk tolerance provide an optimal working interest that should be taken in the opportunity in order to maximize the risk adjusted value. When several horizons are available, but when the total budget is insufficient to take optimal working interest in each, an analytic procedure is given for optimizing the risk adjusted value of the total portfolio; the relevant working interests are also derived based on a cost exposure constraint. Several numerical illustrations exhibit use of the method under different budget conditions, and with different numbers of available horizons. The result is that the computations of portfolio balancing can be done quickly utilizing the analytical expressions presented here, thereby providing rapid assessments of undrilled horizons and their worth.

Portfolio Optimization with Tracking-Error Constraints

This article explores the risk and return relationship of active portfolios subject to a constraint on tracking-error volatility (TEV), which can also be interpreted in terms of value at risk. Such a constrained portfolio is the typical setup for active managers who are given the task of beating a benchmark. The problem with this setup is that the portfolio manager pays no attention to total portfolio risk, which results in seriously inefficient portfolios unless some additional constraints are imposed. The development in this article shows that TEV-constrained portfolios are described by an ellipse on the traditional mean–variance plane. This finding yields a number of new insights. Because of the flat shape of this ellipse, adding a constraint on total portfolio volatility can substantially improve the performance of the active portfolio. In general, plan sponsors should concentrate on controlling total portfolio risk.

A risk-factor model foundation for ratings-based bank capital rules

I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

Limiting risk in environmental problems: Corporate budget constraints and minimum involvement

For a given opportunity in which a company can invest to perform environmental remediation for profit, the influences of value, cost, success probability, and corporate risk tolerance provide an optimal working interest (OWI) that should be taken to maximize the risk-adjusted value (RAV). When several opportunities are available, but when the total budget is insufficient to take OWI in each, an analytical procedure is undertaken for optimizing the RAV of the total portfolio; the relevant working interests are also derived based on a cost-exposure constraint. Several numerical illustrations will exhibit the use of the method under different budget conditions and with different numbers of available opportunities. The result is that the computations of portfolio balancing can be done quickly using the analytical expressions presented here, thereby providing rapid assessments of environmental opportunities and their worth.

Diversification and the Taxation of Capital Gains and Losses

Current U.S. law nets the total portfolio of realized capital gains and losses to compute capital gains taxes. Prior research, however, typically ignores the implication of this provision, i.e., the marginal tax rate for a specific gain or loss depends on the taxpayer's total portfolio of realized gains and losses. We find that these nettings introduce complexity into the relation between share values and capital gains taxes, creating an incentive to diversify. For firms with stock returns that are positively (negatively) correlated with those of the overall market, share values generally are decreasing (increasing) in the capital gains tax rate.