Advanced lnvesLmenLs - Sprlng 2014

Parvard ManagemenL Company age | 1

LCnC CASL 1:
PA8vA8u MAnACLMLn1 CCMAn?

1. AuvAn1ACLS Anu LlMl1A1lCnS Cl 1PL C1lMAL C81lCLlC ALLCCA1lCn
Parvard ManagemenL Company has been founded ln 1974 Lo provlde managemenL for Parvard's
endowmenL, penslon asseLs, worklng caplLal, and LrusLs. 1he perpeLual naLure of Lhe unlverslLy forces
PMC Lo focus on a long-Lerm horlzon Lo Lry Lo preserve Lhe real value of Lhe endowmenL and lLs lncome
dlsLrlbuLlon ln perpeLulLy. 1hus, when chooslng an opLlmal porLfollo allocaLlon, Lhe company ls
confronLed wlLh a blg lssue: Lo balance Lhe needs of long-run reLurns for Lhe lncreaslng endowmenL
spendlng wlLh Lhe rlsks lnvolved by greaLer ylelds.
1he company uses a ollcy orLfollo as an underlylng framework for Lhelr lnvesLmenL acLlvlLy. As
descrlbed on Lhe webslLe of Lhe company
1
, 1hls ollcy orLfollo ls "# $%&'(&$)*#+ ,'($-'+)' #++'*#$&.
#/'01 #22&$ *+#22&2 )0 # /)3 $%#$ )2 45.1&. $' 6& /'2$ #,,(',()#$& -'( 7#(8#(. 90)8&(2)$: -('/ 6'$% $%&
,&(2,&*$)8& '- ,'$&0$)#+ (&$5(0 #0. ()2; '8&( $%& +'01 $&(/<= 1he purpose of lLs porLfollo ls Lo provlde
PMC wlLh a gulde for Lhe acLual allocaLlon and also Lo serve as a benchmark agalnsL whlch Lhey [udge
Lhe success of Lhelr acLlve managemenL sLraLegles.
ln Lhls case seL up ln 2001, Lhe PMC 8oard wlll soon be revlewlng Lhe pollcy porLfollo. ln order Lo obLaln
Lhls porLfollo, Lhe managemenL company sLaff uses Lhe opLlmal porLfollo allocaLlon. 1hey flrsL make
long-Lerm caplLal markeL assumpLlons and Lhen use a mean-varlance opLlmlzaLlon algorlLhm Lo flnd Lhe
efflclenL fronLler of posslble asseL comblnaLlons.
1he opLlmal porLfollo concepL ls based on Lhe modern porLfollo Lheory, whlch sLaLes LhaL lnvesLors are
rlsk-averse and are Lrylng Lo mlnlmlze rlsk whlle sLrlvlng for Lhe hlghesL reLurn posslble. Accordlng Lo
Lhe Lheory, lL ls posslble Lo consLrucL an efflclenL fronLler" of opLlmal porLfollos offerlng Lhe maxlmum
posslble expecLed reLurn for a glven level of rlsk.
1he maln advanLage of Lhls meLhod ls Lhe beneflLs of dlverslflcaLlon LhaL come wlLh lL: allocaLlng an
lnvesLmenL among dlfferenL asseL classes LhaL offer lmperfecLly correlaLed reLurns, ls Lhe key Lo
mlnlmlze Lhe ldlosyncraLlc rlsks. ln addlLlon, some sLudles have shown LhaL asseL allocaLlon explalns a
slgnlflcanL amounL of porLfollo reLurns.
Powever, Lhe opLlmal porLfollo allocaLlon also has llmlLaLlons. ln Lheory and wlLh efflclenL markeLs, Lhls
model glves excellenL resulLs for porLfollo managemenL buL lL ls based on many assumpLlons LhaL do
noL always maLch Lhe real world. Some crlLlclzes LhaL lnvesLors are noL only lnLeresLed ln mean-varlance
opLlmlzaLlon buL Lhey can be senslLlve Lo hlgher momenLs. lurLhermore, Lhe model ls backward looklng
and Lhe opLlmlzaLlon ls based on Lhe caplLal markeL assumpLlons such as reLurn, volaLlllLy and
correlaLlons LhaL are based on expecLed values and should be consLanL ln Lhe model. ln reallLy, markeLs
ofLen mlsprlce rlsk (e.g. uS morLgage bubble) and correlaLlons beLween asseLs are noL flxed and
consLanL forever. Powever, PMC ls less concerned by Lhese llmlLaLlons because Lhe opLlmal asseL
allocaLlon ls more lnformaLlonal Lhan consLralnlng: Lhe board allows lLs allocaLlon Lo move away from
Lhe ollcy orLfollo by uslng LacLlcal asseL allocaLlon beLs Lo anLlclpaLe shorL-Lerm markeL moves.

1
PMC webslLe : hLLp://www.hmc.harvard.edu/lnvesLmenL-managemenL/pollcy_porLfollo.hLml
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Parvard ManagemenL Company age | 2
2. CAl1AL MA8kL1 ASSuM1lCnS
As sald earller, Lhe maklng of caplLal markeL assumpLlons precedes Lhe opLlmlzaLlon. ln Lhls process,
PMC focus on Lwo Lhlngs: Lhe long-Lerm basls and Lhe real reLurns. 1o generaLe approprlaLe
assumpLlons, Lhey used long and shorL-Lerm hlsLorlcal daLa for each asseL class and beneflL wlLh Lhe
advlces of speclallsLs from lnvesLmenL managemenL flrms ouLslde PMC. Slnce Lhe flrm focuses on Lhe
long-Lerm, Lhe expecLaLlons for reLurns and volaLlllLy are harder Lo esLlmaLe and hlsLorlcal daLa are noL
always enough. lorecasLs on correlaLlon are less accuraLe slnce lL Lends Lo vary over Llme. Pence, Lhe
analysLs had Lo make ad[usLmenL for Lhe long Lerms llke Lhe expecLed reLurn on convenLlonal bonds
LhaL had Lo be sllghLly lncreased.
8uL Lhls ls noL Lhe only lssue Lhey're faclng: When Lhe horlzon lncreases, Lhe lnflaLlon rlsk ls hlgher.
1hus, focuslng on Lhe long Lerm lmplles LhaL Lhey also have Lo seek real reLurns (relaLlve Lo Lhe
Consumer rlce lndex). lf prlces slgnlflcanLly lncrease ln Lhe fuLure, Lhe purchaslng power of Lhe
expecLed reLurns wlll be lower. Cne sLraLegy Lo counLer Lhls effecL ls Lo lnvesL ln asseL classes llke
CommodlLles, 8eal LsLaLe and parLlcularly lnflaLlon-lndex 8onds. 1hls lasL sLraLegy ls explalned laLer on
page 4.
1he caplLal markeL assumpLlons are shown ln LxhlblL 11. lL ls lnLeresLlng Lo compare Lhe numbers for
domesLlc and forelgn equlLy reLurns. Accordlng Lo PMC analysLs, boLh asseL classes have Lhe same
expecLed real reLurn buL Lhe forelgn have a sllghLly hlgher rlsk. 1hls dlfference can parLly be explalned
by forelgn exchange rlsk (currency rlsk) and by Lhe economlc slLuaLlon of Lhe chosen counLrles. uesplLes
Lhe rlsk belng hlgher, lL ls lnLeresLlng Lo lnvesL ln LhaL asseL class because lL offers low correlaLlon wlLh
Lhe domesLlc equlLy and wlLh Lhe oLher asseL classes and Lhus lL brlngs hlgh dlverslflcaLlon beneflLs.
3. C81AlnlnC 1PL LlllClLn1 l8Cn1lL8
uslng Lhese caplLal markeL assumpLlons, Lhe analysLs have calculaLed LwenLy-Lwo porLfollos along Lhe
efflclenL fronLler shown (LxhlblL 12). Cne easy way Lo compuLe Lhe efflclenL fronLler ls Lo use Solver"
on MlcrosofL Lxcel.
ln order Lo do so, a few sLeps musL be followed: llrsL, creaLe some arblLrary welghLs for Lhe dlfferenL
asseL classes. 1hey wlll be opLlmlzed laLer. 1hen, wlLh Lhe sLandard devlaLlon of reLurns and Lhe
correlaLlon maLrlx glven ln Lhe Lable ln LxhlblL 11, compuLe
!
Lhe varlance-covarlance maLrlx !!
lL ls now posslble Lo calculaLe Lhe porLfollo reLurn as well as Lhe porLfollo sLandard devlaLlon uslng Lhe
followlng formulas and Lhe arblLrary welghLs creaLed earller:
>'($-'+)' (&$5(0? !
!
! !
!
! !
!
!"
!!!
>'($-'+)' 8#()#0*&? !
!
!
! !
!
!!
AfLer compuLlng Lhese Lwo values, lL ls Lhe Llme for Lhe opLlmlzaLlon. ln Solver, Lhere are Lhree
lmporLanL componenL of Lhe opLlmlzaLlon: flrsL and mosL lmporLanLly, Lhe LargeL LhaL represenLs Lhe
ob[ecLlve of Lhe opLlmlzaLlon. ln our case we wanL Lo mlnlmlze Lhe sLandard devlaLlon of Lhe porLfollo
for a glven reLurn. Pence, we selecL Lhe cell wlLh sLandard devlaLlon (Lhe rooL of Lhe porLfollo varlance
compuLed before) and we Lell solver Lo mlnlmlze lL. 1he second componenL Lo selecL ls Lhe varlable cells
LhaL wlll be opLlmlzed ln order Lo mlnlmlze Lhe ob[ecLlve. 1hese are Lhe cells wlLh Lhe welghLs for each
asseL classes. LasLly, some consLralnLs have Lo be added Lo flnd a plauslble soluLlon. Cne consLralnL ls
LhaL Lhe sum of Lhe welghLs musL be equal Lo one. 1he second sLaLes LhaL Lhe welghLs musL be poslLlve
(beLween 0 and 1) wlLh an excepLlon for mlnlmum welghL ln Cash, whlch can mlnus 30. lurLhermore,

2
uslng Lhe facL LhaL Lhe )4 elemenL of Lhe varlance-covarlance maLrlx z equals !
!"
! !
!"
! !
!
! !
!
.
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Parvard ManagemenL Company age | 3
slnce we are mlnlmlzlng Lhe sLandard devlaLlon for a glven expecLed reLurn, we have Lo flx Lhe cell
conLalnlng Lhe porLfollo reLurn Lo some chosen value.
1o conclude, Lhe soluLlon glven by Solver wlll Lhen be a porLfollo on Lhe efflclenL fronLler. 8y changlng
Lhe flxed porLfollo reLurn ln Lhe lasL consLralnL and repeaLlng Lhe opLlmlzaLlon LwenLy-Lwo Llmes, Lhe
analysLs of PMC have compuLed a seL of porLfollos along Lhe efflclenL fronLler wlLh dlfferenL posslble
asseL comblnaLlons. Cn Lhe llgure on page 3, Lhe efflclenL fronLler ls represenLed as well as Lhe
dlfferenL asseL classes.
4. 8CS Anu CCnS Cl CCnS18AlnlnC C81lCLlC WLlCP1S
AfLer compuLlng Lhe efflclenL fronLler, Lhe sLaff of PMC faced a new lssue. 1he welghLs obLalned ln Lhe
prevlous opLlmlzaLlon were $'' 0'0@$(#.)$)'0#+ $' 6& #**&,$#6+& #+$&(0#$)8&2". 1he opLlmlzaLlon was
lndeed puLLlng Loo much welghL on non-LradlLlonal asseLs classes such as emerglng markeLs,
commodlLles or lnflaLlon-lndexed bonds. Moreover, lL compleLely neglecLed convenLlonal classes
lncludlng domesLlc and forelgn equlLy. 1o flx LhaL problem, Lhey declded Lo consLraln Lhe asseL classes
Lo a range close
3
Lo Lhe currenL ollcy orLfollo.
AfLer Lhls ad[usLmenL
4
, Lhey obLalned Lhe resulLs of LxhlblL 13. lL ls lnLeresLlng Lo noLe LhaL on Lhe one
hand, Lhe blndlng consLralnLs are Lhe mlnlmum resLrlcLlons for Lhe LradlLlonal asseLs classes (domesLlc,
forelgn equlLy and absoluLe reLurns) and on Lhe oLher, Lhe maxlmum resLrlcLlon for less LradlLlonal ones
llke Lhe lnflaLlon-lndex bonds and commodlLles. Pence, Lhls also lncreases Lhe lnflaLlon rlsk of Lhe
porLfollo by puLLlng less welghL ln Lheses classes.
Cne advanLage Lo movlng Lo a more conservaLlve allocaLlon ls LhaL lL corresponds well wlLh Parvard's
rlsk Lolerance, and even wlLh Lhe new opLlmlzaLlon resulLs, Lhe allocaLlon ls sLlll rellanL on Lhe relaLlvely
new asseL classes. lurLhermore, slnce PMC uses an acLlve managemenL of asseLs and Lrade on spread
wlLhln asseL classes (wlLh Lhe long-shorL sLraLegy), lL can ouLperform Lhe porLfollo pollcy wlLhouL Laklng
more rlsk. LasL buL noL leasL, lf Lhe allocaLlon had changed slgnlflcanLly llke Lhe flrsL opLlmlzaLlon
suggesLed, Lhe uomesLlc and lorelgn LqulLy welghLs would have decreased from respecLlvely 22 and
13 Lo noLhlng. ConsequenLly, Lhls would have engendered hlgh LransacLlon cosLs Lo read[usL Lhe
welghLs as well as slgnlflcanL cosLs Lo relocaLe Lhe managers speclallzed ln Lhese asseL classes.
Powever, consLralnlng Lhe porLfollo welghLs comes wlLh a prlce. llrsL, as we can see when comparlng
LxhlblL 12 and 13, Lhls llmlLs Lhe dlverslflcaLlon. 1hus, Lhe new consLralnLs lncrease Lhe sLandard
devlaLlon of each posslble porLfollo and hence move Lhe efflclenL fronLler Lo Lhe rlghL" (see llgure 1 on
p.3). ConsequenLly, Lhls decreases Lhe Sharpe 8aLlo, whlch measures Lhe excess reLurn per unlL of
devlaLlon. 1hls ls also an lssue because lL overrldes Lhe caplLal markeL assumpLlons LhaL Lhe group had
been developlng for a long Llme.
llnally, by resLralnlng Lhe welghLs and Lhe dlverslflcaLlon, PMC also llmlLs Lhe posslble reachable
porLfollos. As we can see on llgure 1, Lhe maxlmum reLurn Lhey can now earn by changlng welghLs ls
around 8 whlle Lhe mlnlmum reLurn ls 4.7 percenLage polnLs (llghL parL of Lhe consLralned curve on
Lhe graph). 1hls also lncreases Lhe Mv's sLandard devlaLlon Lo 4.34, 3 Llmes hlgher Lhan Lhe
unconsLralned Mv.

3
lus or mlnus 10 percenLage polnLs.
4
1hls ls an easy ad[usLmenL Lo do on Solver slnce lL only requlres addlng consLralnLs on Lhe mlnlmum and maxlmum values
LhaL each asseL class welghL can Lake.
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Parvard ManagemenL Company age | 4
3. lnlLA1lCn-lnuLxLu 8CnuS
An lmporLanL prerequlslLe of an asseL allocaLlon ls Lo choose Lhe asseL classes Lo lnclude ln Lhe
porLfollo. Some crlLerla are lmporLanL when speclfylng asseL classes: 1he asseLs wlLhln a class should be
relaLlvely homogenous. 1he asseL classes should be muLually excluslve, rlsk dlverslfylng and Lhey should
have Lhe capaclLy Lo absorb a slgnlflcanL fracLlon of Lhe lnvesLor's porLfollo.
As we can see ln LxhlblL 4 of Lhe case, PMC's currenL pollcy porLfollo (CcLober 2000) lncludes Lwelve
dlfferenL asseL classes, whlch can be grouped lnLo Lhree maln caLegorles (SLocks, AlLernaLlve
lnvesLmenLs and llxed lncome). lnLeresLlngly, PMC has chosen Lo conslder Lhe lnflaLlon-lndexed 8onds
as an addlLlonal asseL class lnslde Lhe llxed lncome caLegory.
AlLhough Lhe muLually excluslve crlLerlon ls noL compleLely respecLed - lnflaLlon-lndex 8onds are a
subcaLegory of uomesLlc 8onds - Lhls asseL class ls homogenous and slgnlflcanLly rlsk-dlverslfylng. lL ls
also absorblng a subsLanLlal-enough fracLlon of PMC porLfollo
3
Lo be consldered separaLely.
lurLhermore, Lhls cholce of conslderlng Lhe lnflaLlon-lndex 8onds as an addlLlonal asseL class follows
Lhe company's focus for real reLurns. As Lhe name suggesLs, Lhe prlnclpals of Lhe bonds are lndexed Lo
Lhe lnflaLlon raLe (deflned by Lhe Consumer rlce lndex) and Lhey are Lhus deslgned Lo proLecL Lhe
purchaslng power ln Lhe long run by cuLLlng ouL Lhe lnflaLlon rlsk of an lnvesLmenL.
lnflaLlon rlsk ls Lhe uncerLalnLy over Lhe fuLure real
value of an lnvesLmenL due Lo Lhe rlslng cosL of goods.
ln 2000 when Lhe case was seL up, Lhe lnflaLlon raLe was
relaLlvely hlgh (3.4) and had been qulLe volaLlle over
Lhe prevlous flve years (as shown ln Lhe flgure on Lhe
rlghL). ConsequenLly, lL was lmporLanL Lo conslder Lhls
lssue and Lo hedge agalnsL LhaL rlsk wlLh Lhe lnflaLlon-
lndex 8onds.
ln addlLlon Lo Lhls beneflL, 1reasury lnflaLlon-roLecLed SecurlLles (1lS) are backed by Lhe u.S.
governmenL and Lhus bear vlrLually no defaulL rlsk. Llke ordlnary 1reasury bonds, Lhey make regular
lnLeresL paymenLs Lo lnvesLors. Powever, Lhe coupons on 1lS are lower Lhan Lhose on ordlnary
1reasurles because Lhe governmenL promlses Lo pay more aL maLurlLy based on Lhe amounL of
lnflaLlon. Lven lf Lhe reLurns are sllghLly lower Lhan uomesLlc 8onds, Lhe volaLlllLy of Lhe reLurn
decreases slgnlflcanLly. Moreover, Lhey are very beneflclal for dlverslflcaLlon because Lhey offer low
correlaLlons wlLh oLher asseL classes (See CaplLal MarkeL AssumpLlons). As a maLLer of facL, Lhe
consLralned opLlmal allocaLlon maxlmlzes Lhe asseL class welghL Lo ampllfy from Lhls dlverslflcaLlon.
Slnce Parvard ManagemenL Company focuses on long-Lerm real reLurns, uncerLalnLy abouL lnflaLlon ls
an lmporLanL lssue for Lhem. 1herefore, Lhey have a hlgh lncenLlve Lo lnvesL ln 1lS and lL would be
advanLageous for Lhem Lo dlsLlngulsh Lhe lnflaLlon-lndexed 8onds from Lhe domesLlc and forelgn
bonds.



3
ln average, 17 of Lhe posslble porLfollos ln Lhe consLralned model presenLed ln LxhlblL 13.
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Parvard ManagemenL Company age | 3
6. ALnulx
!"#$%& () LfflclenL fronLlers compuLed wlLh Solver.