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The biggest new feature of AllocationADVISOR 6.0 is the inclusion of the BlackLitterman model. The Black-Litterman model was created by Fischer Black and Robert

Litterman of Goldman Sachs. Conceptually, it combines a number of the pillars of

modern portfolio theory Sharpes CAPM and Markowitzs mean-variance optimization.

The Black-Litterman model is not an alternative or a replacement of mean-variance

optimization; it is a tool for creating a set of expected returns for use within the

mean-variance optimization framework.

Harry Markowitzs mean-variance optimization is the heart of modern asset allocation.

Unfortunately, a number of people dont use mean-variance optimization because the

resulting asset allocations are highly concentrated in just a few of the assets being

optimized. The Black-Litterman model eliminates this problem by creating better

estimates of expected return that carefully balance risk and return, leading to welldiversified portfolios.

For more information about how the Black-Litterman Forecast Model leads to diversified

portfolios, see the article Black-Litterman: Asset Allocations You Can Actually Use!

For a discussion about how the Black-Litterman model calculates forecasts, see How

does the Black-Litterman Model Calculate Return Forecasts?

We have gone to great efforts to make this sophisticated model easy to use. To create an

Asset Allocation case using the Black-Litterman Forecast model, after naming the

Allocation Case and selecting the Black-Litterman Forecast Model, you begin by

selecting the assets to optimize. Zephyr groups some of the most popular asset classes

together in what we call Asset Palettes. Technically, Asset Palettes are collections of

Market Cap Assets, where Market Cap Assets are asset class index proxies that are linked

to an estimate of the market capitalization of the asset class in question. Using Asset

Palettes created by Zephyr makes it very easy to select a logical set of asset classes.

Zephyr-created Asset Palettes are groups of non-overlapping asset classes that represent

reasonable market portfolios or segments of a market portfolio. AllocationADVISOR

also allows users to create Custom Palettes. The ability to select a predefined Asset

Palette can dramatically decrease the time required to create an asset allocation analysis.

After selecting the Asset Palette, you need to enter a Risk-Premium and a Risk-Free Rate.

For those that need assistance in estimating these values we provide the historical 10, 25,

and 50 year risk premia on six model portfolios, as well as the annual yield on the 3month, 1-year, 5-year, and 10-year US Treasuries. The historical risk-premia and annual

yield data is updated monthly and distributed with Zephyrs Full Index Update.

Select an

Asset

Palette

Enter

Palette Risk

Premium

Enter

Risk-Free

Rate

your own Palette Risk

Premium and Risk-Free Rate.

For those who need

assistance selecting

appropriate values, these two

dialog boxes provide

guidance.

After specifying a Palette Risk Premium and a Risk-Free Rate, all that you need to do is

select Done and an Efficient Frontier graph and Inputs table for the Allocation Case are

added to your workbook.

For those of you who wish to modify the return forecasts to match your own opinions

about future market performance, the Black-Litterman model provides an elegant

framework for combining a base case set of market implied returns with your unique

forecasts. The new mixed Forecast Returns still lead to well-diversified portfolios that

reflect your opinions.

Your unique forecasts of expected returns are called Views. There are two types of

Views Absolute Views and Relative Views each of which is entered on their

respective windows in the Allocation Case tree.

Absolute Views state your unique return forecast of an asset class or group of asset

classes. For example, US Small Cap will have a return of 11.5%.

Enter View

Return and

Confidence

US Small Cap is actually a combination of two asset classes US Small Cap Growth and

US Small Cap Value. The formation of View Groups gives you greater flexibility for

specifying views.

you greater

flexibility for

specifying views

Relative Views specify the expected return differential between two asset classes / view

groups. For example, US Large Cap Growth will outperform US Large Cap Value by

1%.

Enter View

Return and

Confidence

For both types of views, you need to specify a confidence level between 5% and 95%.

This confidence level represents the strength of your view. All else equal, the more

confidence you assign to a View, the more aggressively the model will implement that

view.

Once you have specified your views, select Done.

One of the most requested features that has been added to AllocationADVISOR is the

ability to show two efficient frontiers on the same graph.

In addition to two efficient frontier graphs, you can also plot the benchmark on the

Efficient Frontier graph. The efficient frontier options are available from a right-click

menu.

AllocationADVISOR 6.0 allows users to enter multiple custom portfolios in their

allocation cases. These can be any portfolio that users wish to compare to the efficient

portfolios, such as a current portfolio or a target portfolio. Users can select which of the

custom portfolios will be the Comparison Portfolio, which can be displayed on many of

the graphs and tables.

10

11

We also made two enhancements to the Monte Carlo Simulations for this release. The

first is the ability to enter moving average cash flows. We have also changed the colors

on the Simulation Probability graph, making it easier to distinguish between the different

probabilities.

Conclusion

AllocationADVISOR 6.0 includes the Black-Litterman model, one of the most

sophisticated asset allocation models. Best of all, we have removed the complexity

associated with the model making it intuitive and very easy to use. At last, you will be

able use a mean-variance optimizer and feel good about the resulting allocations. A copy

of the workbook used to create the sample illustrations is available on our web site in the

HTML version of this article.

(http://www.styleadvisor.com/resources/newsletters/NewInAA.html)

For additional information on the Black-Litterman model, see the article The BlackLitterman: Asset allocation you can actually use!

(http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html)

12

Have you given up on mean-variance optimization because the resulting asset allocations

are unintuitive and anything but diversified? Or perhaps you feel the need to use meanvariance optimization coupled with tight optimization constraints? The inclusion of the

sophisticated Black-Litterman asset allocation model into AllocationADVISOR will help

you realize the benefits of mean-variance optimization.

Portfolios created using the Black-Litterman approach and mean-variance optimization

are well diversified and intuitively reflect the investors own forecasts about future

market performance.

Harry Markowitzs mean-variance optimization is widely regarded as the holy grail of

asset allocation. Markowitzs seminal work demonstrated how to form efficient

portfolios based on three inputs returns, standard deviation, and correlations. His work

resulted in a Nobel Prize. Unfortunately, Markowitz never told us how to derive the

inputs, especially the estimated expected returns.

Unlike a number of other Nobel Prize winning ideas, mean-variance optimization has not

enjoyed a high level of practitioner acceptance. This is because the Markowitz algorithm

is very powerful, perhaps too powerful for its own good. The algorithm is very sensitive

to the return forecasts, which have traditionally been created using historical returns. If

two asset classes are similar, but one has a slightly higher forecasted return, the optimizer

allocates everything to the asset with the higher forecasted return and nothing to the other

asset. Because of this input sensitivity, mean-variance optimizers can lead to highly

concentrated asset allocations that contradict the common sense notion of diversification.

The input sensitivity also makes it difficult for investors to incorporate their own

forecasts into a historical model.

Many investors have attempted to overcome these shortcomings in mean-variance

optimization by using tight constraints on the optimization. These artificial limits

interfere with the optimization in a way that renders the output sub-optimal. The tighter

the constraints, the further you move toward dictating the allocations to the optimizer

instead of optimizing the allocations. The Black-Litterman model, on the other hand,

creates better return forecasts so that it is not necessary to constrain the optimization in

order to create diversified portfolios. This allows investors to harness the power of

mean-variance optimization in a practical and intuitive way.

In the first section below we take a closer look at the poorly diversified asset allocations

that typically result from using purely historical inputs. Next we look at the solution, the

Black-Litterman model, and the well-diversified asset allocations that result from using

returns from the Black-Litterman model. In the second section below we demonstrate

why the Black-Litterman approach to incorporating investors forecasts of future market

performance is superior to an ad-hoc approach.

13

Diversified Portfolios

Investors have traditionally used historical returns, standard deviations and correlations

as the inputs for mean-variance optimization. Figure 1 shows an efficient frontier created

using eight years of historical data (the longest period available for this set of indices) for

the forecasts.

Figure 1: Efficient Frontier Based on Historical Returns

allocations of the portfolios along the frontier shows that they are poorly diversified.

Figure 2 compares five asset allocations of five mixes corresponding to the approximate

standard deviation levels 5%, 7.5%, 10%, 12.5%, and 15%.

Figure 2: Asset Allocation Mixes Based on Historical Returns

Historical Returns

lead to

concentrated

portfolios

Of the eight available asset classes, none of the optimal asset allocation mixes contain

more than two asset classes. Historical returns lead to poorly-diversified asset

allocations!

14

diversification and to find asset allocations that maximize expected return for a given

level of risk. Fortunately, there is a solution, albeit a solution that emerged almost 50

years after the creation of mean-variance optimization. AllocationADVISOR 6.0 has a

better tool for estimating expected returns the Black-Litterman model.

The Black-Litterman approach tackles the weakest point of mean-variance

optimizationits sensitivity to the return forecasts. Black-Litterman uses the historical

standard deviations and correlations, values which tend to be stable and make good

forecasts, but develops better estimates of expected returns.

The foundation of the Black-Litterman model is the Implied Returns. To calculate the

Implied Returns we define the market as the set of assets available to the investor. The

Implied Returns are calculated by assuming that the market is in equilibrium (supply for

the assets equals demand) and by using reverse optimization to back out the returns that

would bring about this equilibrium. These calculations require three pieces of

information for the marketthe risk premium, covariance and market capitalizations of

the assets.

If the investor does not wish to add their own views to the forecasts, the Implied Returns

are the Black-Litterman forecasts and are used to create the efficient frontier. Figure 3

shows an efficient frontier created using Implied Returns.

Figure 3: Efficient Frontier Based on Black-Litterman Returns

The superior diversification of the asset allocation mixes that result from the BlackLitterman Implied Returns is demonstrated in Figure 4.

15

Black-Litterman

Implied Returns

lead to diversified

portfolios

Of the eight asset classes, all of the optimal asset allocation mixes contain six or more

of the eight asset classes.

Customizing the Implied Returns with Views

As demonstrated above, the Implied Returns are excellent forecasts for use with meanvariance optimization. Investors, however, often have their own opinions about how the

market is going to behave in the future. These investors often want to adjust the Implied

Returns so that the forecasts better reflect their opinions, or views, on future

performance.

How should an investors views be incorporated into the return forecasts? Why not just

directly edit the Implied Returns so that they reflect the views? As we demonstrate

below, trying to edit the Implied Returns directly leads once again to non-diversified

portfolios. The Black-Litterman model, on the other hand, gives you an intuitive way to

incorporate views without losing the advantage of diversification which comes from

using the Implied Returns.

For our examples we will use two sample views:

View 1: US Large Cap Value will outperform US Large Cap Growth by 1%

View 2: US Small Cap will have a return of 11.5%

These Views can be better understood by comparing them to the Implied Returns. The

Implied Returns forecast that US Large Cap Value will under perform US Large Cap

Growth. View 1, then, is a bullish relative view on US Large Cap Value relative to US

Large Cap Growth. View 2 reflects the investors bullish view on US Small Cap. Why?

Because the View return of 11.5% is greater than the Implied Return for US Small Cap

(the weighted average of US Small Cap Growth and US Small Cap Value) which is

10.92%.

Lets look at one possible ad-hoc approach to implementing these views as an example.

For View 1, we could increase the return of US Large Cap Value and simultaneously

decrease the return of US Large Cap Growth until the difference is 1%. And for View 2,

we could increase the return of the two components of US Small Cap so that the weighted

average return equals 11.5%. Figure 5 shows the resulting efficient frontier and mixes.

16

Ad-hoc approaches

to incorporating

views lead to

concentrated

portfolios

We can see from the allocations in Figure 5 that even though we started with the BlackLitterman Implied Returns, which we have seen lead to well-diversified asset allocations,

the ad-hoc approach to incorporating the views leads to relatively concentrated asset

allocations.

The Black-Litterman model offers an alternative to this kind of ad-hoc adjustment of the

return forecasts. The Black-Litterman model uses a sophisticated mixed estimation

technique to incorporate views into return forecasts which continues to derive returns as a

relatively balanced function of risk. The result is diversified portfolios whose allocations

reflect the views of the investor.

Figure 6 shows the mixes created by using the Black-Litterman approach to incorporate

our two sample views.

Black-Litterman

approach leads to

well-diversified

portfolios that

reflect views

Notice in Figure 6 that at each of the five standard deviation levels we have achieved

improved diversification using the Black-Litterman model relative to the ad-hoc

approach.

17

The other advantage to using the Black-Litterman approach to include views in the

optimization is that the resulting portfolios are affected in an intuitive way. This means

that if you are bullish on Small Cap, the mixes will increase the allocation to Small Cap

by a reasonable amount. While this may sound like an obvious (and necessary) result,

those of you who have attempted to adjust return forecasts manually will recognize that it

is not necessarily easy to achieve.

Figure 7 compares the asset allocation mixes at each of the five standard deviation levels

using the Black-Litterman case without views (just using the Implied Returns) and the

Black-Litterman case with views.

Figure 7: Asset Allocation Mix Comparison

The upper panel of Figure 7 shows the allocations using the Black-Litterman approach

without views while the lower panel shows the allocations using the Black-Litterman

approach with our two sample views. Remember that the sample views were bullish on

US Large Cap Value and Small Cap. Note that the allocations reflect these views in an

intuitive way, with increased allocations to these two assets.

Whats Next

Hopefully by now you are anxious to start using the AllocationADVISORs BlackLitterman Forecast Model. If you havent already done so, you will need to download

AllocationADVISOR 6.0. The AllocationADVISOR workbook file that was used to

create all of the examples in this newsletter is available for download on the html version

of this article: http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html

18

sessions. Our online training schedule is available on our website at:

http://www.styleadvisor.com/training.

For a non-technical discussion of how the Black-Litterman model calculates forecasts,

see How does the Black-Litterman Model Calculate Return Forecasts?

For those of you who would like to know more about the mathematics of the BlackLitterman model and our implementation of it, go to the Black-Litterman Forecast

Methodology section of the AllocationADVISOR manual. This section of the manual

explains reverse optimization, the process of creating Market Cap Assets, and the Zephyr

Asset Palettes. The AllocationADVISOR manual is located in your Style folder as well

as the Start Menu StyleADVISOR Program Group.

For the mathematically inclined, a copy of A Step-By-Step Guide to the BlackLitterman Model: Incorporating User-Specified Confidence Levels is available upon

request (support@styleadvisor.com).

19

Several techniques for creating better return forecasts for use with mean-variance optimization

have been developed recently. We believe that we have found the best of these solutions and

we have incorporated it into AllocationADVISOR. The Black-Litterman forecast model creates

return forecasts which are based on sound economic theory and which help harness the power

of mean-variance optimization. Using Black-Litterman return forecasts in mean-variance

optimization results in intuitive, diversified portfolios which are relevant for practical investing.

For more information about how Black-Litterman leads to diversified portfolios, see the article

Black-Litterman: Asset allocations you can actually use! located on our website at:

http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html

How does the Black-Litterman method create return forecasts?

The model uses a technique called reverse optimization to determine the Implied Returns of a

portfolio based on the available market capitalization of the asset classes being optimized. It

also provides a framework to mix investor views with the Implied Returns to form a new

combined estimate of returns.

Implied Returns

Black-Litterman return forecasts are based on the Implied Returns. Implied Returns is a

concept which is based on market equilibrium. The investor first selects an asset palette, which

is the set of assets that will be optimized. This asset palette is assumed to be the market. We

further assume that the market is in equilibrium. Equilibrium really means that the market

price is such that supply equals demand. In this case, we are assuming that the supply of assets

is equal to the demand for the assets. When we are talking about assets, the price becomes a

return. It is the return that is implied by the market equilibrium that we want to find. This is the

Implied Returns.

What is the market equilibrium? If we believe in efficient markets, then the market today is in

equilibrium. The equilibrium portfolio, then, is the market portfolio. The market portfolio is

the capitalization-weighted portfolio of the assets.

Most of the time investors will use multiple asset classes when creating an asset allocation. In

order to demonstrate the mathematics behind the model without resorting to matrix algebra

(which is beyond the scope of this article) we will look at a simple three asset example:

Asset

US Equity

US Bonds

Intl Equity

Market Cap

$ 11,498

$ 8,280

$ 10,350

The Implied Returns, as the name suggests, are the returns which are implied by the capweighted market portfolio. The Implied Returns are calculated using reverse optimization.

This is sometimes referred to as backing out the returns. There are three components of the

20

calculation of Implied Returns, the Risk Aversion Coefficient, the Covariance Matrix and the

Market Portfolio Weights.

To start, we will calculate the Implied Excess Returns. At the end we will convert these to

Total Returns. In order to keep this article as user-friendly as possible, we will spell out as

much as possible, and avoid using symbols.

Implied Excess Returns = Risk Aversion Coefficient * Covariance * Market Capitalization Weights

The Risk Aversion Coefficient (RAC)

The Risk Aversion Coefficient (RAC) is the rate at which more return is required for more risk.

It is the palette risk premium divided by the variance of the asset palette. The variance is

calculated using the historical returns for the assets. The risk premium is entered by the user.

Risk Premium

Variance

The forward looking Risk Premium is one of the most contentious topics in finance. The equity

Risk Premium is the expected excess return of equity over the Risk-Free Rate. For the

calculation of the Implied Returns, the Risk Premium is an estimate of the Asset Palettes

excess return over the Risk-Free Rate. The Asset Palette Risk Premium acts as a scaling factor

in the reverse optimization process. While we recommend that you select a reasonable number,

the actual number (assuming it is positive) will not change the composition of the efficient

allocations that form the efficient frontier. What is affected by the Risk Premium is the

magnitude of the return forecasts. An unrealistic Risk Premium results in unrealistic forecast

returns leading to unrealistic conclusions regarding future wealth.

For our three asset example we will forecast a Risk Premium of 4%. The Variance of the Asset

Palette is 1.117%.

Risk Aversion Coefficient =

4.00%

1.117%

= 3.404

Covariance (Cov)

The covariance (COV) measures the correlation in the fluctuation of the return series. The most

common example of this is the performance of equity and fixed income. It is generally accepted

that when equity is performing well, fixed income yields tend to be lower. Conversely, when

equity is not performing well, fixed income yields are higher. The covariance captures this

relationship between assets.

The covariance of each pair of assets is calculated using historical correlations and standard

deviations. So, the covariance of Assets A and B is:

Covariance (A,B) = Correlation (A,B) * Standard Deviation (A) * Standard Deviation (B)

21

Cov(US Equity, US Equity) = 0.036

Cov(US Equity, US Bonds) = 0.002

Cov(US Equity, Intl Equity) = 0.010

The other covariances are calculated, and the following covariance matrix is formed:

Covariance

US Equity

US Bonds

Intl Equity

US Equity

US Bonds

Intl Equity

0.036

0.002

0.010

0.002

0.003

0.001

0.010

0.001

0.025

For the calculation of the Implied Returns we are assuming that the market is in equilibrium.

The equilibrium portfolio is the Market Portfolio. The weights of each of the assets in the

Market Portfolio are calculated using the market capitalization of each of the assets. The weight

given to each asset is proportional to the assets share of the total market cap of the Market

Portfolio. These weights are called the Market Portfolio Weights.

In AllocationADVISOR, users can either select to use assets for which we provide monthly

market cap estimates, or create their own data series with a market capitalization value.

For our three assets, the market caps and weights look like this:

US Equity

US Bonds

Intl Equity

TOTAL

Market Cap

$ 11,498

$ 8,280

$ 10,350

$ 28,980

MPW

38.2%

27.5%

34.4%

100%

MPWUSEquity =

Total Market Cap

11,498

28,980

.382

Now that we have the three necessary pieces, lets put them together and calculate the Implied

Returns. Due to the nature of the covariance matrix-the second element in the formula-the

calculations are generally made using matrix algebra. It is for this reason that we have chosen

22

to use a three asset example in this article. We can now break down the formula for Implied

Excess Returns without having to resort to matrix algebra:

IERUSEquity = RAC *

MPWUS Equity

+ Cov(US Equity, Intl Equity) * MPWIntl Equity ]

Implied Returns

The final step is to turn this Implied Excess Return into a Total Return. To do this, the investor

must make an estimate of the risk-free rate of return. Here, we will use a risk-free rate of 4.5%.

Implied Return = Risk-Free Rate + Implied Excess Return

Implied Return for US Equity = 4.50 + 6.05 = 10.55%

The Implied Return of the other assets is calculated in the same way.

US Equity

US Bonds

Intl Equity

Implied

Return

10.6 %

5.2 %

8.9 %

These implied returns can now be used as return forecasts for mean-variance optimization. The

maximum Sharpe ratio portfolio on an efficient frontier created using Implied Returns is the

market portfolio as you defined it. The fact that the Black-Litterman model recommends

holding the market portfolio if you do not have Views is, from a theoretical standpoint, very

appealing. Movements away from market capitalization weighted holdings are based on Views.

Views

The Implied Returns are excellent forecasts for use with mean-variance optimization. Investors,

however, often have their own opinions about how the market is going to behave in the future.

These investors often want to adjust the Implied Returns so that the forecasts better reflect their

opinions on future performance.

The Black-Litterman method takes an opinion such as I think that US Equity is going to do

well, and quantifies it into something called a View. For this Absolute View, what this really

means is that US Equity is going to do better than the 10.6 % forecasted in the Implied Returns.

The user must decide how much better US Equity will perform, and assign a level of confidence

to the View. The View may then be I believe with 75% confidence that US Equitys return

will be 11.5%.

23

Users can also create relative Views. The opinion might therefore be Intl Equity will

outperform US Equity. The Implied Returns forecast the opposite, that US Equity will

outperform Intl Equity. Again, the user must enter the amount of out-performance and a

confidence level. An example is I believe with 85% confidence that US Bonds will

outperform US Equity by 1%.

How are these views incorporated into the return forecasts? The Black-Litterman model uses a

Bayesian approach to incorporating Views into the forecasts while maintaining the advantage of

diversification which comes from using the Implied Returns.

The mathematics of Bayesian probabilities is complicated, but the idea behind it is fairly

straightforward. Bayesian probabilities were designed to incorporate subjective beliefs into

probability distributions. The user starts with a belief, called the Prior distribution. There is

then some event which provides more information, causing the user to wish to modify the

distribution. The event is incorporated into the Prior to form the new belief, the Posterior

Distribution.

When creating return forecasts for mean-variance optimization, the Prior and Posterior

distributions are return distributions. The Prior distribution is the Implied Return distribution.

The events that are incorporated into the Prior distribution are the investors Views. The new

combined return distribution is the Posterior Distribution. These are the returns that are used as

forecasts for mean-variance optimization.

Implied Returns

Views

Black-Litterman Forecast

Returns

For those of you who would like to know more about the mathematics of the Black-Litterman model and our

implementation of it, go to the Black-Litterman Forecast Methodology section in the AllocationADVISOR manual.

This section of the manual explains reverse optimization, the process of creating Market Cap Assets, and the

Zephyr Asset Palettes. The AllocationADVISOR manual is located in your Style folder as well as the Start Menu

StyleADVISOR Program Group.

For the mathematically inclined, a copy of A Step-By-Step Guide to the Black-Litterman Model: Incorporating

User-Specified Confidence Levels is available upon request (support@styleadvisor.com).

24

You cant pick up a newspaper today without reading about the boom in single family home

prices. It is, therefore, timely that Zephyr should add a home price data base to the ever growing

list of over 12,000 indexes found in StyleADVISOR. This database includes home price

quarterly returns for fifty states, ten regions and 379 cities starting in 1975. These returns are

computed by the Office of Federal Housing Enterprise Oversight (OFHEO). Our interest in home

prices was prompted by the announcement that the Chicago Mercantile Exchange will begin

trading derivatives on home prices in selected cities. These instruments will allow home owners

to hedge their real estate exposure. Even those who have no interest in these new securities (to be

issued sometime in 2005) should find the home indexes a useful addition to StyleADVISOR.

There are a number of ways that the home price data can be displayed in StyleADVISOR. Figure

1 plots the home price index for Fort Lauderdale (this index also includes Pompano and

Deerfield Beach) in our Performance graph along with the aggregate home price index for the

entire United States. This is the growth of $100 starting December 1, 1975. The red shaded area

at the bottom of the graph measures the cumulative difference between Fort Lauderdale home

prices and the rest of the country. The fact that the cumulative difference was negative for all this

period means that home prices in Fort Lauderdale lagged the country. Figure 2 shows this

relationship broken up into shorter time periods. Here we see the rolling five year difference

between Fort Lauderdale (blue line) and the US (black line). For a short time in the early 1980s

Fort Lauderdale prices outperformed the US but for the rest of the 80s and all of the 90s prices

lagged most of the rest of the country. Since 2001 there has been a sharp increase in Fort

Lauderdale prices relative to the US. In the five year period ending December 2004, Fort

Lauderdale outperformed the US by 6.29% annually. Many believe that this recent relative

strength in Florida real estate is due to the growing retirement of the baby boomers. This could

certainly be a factor, but it doesnt explain the same phenomenon occurring in places like

Bakersfield, Baltimore, Providence RI and many other non-retirement cities.

Figure 1

25

Figure 2

Another way to compare Fort Lauderdale and US home prices is to look at the calendar year

returns, as seen in Figure 3. It is interesting to note that the single best calendar year for Fort

Lauderdale was 1980 when home prices increased by 19.02%. The best calendar year for overall

US prices was 1978 with home prices appreciating by 13.32%.

Figure 3

26

Figure 4 looks at rolling four quarter (one year) rates of return. We think this graph does the best

job of putting the recent strength in real estate prices into a longer term perspective. Here we can

see that the worst one year return for Fort Lauderdale was the one year ending September 30,

1984 with home prices down 3.37%. The strongest one year period is the one ending September

30, 2004 with prices up 23.89%. Even if we are reluctant to call the recent price appreciation a

bubble, we have to admit that the last few years have not been typical. After a similar price spike

up in 1980, year-to-year home prices in South Florida (as in the US as a whole) were quite

modest. The annual compound growth rate for Fort Lauderdale home prices for the seventeen

years ending December 1999 was 2.37% and for the US was 4.26%.

Figure 4

27

Figure 5 shows four tables that we prepared using the search function in StyleADVISOR that

show the best and worst housing markets for the last five and three year periods.

Figure 5

28

Using the four graphs (Figures 1-4) we have discussed, we have created two new workbooks that

can be downloaded from our website in the Workbooks section (non-Zephyr clients can

download PDF versions of the workbooks). One workbook incorporates four graphs on one page

for each of the fifty states. A second workbook uses the same analysis for the largest 25 cities. Of

course, Zephyr clients can create their own analysis for any of the 379 cities.

Technical Notes for StyleADVISOR Users

To create the graphs in this example we selected Fort Lauderdale from the Home Prices database

as our manager. For the benchmark we selected the United States returns from the same

database. Figure 2 is our Custom Axis graph. For the Y axis we selected Time and for the X

axis we selected Excess Return vs. United States. We converted plot symbols to lines. These

options can be found on the right click menu (Select Axis Statistics and Convert Plot Series).

Figure 4 is our Manager vs. Benchmark graph. Here we selected rolling return and set the rolling

window at 4 quarters. To run this small window size you must first select none in the Style

Basis selection in Analysis Parameters/Summary.

In all of these graphs we have used the new Dynamic Text function to change the titles and

legends to reflect the actual indexes we are using. So instead of saying Manager vs.

Benchmark it says Fort Lauderdale, Fl vs. United States Return. Because we used dynamic

text this title will automatically change if we select another manager and/or benchmark.

To create the four tables of best and worst three and five year returns we did a search selecting

all 379 cities as managers. We screened returns for the best and worst and highlighted the top

twenty for each category. From the right click menu we selected create workbook for selected

managers. In that workbook we added a custom table and selected the two statistics we

displayed.

29

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