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PROJECT: MODERN PORTFOLIO THEORY

1. HISTORICAL DATA

I have also plotted asset wise performance over the


period under review.

A. Graph the month-end value of investment for


the past 24 months:
I have extracted historical data of the following indices
over the period i.e. October 2014 to August 2016:

US Large Stocks S&P 500 index


US high grade bond D0A0
US small stocks Russell 2000 index
Developed Markets MSCI world ex USA index
Emerging Markets MSCI emerging markets
index

I then computed monthly returns for each class of


assets. I then assumed that $1 is invested in each
class of assets and plotted cumulative growth of
investment of a portfolio.

Cumm ulative Growth of Investment


$5.40
$5.20

Perform ance of each class of assets


$1.40
$1.20
$1.00
$0.80
$0.60
$0.40
$0.20
$-

S&P 500

D0A0

DM

EM

B. Table of distribution of monthly return (into


annualized form)
Below I have tabulated key statistics (in annualized
form) as follows:

$5.00
$4.80
$4.60
$4.40
$4.20
$4.00

Rusell 2000

Annualized
Data

S&P
500

D0A0

Russ
ell
2000

DM

EM

Mean %

7.85

4.37

8.69

(4.35
)

(4.36)

Std.
Deviation %

11.70

2.97

14.81

15.06

19.69

Variance %

1.37

0.09

2.19

2.28

3.88

PROJECT: MODERN PORTFOLIO THEORY


Annualized
Data

S&P
500

D0A0

Russ
ell
2000

DM

EM

Median %

3.57

0.98

18.83

(16.8
)

(21.5)

Maximum %

101.2

26.9

95.8

88.8

176.1

Minimum %

(72.4
)

(13.1
)

(105.
5)

(92.2
)

(114.
2)

C. Correlation and Covariance Matrices

Matrix
(Annuali
zed)

2000

S&P 500

0.013
7

0.000
5

0.014
3

0.014
8

0.015
2

D0A0

0.000
5

0.000
9

0.001
2

0.000
8

0.000
3

Russell
2000

0.014
3

0.021
9

0.014
7

0.015
4

0.014
7

0.022
7

0.022
6

0.015
4

0.022
6

0.038
8

0.001
2
0.000
8
0.000
3

Correlat
ion
Matrix

S&P
500

D0A0

Russe
ll
2000

DM

EM

DM

0.014
8

S&P 500

1.000
0

0.143
5

0.823
2

0.839
2

0.660
3

EM

0.015
2

D0A0

0.143
5

1.000
0

0.271
6

0.172
1

0.049
9

2. TWO ASSET CLASSES US STOCK (S&P 500)


AND US BONDS (D0A0)

Russell
2000

0.823
2

1.000
0

0.661
4

0.528
1

A. Mean-variance frontier and Mean-standard


deviation

DM

0.839
2

0.661
4

1.000
0

0.763
4

EM

0.660
3

0.528
1

0.763
4

1.000
0

Russ
ell

DM

EM

Covarian
ce

S&P
500

0.271
6
0.172
1
0.049
9

D0A0

Weightages
(%)
S&P
D0A0
500
100
0
90
10
80
20
70
30
60
40
50
50

Portfolio
Return
(%)

Portfolio
Variance
(%)

5.90
5.54
5.18
4.82
4.46
4.10

1.37
1.10
0.86
0.66
0.48
0.34

Portfolio
Standard
Deviation
(%)
11.71
10.50
9.30
8.11
6.95
5.83

PROJECT: MODERN PORTFOLIO THEORY


40
30
20
10
0

60
70
80
90
100

3.74
3.38
3.02
2.66
2.30

0.23
0.15
0.10
0.08
0.09

4.76
3.82
3.09
2.76
2.97

Mean - Standard Deviation Frontier


7.000%
6.000%
5.000%

Mean - Variance Frontier

4.000%

7.000%

Portfolio Return 3.000%

6.000%

2.000%

5.000%

1.000%

4.000%

0.000%
0.00% 5.00% 10.00% 15.00%

Portfolio Returns 3.000%


2.000%

Portfolio Risk

1.000%
0.000%
0.00%

0.50%

1.00%

Portfolio Variance

1.50%

B. Global minimal-variance portfolio


By using the Solver add-in in Excel, I derived that
at the following weightages of the S&P 500 and
D0A0 in the portfolio, the variance will be minimal:
Weightages
(%)
S&P
D0A0
500
9
91

Portfolio
Return
(%)

Portfolio
Variance
(%)

Portfolio
Std. Dev
(%)

2.619

0.08

2.76

We have plotted minimal variance by taking into


account Risk Free Return i.e. Daily Yield Rates. 1

1 Risk Free Return = 2.28% (quoted at US Department


of Treasury as of 27 Sep 2016)

PROJECT: MODERN PORTFOLIO THEORY

Global Minimal Variance

Optimal Risky Portfolio

2.70%
2.60%
2.50%
Return 2.40%
2.30%
2.20%
2.10%
0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00%
Risk

5.00%
4.50%
4.00%
3.50%
3.00%
Return 2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
0% 1% 2% 3% 4% 5% 6% 7% 8%
Risk

C. Tangent Portfolio and Sharpe Ratio


By using the Solver add-in in Excel, I derived that
at the following weightages of the S&P 500 and
D0A0 in the portfolio, it is currently at an optimal
risk level.
Weightages
(%)
S&P
D0A0
500
61
39

Portfolio
Return
(%)

Portfolio
Std. Dev
(%)

Sharpe
Ratio2

4.48

7.02

0.3135

2 Sharpe Ratio is computed as follows = (Expected Portfolio


Return Risk Free Return) Portfolio Std. Dev

D. Capital Allocation Line (CAL) - Optimal Risky


Portfolio

PROJECT: MODERN PORTFOLIO THEORY


7.000%

Weight: Optimal
Portfolio
S&P 500
D0A0
20%
13%

6.000%
5.000%

67%

Comment:
As sentiments of investors become more risk
averse, portfolio weightages have shifted towards
risk-free assets, as depicted in F. Therefore, if
investors become more and more risk averse, then
their majority of investments will be in risk free
assets.

4.000%
3.000%
2.000%
1.000%
0.000%
0.00%

Weight: Risk-free
Asset

5.00%

10.00%

15.00%

E. Optimal Allocation between risk free asset


and Optimal Risky Portfolio
(risk aversion coefficient A = 4)
Weight: Optimal Portfolio
55%

Weight: Risk-free Asset

Complete portfolio expressed in terms of


asset classes
Weight: Optimal Portfolio
S&P 500
D0A0
33%
22%
F. Complete portfolio expressed in terms of
asset classes
(risk aversion coefficient A = 6)

Weight: Risk-free Asset

PROJECT: MODERN PORTFOLIO THEORY


3. ALL FIVE ASSET CLASSES - WHEN SHORT
SALES ARE ALLOWED
A. Mean-Variance frontier and Mean-Standard
deviation

Portfolio3

Portfolio Return
(%)

A
B
C
D
E
F
G
H
I
J

7.20
5.50
5.24
4.70
4.40
4.00
3.50
3.20
3.02
2.95

Portfolio
Standard
Deviation
(%)
16.89
12.00
11.84
9.30
8.50
5.45
4.03
3.32
4.00
4.21

Mean Variance Frontier


8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0.00%

10.00%

15.00%

20.00%

B. Global Minimal-Variance Portfolio


By using the Solver add-in in Excel, I derived that
at the following weightages for five classes of
assets in the portfolio, the variance will be minimal:
S&P
500
0

3 Portfolio weightages have been worked using Solver


in excel. Detailed working has also been documented.

5.00%

Weightages (%)
Russell
D0A0
DM
2000
91
7
2

Portfolio
Return
(%)

Portfolio
Variance
(%)

2.64

0.07

EM
0
Portfolio
Standard
Deviation
(%)
2.66

PROJECT: MODERN PORTFOLIO THEORY

Global Minimal Variance Portfolio

Tangent Portfolio

2.70%

5.00%

2.60%
4.00%

2.50%
2.40%

3.00%

2.30%

2.00%

2.20%
1.00%

2.10%
2.00%
0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

0.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

C. Tangent Portfolio and Sharpe Ratio


By using the Solver add-in in Excel, I derived that
at the following weightages for the five classes of
assets in the portfolio are at an optimal risk level.
S&P
500
46
Portfolio
Return
(%)
4.29

Weightages (%)
Russell
D0A0
DM
2000
46
11
(1)
Portfolio
Standard
Deviation
(%)
6.33

EM
(2)

Sharpe Ratio
0.3174

D. Capital Allocation Line (CAL) - Optimal Risky


Portfolio

PROJECT: MODERN PORTFOLIO THEORY


4. ALL FIVE ASSET CLASSES - SHORT SALES ARE
NOT ALLOWED

Capital Allocation Line (CAL)


8.00%

A. Mean-Variance frontier and Mean-Standard


deviation

7.00%
6.00%
5.00%

Portfolio4

4.00%
3.00%

A
B
1.00%
C
0.00%
0.00%
5.00%
10.00%
15.00%
20.00%
D
E
F
G
E. Optimal Allocation between risk free asset
H
and Optimal Risky Portfolio
I
Weight: Optimal Portfolio
Weight: Risk-free JAsset
60%
2.00%

Portfolio Return
(%)
5.50
5.30
5.00
4.70
4.40
4.00
3.50
3.20
3.02
2.95

Portfolio
Standard
Deviation
(%)
12.00
11.00
10.00
9.30
8.50
5.45
4.03
3.32
4.00
4.21

Complete portfolio expressed in terms of


asset classes
Weight: Optimal Portfolio

S&P 500

D0A0

27.7%

27.5%

Russell
2000
6.7%

DM

EM

(0.6%)

(1.3%)
4 Portfolio weightages have been worked using Solver
in excel. Detailed working has also been documented.

PROJECT: MODERN PORTFOLIO THEORY

Mean Variance Frontier


6.00%
5.00%
4.00%
3.00%

By using the Solver add-in in Excel, I derived that


at the following weightages for the five classes of
assets in the portfolio, the variance will be minimal:
Weightages (%)
Russell
D0A0
DM
2000
91
7
2

S&P
500
0

2.00%
1.00%
0.00%
2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00%

Portfolio
Return
(%)

Portfolio
Variance
(%)

2.64

0.07

EM
0
Portfolio
Standard
Deviation
(%)
2.66

Global Minimal Variance Portfolio


2.80%
2.60%
2.40%
2.20%
2.00%
0.00%

Commentary:
By short selling in Part 3, Portfolio returns are
maximized; however, it also brings higher risk as
compared to a portfolio in which short selling is not
allowed.
B. Global Minimal-Variance Portfolio

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Commentary:
The weightages under both the scenarios are
similar and within limits for minimal variance
portfolio, therefore no variation is observed.
C. Tangent Portfolio, CAL of the Optimal Risky
Portfolio and Sharpe Ratio

PROJECT: MODERN PORTFOLIO THEORY


By using the Solver add-in in Excel, I derived that
at following weightages for the five classes of
assets in the portfolio at optimal risky level.
S&P
500
44
Portfolio
Return
(%)
4.33

Weightages (%)
Russell
D0A0
DM
2000
45
11
0
Portfolio
Standard
Deviation
(%)
6.47

Capital Allocation Line (CAL)


6.00%
5.00%

EM

4.00%

3.00%
2.00%

Sharpe Ratio
0.3168

Tangent Portfolio
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

1.00%
0.00%
0.00%

5.00%

10.00%

15.00%

Commentary:
The portfolio is limited to assets without short
selling; thus we know that:
a. Portfolio Return (no short selling) is higher than
return of portfolio (where short selling was
allowed).
b. Sharpe Ratio for portfolio (with short selling) is
greater than the ratio for this portfolio.

PROJECT: MODERN PORTFOLIO THEORY


5. RISK PARITY MODEL
Using data of 3C and before applying SOLVER,
Portfolio

Weighta
ges

Volatilit
y

Contributi
on to
Portfolio
Risk

Risk
Weight

S&P 500

0.11

11.71%

8.30%

21.06%

D0A0

0.71

2.97%

13.03%

33.07%

Russell
2000

0.09

14.81%

8.27%

20.99%

DM

0.05

15.06%

4.51%

11.45%

EM

0.04

19.69%

5.29%

13.43%

S&P 500

D0A0

DM

EM

Russell 2000

Correlation is not ignored (Version 1)


Portfolio

Weighta
ges

Volatilit
y

Contributi
on to
Portfolio
Risk

Risk
Weight

S&P 500

0.11

11.71%

4.65%

20.00%

D0A0

0.43

2.97%

4.65%

20.00%

Russell
2000

0.09

14.81%

4.65%

20.00%

DM

0.08

15.06%

4.65%

20.00%

EM

0.06

19.69%

4.65%

20.00%

PROJECT: MODERN PORTFOLIO THEORY

S&P 500

D0A0

DM

EM

Russell 2000

Note: In version 1, assets are not 100% weighted due to limitation


of SOLVER in excel.

Correlation is ignored and the weight of each


asset class is proportional to the inverse of its
variance (Version 2)
Portfolio

Weighta
ges

Volatilit
y

Contributi
on to
Portfolio
Risk

Risk
Weight

S&P 500

0.06

11.71%

8.83%

22.42%

D0A0

0.86

2.97%

34.83%

88.41%

Russell
2000

0.03

14.81%

6.98%

17.73%

DM

0.03

15.06%

6.87%

17.43%

EM

0.02

19.69%

5.25%

13.33%

S&P 500

D0A0

DM

EM

Russell 2000

Correlation is ignored and the weight of each


asset class is proportional to the inverse of its
standard deviation (Version 3)
Portfolio

Weighta
ges

Volatilit
y

Contributi
on to
Portfolio
Risk

Risk
Weight

S&P 500

0.14

11.71%

6.59%

28.31%

D0A0

0.55

2.97%

6.59%

28.31%

Russell
2000

0.11

14.81%

6.59%

28.31%

DM

0.11

15.06%

6.59%

28.31%

PROJECT: MODERN PORTFOLIO THEORY

Portfolio

Weighta
ges

Volatilit
y

Contributi
on to
Portfolio
Risk

Risk
Weight

EM

0.08

19.69%

6.59%

28.31%

S&P 500

D0A0

DM

EM

Russell 2000

PROJECT: MODERN PORTFOLIO THEORY


6. TOTAL MARKET CAPITALIZATION
Total Market Capitalization of each class of assets as of
August 31, 2016:
Asset Class
S&P 500

USD
(Millions)
581,155

Weights
(%)

Ref

0.78

W1

31.23

W2

0.01

W3

Commentary:
It is evident that Portfolio computed based on SOLVER
(Part 3C) is less risky and has a greater Sharpe Ratio
as compared to the Portfolio based on Market
Capitalization weights.
Variance of value-weighted
12.14%^2 = 1.47%

portfolio is

^2

i.e.

7. FINAL OPTIMAL RISK PORTFOLIO


D0A0
Russell 2000

23,286,856
5,872

DM

13,434,409

18.02

W4

EM

37,256,308

49.97

W5

Comparison of Portfolio based on Market


Capitalization weights with Portfolio in Part 3C:
Portfolio based on Market Capitalization Weights
W1
W2
W3
W4
W5
E (r)

12.14
0.01
0.31
0.00
0.18
0.50 4.94%
%
Portfolio (Optimal Risky Portfolio) Part 3C
W1
W2
W3
W4
W5
E (r)

0.11
(0.01) (0.02) 4.29% 6.33%
0.46
0.46

50% of money in the optimal risky portfolio based on


my view (Portfolio 3 C) and the other 50% in the
market portfolio:
W1
0.23

Final Optimal Risky Portfolio


W2
W3
W4
W5
E (r)
0.39
0.06
0.09
0.24 4.62%

8.57%