Mean-variance optimization

Portfolio statistics – many assets

ᇱ
Portfolio mean is the weighted average,

Portfolio variance is the sum of (weighted)

variances AND covariances, ᇱ

Example for three assets

௫ ௫ ௬ ௬ ௭ ௭
ଶ ଶ ଶ ଶ ଶ ଶ
௫ ௫ ௬ ௬ ௭ ௭ ௫ ௬ ௫௬ ௬ ௭ ௬௭ ௭ ௫ ௭௫

Geometry 2
Many risky securities
Many more combinations of portfolios are
possible

If you plot all the portfolio combinations, they

will no longer plot in a line. Rather, they will
plot as an area 1.8%

1.6%

1.4%

1.2%

1.0%
Mean

0.8%

0.6%

0.4%

0.2%

0.0%
0% 5% 10% 15% 20% 25% 30% 35%
StdDev
Geometry 3

Minimum variance frontier

Geometry 4
Extending to include risk-free asset

Geometry 5

Extending to include risk-free asset …

The optimal combination becomes linear

A single combination of risky and risk-free

assets will dominate

Note confusing terminology

• With only risky assets, the efficient frontier is a
parabola
• With risky and riskfree asset, the efficient frontier
is a straight line

Geometry 6
Efficient frontier reprise

Geometry 7

Global minimum variance portfolio

Has the lowest possible variance among all
combinations of stocks
E(r)

G
Global minimum
variance portfolio
(r)

Geometry 8
Tangency portfolio
Maximizes the ratio of expected return to
standard deviation

Tangency
portfolio
E(r)
T

(r)

Geometry 9

Two-fund separation
Combinations of the risk-free asset and the
tangent portfolio provide the best risk and
return tradeoff available to an investor

This means that the tangent portfolio is

efficient and that all efficient portfolios are
combinations of the risk-free investment and
the tangent portfolio. Every investor should
invest in the tangent portfolio independent of
his or her taste for risk

Geometry 10
Two-fund separation …
An investor’s preferences will determine only
how much to invest in the tangent portfolio
versus the risk-free investment
• Conservative investors will invest a small amount
in the tangent portfolio
• Aggressive investors will invest more in the
tangent portfolio
• Both types of investors will choose to hold the
same portfolio of risky assets, the tangent
portfolio, which is the efficient portfolio

Geometry 11

Diversification

Geometry 12
Diversification …
Equally-weighted portfolio
• A portfolio in which the same amount is invested
in each stock

Variance of an equally-weighted portfolio of

stocks
௣

Geometry 13

Diversification …

Geometry 14
Limits of diversification

Volatility

Unique (Idiosyncratic)
Risk

Market (Systematic) Risk

Number of
securities

Geometry 15

Partner’s Healthcare
Healthcare network of hospitals
• Differing needs in terms of size of their
endowment assets, operating budgets etc.
• Different allocations to various pool of assets

Two pools
• STP: Safe pool. Can be thought of as risk-free
asset
▪ Average yield in Spring 2005 was 3.2%
• LTP: Risky asset pool
▪ Managed by external money managers

Excel 16
Asset allocation problem
Baseline asset mix of LTP
• Domestic Equity 55%
• International Equity 30%
• Long-Term Bonds 15%
Possible addition of real assets
• REITs
• Commodities

What should be the composition of LTP?

How should the various member hospitals

decide their allocation decisions?
Excel 17

Data

Correlations
Exp Return StdDev US Equity Foreign EquiBonds REITs Commodities
US Equity 12.94% 15.21% 1.00 0.62 0.25 0.56 -0.02
Foreign Equity 12.42% 14.44% 0.62 1.00 0.06 0.40 0.01
Bonds 5.40% 11.10% 0.25 0.06 1.00 0.16 -0.07
REITs 9.44% 13.54% 0.56 0.40 0.16 1.00 -0.01
Commodities 10.05% 18.43% -0.02 0.01 -0.07 -0.01 1.00

Covariances
Exp Return StdDev US Equity Foreign EquiBonds REITs Commodities
US Equity 12.94% 15.21% 0.023134 0.013617 0.004221 0.011533 -0.000561
Foreign Equity 12.42% 14.44% 0.013617 0.020851 0.000962 0.007821 0.000196
Bonds 5.40% 11.10% 0.004221 0.000962 0.012321 0.002405 -0.001432
REITs 9.44% 13.54% 0.011533 0.007821 0.002405 0.018333 -0.000250
Commodities 10.05% 18.43% -0.000561 0.000196 -0.001432 -0.000250 0.033966

STP 3.20%

Excel 18
Risk-return tradeoff
14%
US Equity
12% Foreign Equity

LTP
10%
Commodities
REITs
8%
Mean

6%
Bonds
4%
STP

2%

0%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
StdDev
Excel 19

Real assets
REITs have low risk and reasonable expected
returns

Commodities have much higher risk but only

slightly higher expected returns

Ultimately, it depends on the correlation of

these asset classes with LTP

Excel 20
Optimal portfolios for Partners

Excel 21

Tangency portfolios for Partners

Tangency Portfolios
US Equity 41% 32% 24%
Foreign Equity 47% 43% 31%
Bonds 12% 11% 11%
REITs 0% 14% 10%
Commodities 0% 0% 24%

Mean 11.77% 11.40% 10.92%

StdDev 11.98% 11.38% 9.45%
Sharpe Ratio 0.715 0.721 0.816

Excel 22
Efficient frontier again

Excel 23

Optimal portfolios again

Different hospitals have different target
return/risk levels of LTP. How can one
accommodate this? For e.g., what should a
hospital wishing to target 12% risk of LTP do?

A portfolios exists on the tangent line that is

above and to the right of the tangency
portfolio
• Has return of 13% and has a 127% position in
LTP financed with borrowing / shorting in the STP
• Can one use leverage to fund portfolio
investment and enhance returns?
Excel 24
Portfolio math

Math 25

Portfolio math …

Math 26
Portfolio math …

Math 27

Global MVP portfolio

Math 28
Two-fund separation

Math 29

With a riskless asset

Math 30
Tangency portfolio

Math 31

Expected returns

Math 32
Covariance
Relevant measure of risk is the covariance
with the tangency portfolio
• Why is risk covariance?
• Because it is the marginal variance or risk

Intuition
• In economics, it is the marginal cost of goods
that determines their prices, not their total or
average cost
• Likewise, the marginal variance or covariance
determines the additional risk of an investment,
and therefore its price (here, expressed as
returns not dollars)
Math 33

Summary of optimization steps

Suppose we have N assets. To do the mean
variance analysis, we need
• N expected returns (one for each asset)
• N variances (one for each asset)
• N(N−1)/2 covariances (for pairs of assets)

To find the portfolio frontier we need to:

• Find the portfolio with the highest expected
return for each (feasible) standard deviation
• Find the portfolio with the lowest standard
deviation for each expected return

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Implementation issues
 Sometimes recommendations of MV analysis
seem unreasonable
 Large short (or long) positions
 Generate high turnover
• Significant changes in portfolio composition from
one period to the other
• Generate high transaction costs
 Investments in illiquid securities
• Securities may possess desirable risk-return
characteristics but may not trade in sufficient
volume

Excel 35