Portfolio Optimization Strategy: Models Time Optimization Strategy: Models Time Horizons ... for choosing a portfolio optimization approach? ... the portfolio construction approaches

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  • PortfolioOptimizationStrategy:Models&TimeHorizons

    Apresentationtothefi360Insights2016Conference

    G.MichaelPhillips,JamesT.Chong,WilliamP.JenningsCenterforFinancialPlanning&Investment,CSUNorthridge

    &MacroRiskAnalytics(c4cast.com,Inc.)Pasadena,CA

    SarahJ.Underwood,MSMacroRiskAnalytics

    CenterforComputationallyAdvancedStatisticalTechniquesPasadena,CA

  • Framingtheproblem:

    Therearemanyapproachestoportfoliooptimizationandconstruction

    (MacroRisk.comprovidesatleastadozenmethods) Doesitmatterwhichmethodisused?

    fi3602016 Contact:mphillips@macrorisk.com 2

  • Thispresentation

    Somebackgroundregardingdifferentapproaches Specificdiscussionofleadingcontenders Resultsofashootoutbetweendifferentapproaches,assessingwhenvariousmethodsarepreferred

    AfewselectedRealWorldexamples

    fi3602016 Contact:mphillips@macrorisk.com 3

  • ABitAboutOurBackgroundforthistopic:

    WeareprofessorsatCSUNsDavidNazarian CollegeofBusiness&Economics,whichnowhasover8000majors,manytakingfinancialplanning&wealthmanagementcoursework

    James&MikecoteachanundergraduatehonorsseminartherethatmanagesthreeportfoliosfortheUniversityCorporationandUniversityFoundation,withabout$3.5mmAUM

    Theauthorsadviseasmalllongonlyhedgefundandprovideadditionaladvicetoselectedotherproducts

    Goingfromgliblecturestoinvestingrealmoneyprovidesbracingopportunitiestoensurethatourrealitychecksdontbounce

    fi3602016 Contact:mphillips@macrorisk.com 4

  • Observations: Whatsinthetextbooksdoesntalwayssquarewithpractice,somethingwhichbecamecrystalclearwhenwestarteddoingthingsintherealworld

    MostfinancialmanagementandinvestmentstextbooksfocusonCAPMandtraditionalMVOtocreateportfolios.

    Ourstudentportfolios,likeretirementandendowmentfunds,arenotrebalancedortweakedeveryday,everyweek,oreveneverymonth.Theyareadjustedtwiceayear(oncepersemester)whichisstillmorefrequentthanmanylowtouchfunds.

    Manyfinancialplanningclientsseeklongtermcapitalgainsandplannersgooutoftheirwaytoavoidshorttermgains;ourfinancialplanningstudentsaretaughtthisasamanagementgoal.

    fi3602016 Contact:mphillips@macrorisk.com 5

  • Moreobservations:

    ManyWallStreetproductmanagersusevariationsofModernPortfolioTheorytocreateportfolios.

    However,throughmanyhoursofconversationwithfinancialplanners,itsclearthatmanyfinancialplannersandportfoliomanagersfocusmoreoninvestmentpickingthanportfoliocrafting,

    Afterwhichtheyapplyvariousheuristicstocreatemodelportfoliosortomakeclientportfoliodecisions;rarelydomostfinancialplannersengageinoptimization

    fi3602016 Contact:mphillips@macrorisk.com 6

  • Afewpopularnonoptimizationheuristicapproachesweseeaswetalkwithportfoliomanagers: InvestmentClubapproach:CreateaWatchlist(buylist)ofseveraldesirableinvestments,thenvoteonhowmuchofavailablefundsshouldbeinvestedinthebestofthenewpicksorideas

    AllIn(oldschool,preMPT,approach;stillfollowedbysomeconcentratedhedgefundsandprivateequityfunds):Identifyafewgoodinvestmentsandputallyourmoneyintothese,putnewmoneyintowhicheverlookstobethebestatthetime

    Copycat:LookatholdingsinpopularUITsorfilingsbywealthyinvestorsandthencopytheirportfolioweights

    fi3602016 Contact:mphillips@macrorisk.com 7

  • AssetclassBasedPortfoliosareundoubtedlythemostpopularapproachtooptimalportfolioconstruction. Inthebasicrisktoleranceapproach,thewholeworldisviewedaseithergrowthassets(equities)ordefensiveassets(bonds)andyouroptimalportfolioisdeterminedbyinvestingyourrisktolerancepercentageingrowthassetsandtheremainderinsafetyassets

    Oneofthebestknownisa60/40equity/bondsportfolio (Atarecentfinancialplanningconference,variousguruswereproposinga40/60allocationbecauseoftheFedspolicies)

    Somepopularoptimizationsoftwareisjustaimedatassetclassindexesratherthanspecificholdings

    fi3602016 Contact:mphillips@macrorisk.com 8

  • Whiletherearemanyportfoliooptimizersandmodelportfoliosavailable,forthemostpartthesefocusonassetclassoptimizationwhichhasnumerouspotentialproblems. Itisdifficulttopurchasetheentireassetclass Itisdifficulttotailorsuchportfoliosaroundindividualfinancialtraits(includinghumancapital,nontradedinvestments,realestate,etc)

    ItisdifficulttocreateSRI/ESGportfoliosattheassetclasslevel Selectingindividualassetsfromtheclasswillnotgenerallyresultinperformanceequivalenttotheassetclass

    Someportfolioallocationwithintheassetclassisnecessaryandportfoliomanagerswillmorelikelyfail,resultinginportfoliosthatdonothavetheexpectedcharacteristics

    fi3602016 Contact:mphillips@macrorisk.com 9

  • Bottomline,assetclassesdontworkverywelltodescribeorcreateportfoliosWeaddressthisfurtherinourmostrecentpublication(andlastyearsfi360presentation)

    Chong,J.,Jennings,W.P.,andPhillips,G.M.Issueswithassetclassbasedportfolioconstruction:Ananalysisofmutualfundcharacteristics.JournalofWealthManagement,Winter2015.

    fi3602016 Contact:mphillips@macrorisk.com 10

  • Further,overlongerperiods,lowfrequency(intrinsicvalue)changeshappenthatarentcapturedinreturnsbasedmodelsWeidentifyfivekeytypesofriskthatimpactlongerterminvestors

    1. Capitalmarketrisk(CAPMordownsidebeta)2. BehavioralRisk(ormomentumrisk)3. EconomicRisk4. AttributionStabilityRisk5. Idiosyncratic(firmspecific)Risk

    fi3602016 Contact:mphillips@macrorisk.com 11

  • Chong,J.T.,Jennings,W.P.,andPhillips,G.M.(2014).Monitoringthefiverisks:Analyticalriskmeasurementforretailinvestorsandwealthmanagers. Investments&WealthMonitor,March/April, 1719and24.

    Chong,J.,Jennings,W.P.,andPhillips,G.M.(2012).Fivetypesofriskandafistfulofdollars:Practicalriskanalysisforinvestors. JournalofFinancialServiceProfessionals,66(3),6876.

    Chong,J.,andPhillips,G.M.(2011).Betameasuresmarketriskexceptwhenitdoesnt:Regimeswitchingalphaanderrorsinbeta. JournalofWealthManagement,14(3),6772.

    Someofouradditionalreferencesinclude:

    fi3602016 Contact:mphillips@macrorisk.com 12

  • Q:So,howdoweweightourinvestments?

    A:Weallknowthesolution:meanvarianceoptimization(MVO)isbest,taughtinallthebooks,andyoucandoitwithExcelsSolver!

    http://www.solver.com/optimizationsolutionsinvestmentandportfoliomanagementexamples

    fi3602016 Contact:mphillips@macrorisk.com 13

  • Maybethatstheanswer,butmaybenot

    OnecandoMVOwithExcel,buttodosorequiresnontrivialdataanalysisandpowerfulspreadsheetoptimizationthat,inourexperience,exceedsthecurrentabilitiesoftypicalfinancialplanners

    Further,whileMVOmayworkwhenthereisregularinfloworoutflowintotheAUMbeingoptimized,overtimetheunderlyingreturnscorrelationstendtochange.

    Foractivelymanagedmutualfundsorcorporatetreasuryoperations,regularreoptimizationislessofaproblem.However,forlowtransactionscostsportfolios,volatilecorrelationscanbeproblematic.

    fi3602016 Contact:mphillips@macrorisk.com 14

  • TherearelotsofotherapproachesbeingdiscussedwhenthinkingaboutMVO FatTails(e.g.,MandelbrotandtheStableParetian Distribution;MixturesofDistributions)

    MorningstarsresearcherspromotingTruncatedLevyFlightmodelingofreturnsdistributions(atransitionaldistributionbetweentheNormalandtheStableParetian distributions)

    Copulas MonteCarlobasedefficientfrontiers (andthereareafewotherapproachesdiscussedbelow)

    fi3602016 Contact:mphillips@macrorisk.com 15

  • Conventionalwisdom,streetknowledge,andthepreviouspointssuggest:

    Differentapproachesmightbebetterdependingontheanticipatedholdingperiodfortheportfolio

    Differentapproachesmightbebetterdependingonthedesiredcharacteristicsoftheportfolio

    Differentapproachesmightbebetterdependingontheacceptableassetmix

    fi3602016 Contact:mphillips@macrorisk.com 16

  • So,finally,ourresearchgoal:

    Whataresomeguidelinesforchoosingaportfoliooptimizationapproach?Howdotheyactuallyworkinpractice?

    OurapproachwillbeanempiricalexperimentusingMonteCarlosamplingandsimulationmethods.

    fi3602016 Contact:mphillips@macrorisk.com 17

  • Outlineoftheexperiment:1. Identifytheportfolioconstructionapproachestoanalyze2. Usingastandarduniverseofstocks,conductaMonteCarloanalysis

    I. IdentifyasubsetoftheuniverseII. CreateaportfolioasofagivendateusingachosenmethodIII. AssesshowthatportfoliowouldperforminsubsequentperiodsIV. RepeatatotherdatesV. RepeatwithadifferentsubsetVI. RepeatwithdifferentmethodsVII. Summarizevariousexperimentsandseeifthereareanyclearpatternsor

    results

    fi3602016 Contact:mphillips@macrorisk.com 18

  • Ourmethodsusedherearebasedinparton:

    Underwood,S.J.(2013).Optimalfinancialportfolioselection.Unpublishedmaster'sthesis,CaliforniaStatePolytechnicUniversity,Pomona,Pomona,CA.

    Chong,J.,andPhillips,G.M.(2013).Portfoliosizerevisited. JournalofWealthManagement,15(4),4960.

    fi3602016 Contact:mphillips@macrorisk.com 19

  • WeusedourownproprietarycloudbasedprogramforthispaperwhichallowedMonteCarlosimulationstobeperformed.(ThisisNOTcommerciallyavailablesoftware.)

    Inputsneededinclude Buylists Portfolioformationdates NumberofMCiterations PortfolioConstructionMethod Numberofassetstobesampled Maxholdingpercentage Otherparametersdependingonmethodbeingstudied

    fi3602016 Contact:mphillips@macrorisk.com 20

  • 1.Identifytheportfolioconstructionapproachestostudy

    MaximumSharpeRatio(MVO) MaximumSortino Ratio MaximumUpsideScaledReturn MinimumMacroRiskExposure EquallyWeighted(fromentirebuylist) VariousEquallyWeighted(fromvariousbuylist subsets)

    fi3602016 Contact:mphillips@macrorisk.com 21

  • PreliminaryDefinitionsDefine asaverticalvectorofones,so isasquarematrixofones.Foraportfoliowith holdings,lettheverticalvector representtheweightsoftheholdingsintheportfolio.Sovector hastheshape1 .Letthematrix bea matrixofassetdailyreturnsover days.Sothefunctionfortheportfoliodailyretur