1. The swing of risk/return

2. The applications of the Markowitz’s Model
The Markowitz model is used to build the efficient frontier…
… but it is used to determine the strategic asset allocation (= the optimal portfolio for long term) for each investor or for a class of investors (utility function is not easy to measure)
When you build the efficent frontier there are some problems

3. Risk/Return

4. The definition of strategic asset allocation
Some problems to debate:
1.Which measure of risk?
2. How many and which asset classes?
3. How to estimate expected returns, volatility and correlations ? On what time scale?
4. How to pass from the efficent frontier to real portfolio for each investor?
5. What is the relationship between the efficient theoretical frontier and the "true" product purchased by the customer?

5. 1.Which measure of risk?
Standard deviation is a two-sided measure: you can use also alternative measures based on the downside-risk (standard semi-deviation, or Value at Risk)
You can use them based on probabilistic concepts such as
Value at Risk (maximum potential loss over a time span and a certain confidence interval )
Shortfall probability (the probability of not reaching a final return at a future date)

6. Performance distribution
Alternative measures instead of standard deviation
Shortfall
Performance distribution
Downside risk
Shortfall
The probability of not reaching a final return
at a future date
VaR
threshold
Return
Frequency
VaR at 95%
Performace distribution
95%
Value at Risk maximum potential
loss over a time span and
a certain confidence interval

7. 2. How many and which asset classes?
The portfolio optimization is based on the estimation of the expected returns, volatility and correlations
Is it better to select not many asset classes (e.g. short term securities, bonds in Euro, bonds in different currency,european stocks or international stocks), or you can make a more analytical choice?
How do you divide bonds and stocks?

8. Asset allocation strategic asset allocation ( medium long term)
tactical asset allocation (short term)
The goal is finding the right equilibrium between
A)stocks and bonds;
B) domestic or foreign assets;
C) traditional asset class or alternative asset class.

9. The right composition of portfolio
The selection of asset class:
bond(rating ,maturity, issuer)
stocks(large,small, growth,value),
The frequency of change of composition of portfolio
The measures of each asset class (the expected return, risk and correlations)
The impact of financial forecast for each asset class:
macroeconomics factors ( the level of interest rate and inflation rate)
evalutative factors (the reliability of used models)
psychological factors (sentiment, VIX, ratio return = stock return/bond return, ratio call/put)

10. Financial crisis
The skill of asset manager will decrease during the crisis
He will not able to forecast the future market’s trend
He uses excess trading ( behavioral finance) to reduce his losses
Excess trading means to improve trading costs

11. asset allocation styles
Conservative(portfolio with short term products close to risk free rate)
Moderate (asset manager selects a equity component close to the market (beta =1)or he selects ETF and/or a residual component of bonds (government bonds , or investment grade bonds) to keep a medium/low risk
Aggressive (mid-cap or small-cap) growth with high (P/E) and low dividend/price. Speculative grade bond ( he will wait for a upgrading to take a profit from credit risk)

12. Portfolio policy
Strategic ( efficient market, you like the diversification without considering the timing. The strategic investor knows the benchmarks. This strategy is called beta o market risk)
Tactical -inefficient market , timing (active beta could be obtained through the market timing, that is, varying the exposure to the market); selectivity of asset class to under or overweight compared to the selected benchmark.
Dynamic – inefficient market. Asset manager wants to beat the benchmark, but in bad conditions of the market he is ready to keep a minimum return of portfolio( floor portfolio).

13. Asset Allocation: right choice?
Gary P.Brinson, L.Randolph Hood, Gilbert L.Beebower, “Determinants of Portfoglio Performance”, Financial Analysts Journal, July-August 1986
Gary P.Brinson, Brian D.Singer, Gilbert L.Beebower, “Determinants of Portfoglio Performance II: An Update”, Financial Analysts Journal, May-June 1991

14. Discretionary intervention compare to benchmark
Active and Passive Management
PASSIVE ACTIVE
TRACKING ERROR
Discretionary intervention compare to benchmark
INDEXED FUNDS
HEDGE FUNDS
Quantitative Quantitative/Qualitative
Asset Management
TEV= tracking error volatility

15. 3. How to estimate expected returns, volatility and correlations
3. . How to estimate expected returns, volatility and correlations ? On what time scale?
The expected return
mean reversion return and the problem of historical used sample
The expected returns based on subjective or long term valuations? The problem of time scale of investor
Volatility
Historical volatility vs. implicit volatility
Time scale and the frequency of data samples

16. 3. Correlations? Correlations
The stability of market conditions (ex. Euro effect)
Total return vs domestic return+currencies
The frequency of data samples (no daily data!)

17. 4. How do you get through the efficent frontier to real portfolio for each investor?
The selection can not be based on the utility function (see the optimal portfolio)
At the end asset managers divide into segments the efficient frontier for given levels of standard deviation…

18. 5. The optimal portfolio vs.“true”portfolio
When asset managers detemine portfolio optimization they need to translate it in a true portfolio
They build a benchmark .
It could be made up of 30% bonds in Euro, 20% bonds Ex Euro, 25% stocks in Euro, 25% stocks ex Euro
Implications/risks
How efficient the selected benchmark is?
Who defines the asset allocation? The risk of commercial optimization”
How to set the risk of limits for asset manager?

19. The map of risk/return