Portfolio overview
Rob Hayward
August 2021
1 Introduction
The key to managing a portfolio is diversification. In 1953 Harry Markowitz published papers that became the foundation for Modern Portfolio Theory (MPT). This was a rigorous affirmation of the idea of diversification and that you should not put all your eggs in one basket.
Harry Markowitz
2 Modern Portfolio Theory
The basis of modern portfolio theory is the idea that investment decisions can be reduced to two elements; risk and return. If we assume that people are risk averse then people will only take more risk if they are given a higher expected return. However, at the time that they investment, they do not know the actual investment outcome.
Figure 1 shows the relationship between risk and return. The efficient frontier is established by combining assets that are not correlated so that return can be maintained while risk is reduced. MPT says that the best investment is the Market Portfolio (MP). This is the combination of all assets in the investment universe, weighted according to their capitalisation.
Figure 1: MPT
3 Investment universe and the market portfolio
The investment universe is a theoretical idea. In theory, it includes all the assets in the world. However, it is very difficult to invest in many private assets. Therefore, the investment universe is usually reduced to some sub-set. In our case, the investment universe will include the following assets:
Cash: this is safe and liquid but eroded by inflation. In our example, there is no return and no inflation. It is more-or-less the risk-free asset.
US Equity: this is represented by the Exchange Traded Fund (ETF) called SPY. This covers all the 500 stocks in the S&P 500 index. This is an index of the largest 500 companies in the US. US equities usually do well when the economy does well and firms are making profits. Anything that hits profits, such as weaker economic growth, higher inflation or higher costs will be negative for stocks.
US government bonds: these are debts that are issued by the US government. We will invest in an ETF called TLT. This will invest in US government bonds with a 20-year maturity. US government bonds are issued to cover the gap between taxation and spending. As the US government can tax people and print money, they are very safe. However, higher interest rates can make cash an alternative investment and higher inflation will erode the value of the debt, so rates and inflation are bad for bonds. This means that there is some risk before maturity and the value of these bonds will move around according to the latest expectations about inflation and interest rates.
Gold: is a traditional safe-haven against inflation and some other sorts of financial disruption. We can invest in an ETF called GLD. Gold and government bonds are considered to be safe-havens.
Emerging Economy Equities: are equities in emerging economies. The EEM ETF will follow the MSCI Emerging Economies Equity index. This is dominated by Chinese, Taiwanese and Korean companies. However, it also includes those from other developing economies around the world. These stocks tend to be more volatile than those of the developed economies, but still focused on the profits that companies in their countries make.
Corporate bonds: are bonds issued by corporations rather than the government. We can invest in an ETF called JNK. These bonds are not as safe as firms may be unable to pay back their debts. A weak economy will increase the risk of default and cause corporate bonds to under-perform government bonds. Otherwise, there is some relationship between government bonds and corporate bonds. They are both affected by interest rates and inflation. The gap between the two is called the risk premium.
4 Exchange traded funds (ETF)
Exchange traded funds are a financial innovation that has exploded in the last 10 years. They are passive investments that track indices like the SPY, TLT, GLD, JNK and EEM. Indices are collections of securities that are used to assess performance of particular assets: US stock, US government bonds, gold, US corporate bonds and emerging economy stocks.
Figure 2: ETF Structure
Figure 2 shows the structure of a standard ETF. There is an Authorised Participant (AP), usually an investment bank or hedge fund, that will ensure that the price of the ETF reflects the value of the underlying securities. The AP does this by delivering underlying securities in exchange for newly-created ETF securities initially and buying or selling ETF or the underlying whenever they get out of line. This process is called arbitrage and provides an opportunity for the AP to make money.
5 The Game
Your job is to run a portfolio through a simulated period of 3 years from today. You can change the portfolio each year. You will have information about the economic conditions and forecasts for the economy and interest rates in the period ahead.
To get an idea of what can happen, here is a review of the two main assets (US stock and bonds for the period 2002-2018. For this study:
- there are equal weights (50:50) of SPY and TLT
- there are no costs
- there is no re-balancing, this means that the weights are 60:40 at the end
- rebalancing will tend to improve returns as it will sell winners and buy losers
- rebalancing will increase costs
You can see that the combination of stocks and bonds will give a less volatile investment performance than either of the components. The overall performance of the assets is given in Table 1. The key metric is the Sharpe Ratio, this give the return per unit of risk.
| Portfolio | AnnRet | AnnVol | Sharpe | DailyMax | DailyMin |
|---|---|---|---|---|---|
| Equity | 10.32 | 18.48 | 0.56 | 14.52 | -9.84 |
| Debt | 6.95 | 13.34 | 0.52 | 5.17 | -5.04 |
| Portfolio | 7.74 | 8.66 | 0.89 | 5.18 | -3.83 |
In the game you will be able to adjust the portfolio weights. This will mean that you are involved in active management
- the weights do not have to be 50:50
- change to meet circumstances
- market-timing is not usually successful
- add other assets to the portfolio
- diversification: cash, commodities, corporate bonds
- country diversification (China)
You need to determine when are stocks and bonds going to do well?