Principles of Portfolio Construction

Transcription

1 Principles of Portfolio Construction Salient Quantitative Research, February 2013

2 Today s Topics 1. Viewing portfolios in terms of risk 1. The language of risk 2. Calculating an allocation s risk profile 3. Correlation and portfolio risk 4. Illustrating the benefits of diversification 2. These concepts in practice 1. Salient Risk Parity 3. Trend Following strategies 1. Introduction and Theory 2. Trend Following benefits 3. Salient Pure Trend 2

3 Viewing portfolios in terms of risk These concepts in practice Trend Following strategies 3

4 1.1 The Language of Risk Not as Complicated as it Looks Volatility Intuition: a measure of the amount by which manager returns differ from their mean, on average. Technically: the standard deviation of returns. Symbols: for an individual strategy, for a portfolio combining multiple strategies. Importance: Helps us form expectations for the normal behavior of a strategy. Example: the strategy has a volatility of 5%/year, so we expect returns to be in the range of +/- 5% around their average about 2/3 of the time. For today: is the volatility of individual strategy. is an ingredient in calculating, the volatility of a portfolio containing strategy and other strategies. 4

5 1.1 The Language of Risk Correlation Intuition: measures degree to which two returns move together. Correlation of 1 indicates that returns move in lock-step. Correlation of 0 indicates that they are totally unrelated. Correlation of -1 indicates that they move exactly opposite to each other. Symbol:, is the correlation between returns on strategies and. Importance: Tells us if the returns of one asset are significantly different from those of another asset. For today: Variance used with to calculate, the volatility of a portfolio containing strategy. Intuition: the square of volatility. Symbols: is the variance of portfolio, is the variance of strategy. Importance: While we generally think in terms of volatility, need to do calculations in terms of variance for technical reasons. 5

6 1.2 Calculating an Allocation s Risk Profile An Example with 2 Assets Portfolio of 2 assets with weights: and. The variance of the portfolio is then: =, =, +, + Risk Contribution from Asset 1 +, +, Risk Contribution from Asset 2 6

7 1.3 Correlation and Portfolio Risk Diversification Depends on Correlation 8.0% 7.0% More Stocks 6.0% Excess Return 5.0% 4.0% 3.0% 2.0% 1.0% More Bonds 0.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Volatility (σ p ) Corr(Bonds,Stocks) = -1 Corr(Bonds,Stocks) = -0.5 Corr(Bonds,Stocks) = 0 Corr(Bonds,Stocks) = 0.5 Corr(Bonds,Stocks) = 1 7

8 1.3 Correlation and Portfolio Risk Return Scales Linearly, Risk Does Not 8.0% 7.0% More Stocks Excess Return 6.0% 5.0% 4.0% 3.0% 60% Stocks 40% Stocks 20% Stocks 2.0% 1.0% More Bonds 0.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Volatility (σ p ) Corr(Bonds,Stocks) = -1 Corr(Bonds,Stocks) = -0.5 Corr(Bonds,Stocks) = 0 Corr(Bonds,Stocks) = 0.5 Corr(Bonds,Stocks) = 1 8

9 1.3 Correlation and Portfolio Risk Return Scales Linearly, Risk Does Not 8.0% 7.0% Portfolio Weights: 40% Bonds, 60% Stocks 107% -7% Bond Risk Equity Risk More Stocks Excess Return 6.0% 5.0% 4.0% 3.0% Portfolio Weights: 80% Bonds, 20% Stocks 60% Stocks 40% Stocks 20% Stocks 2.0% More Bonds 77% 23% 1.0% Bond Risk Equity Risk 0.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Volatility (σ p ) Corr(Bonds,Stocks) = -0.5 Corr(Bonds,Stocks) = 1 9

10 1.4 Illustrating the Benefits of Diversification Same Return, Less Risk $5.00 Growth of $1 in a Traditional Portfolio vs Risk Parity $4.50 $4.00 $3.50 Total Return $3.00 $2.50 $2.00 $ % Stocks, 40% Bonds Risk Parity at 60/40 Level of Return $1.00 Return 9% 9% $0.50 Risk 9% 5% Return/Risk $ Year 60% Stocks, 40% Bonds Risk Parity at 60/40 Level of Return 10

11 Viewing portfolios in terms of risk These concepts in practice Trend Following strategies 11

12 2.1 Salient Risk Parity: Direct Diversification Crude Oil Gas Oil US Large Cap US Mid Cap Energy US Equity Agriculture Other Developed Equity Gold Copper Metals Commodities 25% Equities 25% Emerging Market Equity Taiwan 10 Yr. US Govt. Debt Rates 25% Credit 25% Developed Corporate Credit US Investment Grade Corporate Credit 10 Yr. German Govt. Debt Developed Sovereign Debt High Yield European Investment Grade Corporate Credit 10 Yr. Canadian Govt. Debt Emerging Market Debt US High Yield 10 Yr. Japanese Govt. Debt 10 Yr. UK Govt. Debt European High Yield 10 Yr. Australian Govt. Debt Emerging Market Debt 12

13 2.1 Full Risk Parity vs. Risk Parity Orientation The Salient Risk Parity Index $4 SDCERA Salient Risk Parity Index Growth of $1 $3.1 Growth $2 $2.3 $1 0.00% (10%) (20%) (30%) (40%) Drawdown (50%) Year (60%) 13

14 Viewing portfolios in terms of risk These concepts in practice Trend Following strategies 14

15 3.1 Introduction to Pure Trend Strategies What Are They & Why Do They Work? Trend strategies: exploit tendency of assets with positive returns to continue generating positive returns. Predictability of asset returns based on past returns has been established in virtually every liquid futures and forward currency market. Theoretical explanations of trend generally focus on: Under-reaction, which may result from slow diffusion of news or the disposition to sell winners early and hold on to losers too long. Over-reaction, which may be caused by a positive feedback loop or herding. The insurance component of futures returns, which implies a premium paid to speculators by hedgers. First documented in 1993, no evidence that exploitation has diminished the strategy s effectiveness. 15

16 3.2 Trend Following Benefits Divergent Return Stream 20.0% Quarterly Returns 1990-Present 15.0% Q Salient Pure Trend Returns 10.0% 5.0% 0.0% -5.0% -10.0% Q2 & Q Q % -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% S&P 500 Total Returns 16

17 3.3 Salient Pure Trend Gas Oil 45 Assets Traded Lead Long Term 50% Australia 17 Equity Index Futures US (small, medium and large cap), Canada, UK, France, Germany, Italy, Spain, Sweden, Japan,Australia, Hong Kong, China, Taiwan, South Africa, India 22 Commodity Futures Crude Oil, Brent Crude, Natural Gas, Heating Oil, Gasoline, Gas Oil, Cattle, Hog, Corn, Soybean, Sugar, Cotton, Wheat, Coffee, Cocoa, Gold, Copper, Silver, Zinc, Nickel, Lead, Aluminum Medium Term 25% Short Term 25% 6 Interest Rate Futures U.S. 10 Year, Canadian 10 Year, Bund, Gilt, Japan 10 Year, Australian 10 Year 100% Exchange Traded Zinc Spain Italy India 17

18 Growth 3.3 Salient Pure Trend Our Index Versus Common Benchmarks $1,024 $512 $256 $128 $64 $32 $16 $8 $4 $2 $1 Salient Pure Trend Index 20% Volatility BARCCAP CTA 20% Volatility Growth of $ Year $549.6 $35.4 $ % (10%) (20%) (30%) (40%) (50%) (60%) (70%) Drawdown 18

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