portfolio construction and evaluation

1© 2014 Windham Capital Management, LLC

1

Portfolio Construction and Evaluation

Jonathan KazarianWindham Client Consultant

3/27/2014


Goal:

Generate an efficient portfolio which satisfies our client’s

needs.


Hypothetical Client

One million in investable

assets

Requests global

diversification but maintains a home bias

Concerned about losses, particularly of 15% or more

Goal: double value over 12

years


Agenda

1. Discuss the asset allocation process

2. Develop Capital Market Forecasts

3. Construct a Mean Variance efficient portfolio

4. Evaluate portfolios using exposure to loss and potential wealth analytics


Asset Allocation

■ Identify eligible asset classes

■ Estimate return, risk and correlations

■ Generate efficient portfolios

■ Select portfolios that match our tolerance for risk


Eligible Asset Classes

■ Improve portfolio efficiency by raising return or lowering risk

■ Independent of other asset classes

■ Constituents of an asset class must be relatively similar

■ Have the capitalization capacity to absorb a meaningful fraction of our portfolio

Mark Kritzman, “Toward Defining an Asset Class”, Journal of Alternative Investments, Summer 1999


Capital Market Forecasting

“The process of selecting a portfolio may be divided into

two stages. The first stage starts with observation

and experience and ends with beliefs about the

future performance of available securities. The

second stage starts with relevant beliefs about future

performances and ends with choice of portfolio. This

paper is concerned with the second stage.”

Harry Markowitz, “Portfolio Selection,” Journal of Finance, March 1952


Standard Deviation

Not static throughout time

Chow, G., Jacquier, E., Kritzman, M., and Lowry, K., Optimal Portfolios in Good Times and Bad, Financial Analysts Journal, May/June 1999

Asset Class Full Sample Turbulent

Large Cap Stock 16.53% 23.56%

Small Cap Stocks 21.34% 29.51%

Foreign Stocks 18.78% 24.05%

Commodities 22.63% 30.62%

Real Estate 21.88% 35.82%

US Bonds 4.01% 6.20%

Cash 0.72% 0.86%

Data from 02/1989 - 02/2014, Turbulence Threshold at 20%

• The table above shows standard deviation estimates for both normal and turbulent regimes

• Volatility rises during times of turbulence


Correlations

Chow, G., Jacquier, E., Kritzman, M., and Lowry, K., Optimal Portfolios in Good Times and Bad, Financial Analysts Journal, May/June 1999

Full Sample Large Cap Stock Small Cap Stocks Foreign Stocks Commodities Real Estate US Bonds

Small Cap Stocks 0.84

Foreign Stocks 0.74 0.65

Commodities 0.18 0.20 0.24

Real Estate 0.55 0.63 0.48 0.14

US Bonds 0.12 0.00 0.09 -0.02 0.14

Cash 0.03 -0.04 -0.05 0.06 -0.07 0.16

Turbulence Large Cap Stock Small Cap Stocks Foreign Stocks Commodities Real Estate US Bonds

Small Cap Stocks 0.83

Foreign Stocks 0.76 0.66

Commodities 0.28 0.33 0.23

Real Estate 0.64 0.71 0.54 0.25

US Bonds 0.27 0.18 0.23 -0.04 0.23

Cash 0.23 0.15 0.08 0.25 0.15 0.24



Returns

Asset Class Historical Equilibrium (Beta) View (Confidence) Blend

Large Cap Stock 11.40% 8.08% (1.16) N/A 8.08%

Small Cap Stocks 12.08% 8.68% (1.33) 10% (50%) 9.34%

Foreign Stocks 6.92% 9.85% (1.66) N/A 9.85%

Commodities 7.60% 7.72% (1.06) 5% (50%) 6.35%

Real Estate 11.67% 8.26% (1.21) N/A 8.26%

US Bonds 6.90% 4.47% (0.14) N/A 4.47%

Cash 3.46% 4% (0) 1% (75%) 1.74%

• We use Equilibrium Returns blended with views for specific asset classes• We estimate the market’s expected return equal to 7.5% and the risk-free

return equal to 4.00%



Mean Variance Optimization

“The process of selecting a portfolio may be divided

into two stages. The first stage starts with observation

and experience and ends with beliefs about the future

performance of available securities. The second

stage starts with relevant beliefs about future

performances and ends with choice of portfolio.

This paper is concerned with the second stage.”

Harry Markowitz, “Portfolio Selection,” Journal of Finance, March 1952


Optimal Portfolios

Asset Class Conservative Moderate AggressiveLarge Cap Stock 15.15% 19.19% 12.35%

Small Cap Stocks 5.58% 8.21% 27.95%

Foreign Stocks 17.28% 22.83% 33.58%

Commodities 8.20% 9.81% 4.62%

Real Estate 4.03% 4.96% 0.89%

US Bonds 35.00% 35.00% 20.61%

Cash 14.76% 0.00% 0.00%

Return 6.12% 7.16% 8.20%

Risk 7.81% 10.07% 13.45%

• The return and risk are derived using Equilibrium returns adjusted for our views and historical standard deviations and correlations


Portfolio Selection

■ Theoretical Approach: Risk Aversion

►“How many units of returns you are willing to give up in order to decrease risk by one unit”

■ In Practice:

►Exposure to Loss

� Probability of Loss

� Value at Risk

►Future Wealth

“What’s your number?

http://www.adrants.com/


Exposure to Loss

■We can estimate the likelihood that a portfolio with a particular expected return and standard deviation will experience a certain loss over a particular horizon.

►Probability of Loss

■Alternatively, we can easily estimate the largest loss a portfolio might experience given a certain level of confidence.

►Value-at-Risk

■For normal periods, risk parameters are based on the entire

sample of returns

■For the turbulent regime, risk parameters are based on the

turbulent sub-sample of returns


Exposure to Loss (Within Horizon)

■ Investors typically measure exposure to loss at the end of their investment horizon

►This ignores what may happen along the way; this is a dangerous oversight

■Within Horizon risk provides a more realistic risk assessment

Probability of a 10% Loss at the End of the Horizon

is 20%

Probability of a 10% Loss Within the Horizon is

80%

Kritzman, M. and Risk, D., The Mismeasurement of Risk, Financial Analysts Journal, May/June 2002


Exposure to Loss (Probability of Loss)

• Likelihood of losses increases during Turbulent periods• The current portfolio has less than a 1% chance of losing 15% or more at

the end of 15 years• But there is over an 18% chance that the portfolio will depreciate by

similar amounts along the way• This increases to nearly 47% in turbulent periods


Exposure to Loss (Value-at-Risk)

• Again, we can observe drastic differences in value at risk• The worst outcome for a moderate investor given a 1% probability in

normal periods is an increase in value of $22,000• In comparison, the worst outcome in the interim period is a decline of at

least $266,668• When in periods of turbulence, the worst outcome increases to $383,329


Wealth Analysis (Monte-Carlo Simulation)

Procedure:1. Randomly generate 2000 different asset return histories using our

estimated return, risk and correlation. Each history is 20 years in length2. For each month, calculate the portfolio return3. Compound the portfolio wealth by this return


Additional Evaluation Measures

■ Factor Analysis

►Identify and measure common sources of risk and return for managers, asset classes, and portfolios

►Go beyond asset allocation to identify the underlying exposures to specific sources of risk

■Risk Budgets and Value at Risk Sensitivity

►Evaluate the risk of each asset class in isolation

►How does changing our allocation impact our portfolio’s risk?

■ Stress Testing & Scenario Analysis

►Estimate potential economic loses in unfavorable markets

►Examine portfolio-specific weakness

� Ex. how sensitive are our portfolios to interest rate shocks?

■Wealth Analysis incorporating Cash Flows

►Use simulation to analyze how cash flows will impact future wealth for different portfolios


Proposed Portfolio: Moderate

Asset Class ModerateLarge Cap Stock 19.19%

Small Cap Stocks 8.21%

Foreign Stocks 22.83%

Commodities 9.81%

Real Estate 4.96%

US Bonds 35.00%

Cash 0.00%

Return 7.16%

Risk 10.07%

Probability of 15% Loss

at the End of a 12 year

Horizon

Probability of 15% Loss

Within Horizon 12 year

Horizon

Value at Risk at the 1%

Level at the End of a 12

year Horizon

Value at Risk at the 1%

Level Within the 12 year

Horizon

Median Wealth Potential

in 12 years

0.19% 9.05% -$21,874 $266,668 $2,179,778


Thank You

Webinar: Windham Software Overview

April 2nd at 11:00AM EDT

Webinar: Measuring Potential Investment

Outcomes Using Simulation

April 16th at 10:00AM & 2:00PM EDT

Register online at www.windhamgs.com/news

Questions and feedback:

[email protected]


Disclaimer

The information contained in this presentation (the “Presentation”) is prepared solely for informational purposes. The Presentation is neither an offer to buy or sell nor a solicitation of an offer to buy or sell any security, or interests or shares in any fund or strategy. Historical data and other information contained herein is believed to be reliable but no representation is made as to its accuracy or completeness or suitability for any specific purpose. Past performance is not indicative of future performance, which may vary. There can be no assurance that the strategies’ investment objectives will be achieved. All strategies in this Presentation place investor capital at risk. Future returns are not guaranteed and a loss of principal may occur.

References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only. Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other results similar to the index. The composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in relation to expected or achieved returns, investment holdings, portfolio guidelines, correlations or tracking error targets, all of which are subject to change over time.

Prospective investors should not rely on this Presentation in making any investment decisions. Windham’s portfolio risk management includes a process for managing and monitoring risk, but should not be confused with, and does not imply, low risk. Asset classes and proportional weightings in Windham portfolios may change at any time without notice. Windham does not provide tax advice to its clients and all investors are urged to consult with their tax advisors with respect to any potential investment.

Please refer to Windham’s ADV Part 2A for additional information. Windham and its owners disclaim any and all liability relating to this Presentation, including without limitation any express or implied representations or warranties for statements contained in, and omissions from, this information.

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