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Total Return Utility Functions Suitable for Optimization

Alpha, Beta, Market Timing, and the Liability, All in One
M. Barton Waring
barton.waring@aya.yale.edu
360 941-3566

Working Paper
May, 2007
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Most efforts to set up optimization routines simply try to find the desired weights
of asset classes. Since these optimizations are typically fed by expected return
assumptions for fully diversified asset classes which are just factor beta positions
they are somewhat limited. What would an optimizer look like if it were a total return
optimizer, dealing correctly with beta and alpha -- and better yet, with both types of
alpha, those from security selection efforts and those from beta timing or market timing
efforts?
What would this mean to the investor? It would mean a great deal. It would
provide the ability to simultaneously optimize for long term strategy, and to also
appropriately incorporate short term tactical views. What a plus, especially in
conjunction with the ability to incorporate views about the active managers that the
investor is considering hiring. One can imagine an optimization that simultaneously
works across all the strategic and tactical dimensions of investment strategy.
Further, what would the optimizer look like if it were also capable of dealing with
the liability in a comfortable and complete way? Again, it would mean a great deal.
Controlling liability-relative risk should be a central task of most investors.
Here we present such a talented optimizer, and we do it while staying comfortably
within the realm of single- and multiple-index models of return and risk. Nothing esoteric
or made up; the finance we will use should be comfortable to all, well within the heart
of those very basic single- and multiple index and market models so familiar to students
of finance. It is the assemblage that is novel, not most of the pieces.
The math will be presented first in scalar algebra for intuition, and then in vector-
matrix algebra for implementation. The former is useful to anyone wanting a better
understanding of how one incorporates these different inputs, but the latter will be of
greater interest to that hard core of serious practitioners that actually get their
fingernails dirty in the gardens of asset allocation.
Of necessity, this latter section is mathematically intense. But it is the authors
observation that the basic technology of surplus optimization hasnt been used much,
perhaps simply because the math for some of the ancillary parts of a full process is just
complicated enough that it is difficult to work out. So this, as a reference source, may aid
the process of dissemination of this technology.
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With that background, well build the fully generalized vector-matrix form of
these utility functions, again first starting in an asset-only form and then adding the
additional complexities of the liability.
Finally, well discuss how to make variations for optimization tasks that may not
require all the capabilities set up in the general version, adapting this mathematical
structure to different types of problems.
A. AN I NTRODUCTI ON TO PARSED UTI LI TY FUNCTI ONS:
ASSET-ONLY
1. An asset-only model of total returns:
a. The Grinold and Kahn benchmark-relative approach to
modeling total returns
Theory tells us that the return of a portfolio of assets, A, can always be expressed
in terms of its market, or beta terms, and its residual terms. Grinold & Kahn [2000], in
the appendix to chapter 4 of their wonderful book, Active Portfolio Management, parse a
generalized form of the CAPM more accurately, a single-index model against a
specified benchmark as follows:
1


A F A b
R R f | o = + + (1)
(This is read as the total return of a portfolio of assets is equal to the risk-free
rate, plus the beta of the assets relative to the benchmark portfolio times the expected
excess return over the risk-free rate of the benchmark portfolio, plus an alpha.) This
reference to a fixed benchmark was convenient to their purpose, saving some complexity
not needed to meet their objectives. They were focused, appropriately to the task of their
book, on dealing with active management issues across portfolios of securities, where a
benchmark is typically pre-specified. They werent focused on selecting asset classes, on
strategic asset allocation (SAA) issues. By specifying the model in terms of a pre-set
benchmark it made some things easier for example, the ideal beta in that case is always

1
While the story is brief in this reference, it is rich, and the student of this topic is encouraged to
start with this source.
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unity, or matched with the beta of the benchmark, and that made if appropriately
parsimonious for their purpose.
But the ambitions of this article, set forth above, require more generality. Since
were going to include strategic asset allocation solutions among our ambitions, we cant
settle for using a pre-determined benchmark the policy portfolio needs to be optimized
in pari pasu with the active decisions. The optimal beta solution has to be able to float, to
be more conservative or more aggressive than the reference portfolio depending on the
investors lambda, or risk aversion parameter. To determine strategic asset allocation
policy is to set an investment benchmark, a complex benchmark to be sure, but a
benchmark nonetheless. We cant be limited by the confines of having the benchmark
pre-specified.
b. A more generalized market model approach
We can improve and generalize their approach so that it is broadly usable for asset
allocation purposes by specifying the reference portfolio for beta calculations as the
consensus or equilibrium portfolio, Portfolio Q. To students of consensus expected
returns, Portfolio Q is recognizable as the market portfolio and so it is no surprise that
we work with it in this manner. At the heart of every efficient frontier, acknowledged or
not, is such a reference portfolio, a consensus portfolio representing the beliefs of the
collective market place. In our work we choose to select it intentionally and explicitly. As
a result, we in effect move from the single index model of equation (1) to a more fully
generalized market model:

A F A Q
R R f | o = + + (2)
(Now, this reads that the total return of the asset portfolio is equal to the risk-free
rate, plus the beta of the assets relative to the market portfolio, times the expected excess
return of the market portfolio, plus an alpha.) Well think of this Portfolio Q as a
portfolio that closely approximates the world wealth portfolio described by Roll
2
(or at
least the investable portion of it). However, it can be any reference portfolio thought by
the analyst to represent the consensus of the market.

2
Roll, Richard. A Critique of the Asset Pricing Theorys Tests. Journal of Financial
Economics, March 1977 (volume 4, number 2, pp. 129-176).
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For notation in scalar algebra (well be operationalizing these equations in a later
section in vector-matrix algebra) well use uppercase letters to denote a return inclusive
of the risk free rate, and lowercase letters to denote a return in excess of the risk free rate,
F
R . So
Q
f and
b
f are the excess return forecast for the consensus portfolio in
equation(2) (and for the benchmark portfolio in equation (1)). Each consists of the sum of
the equilibrium or consensus forecast plus the exceptional market return forecast, so that
Q Q Q
f f = + A . In effect, the forecast return for the market,
Q
, is an expected risk
premium, and the exceptional market return forecast term
Q
f A is a market timing input.
3

c. Why reference Portfolio Q?
For ordinary asset allocation work across a set of asset classes, it isnt necessary
to include any reference to the consensus, or market, portfolio. Why here? There are a
couple of reasons. One is that it simply reflects the authors bias that when modeling
betas in the course of asset allocation work one should be modeling them consistently
with capital markets theory, either CAPM or some version of APT, in which the market
portfolio is the low risk portfolio and the reference point for most decision making.
But secondly, it facilitates a clear understanding of the differences between beta
and alpha, which will be important in our overall construct. In current practice, it is
aggravatingly normal to see expected return inputs to asset allocation studies that mix
equilibrium and nearer-term expectations (tactical expectations) without differentiation.
Since they are rewarded differently, the one being rewarded unconditionally and the other
being rewarded only on the joint condition of inefficiency and skill in the analyst, they
should be differentiated. And we will support that goal.
d. Including active asset allocation inputs: Beta timing
The exceptional market forecast,
Q
f A , is a non-equilibrium expectation for excess
return such as one might hold if one had a view of what the consensus portfolio (or any
other particular benchmark) might return in the forecast period above or below the

3
For portfolio Q, expected alpha is zero, by construction. For other portfolios where expected
alpha might be non-zero, it could be included in our term f, such that
Q Q Q
f f o = +A + .
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neutral expectation provided by the consensus. This is an input that would drive tactical
asset allocation, or beta timing positions within the optimal asset allocation policy: For
example, if one had a positive expectation in the next year for market returns, one would
be justified in holding a portfolio with a higher beta than would hold with only
equilibrium expectations.
As an active expectation,
Q
f A has a horizon, a beginning and an end (only
equilibrium views are horizonless). It is useful only for that specific horizon, after which
time it must be reviewed, renewed, changed, deleted, or whatever because it expires.
When it is revised or changed, the optimization must be redone, and new active beta
positions established (discussed below). If the exceptional market forecasts are skillful,
they will add return, and over many cycles this will be visible in a regression of realized
returns as a positive regression alpha. If they are not skillful, they will randomize the
portfolio, and will only add positive alpha returns by chance. At the time of this writing,
in the early summer of 2004, many sponsors are expecting interest rates to rise and thus
that bonds will have a negative expected return.
4
This type of non-equilibrium view
should be expressed, if strongly held, as an exceptional market forecast, not as a strategic
or equilibrium component, and it will cause an underweight to bonds only so long as the
view is held and incorporated in that way in the optimization.
e. Incorporating alpha from active managers
The residual or alpha, o , is the uncorrelated or idiosyncratic component of
returns at difference from the market-related component of returns, and is appropriately
used in the context of both expectations and of realizations, but for optimization as here
we are using expectations for this value. It will be non-zero in expectation only in the
presence of the two conditions of Waring, et al [2000] and Waring and Siegel [2003]
5
,
i.e., that there is some inefficiency in the market, and that there is above-average skill
available with which to capture it. The first is pretty easy to accept; the second is much

4
And sometimes this view is expressed without regard to the likelihood that it has already been
priced into the forward rate curve.
5
The reader is presumed to have some familiarity with these two articles, as they lay a
groundwork for understanding how active positions are incorporated into the portfolio.
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harder to verify. Yet everyday most investors do behave consistent with a belief that they
satisfy both conditions.
f. Parsing the return model
Dividing the components of equation (2) between the consensus and the
exceptional market forecasts, and between the SAA beta and the portfolio active beta,
and multiplying through, we get the following 4-part parsed form of total return. It is
generally consistent with the Grinold and Kahn parsing, referred to above, yet different in
some details that will be important later. The differences are related to my plan to enable
the benchmark level of beta (the SAA policy itself) to be evaluated in the optimization,
rather than assuming it as a given):
( )( )
A F SAA PA Q Q
R R f | | o = + + + A + (3)

Part 4
Part 1 Part 2 Part 3
A F SAA Q PA Q SAA Q PA Q
R R f f | | | | o = + + + A + A + (4)
These parts, and this ordering of those parts, will be valuable as we proceed.
2. The asset-only model of total risk:
Similarly, portfolio variance can be expressed in terms of the same market and
residual risks that we just dealt with on the return side, and that it can likewise be parsed
into four component terms. We need only to separate beta into its SAA component and its
portfolio active component, and square the separated pieces. Again, we have changed
from the G&K single-index reference portfolio, to a market model based on Portfolio Q:

( )
2 2 2 2
2
2 2
A A Q
SAA PA Q
o | o e
| | o e
= +
= + +
(5)

2 2 2 2 2 2 2
Part 4
Part 1 Part 2 Part 3
2
A SAA Q SAA PA Q PA Q
o | o | | o | o e = + + + (6)
The only new term not defined above is
2
e , the residual variance. Again, these
pieces and this ordering of them will prove to be valuable.
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3. A total return utility function using these return and risk models
Here is the payoff: a total return utility function that properly accounts for beta, or
policy inputs, for market timing across beta components, and for manager selection
inputs (forecast alphas and active risks for managers). By simply combining these two
return and risk functions in the parts and in the order used above, a parsed mean-variance
utility function is developed that operates correctly in total return space:

f
U R = (7)

2 2
SAA Q SAA SAA Q
| | o + (Part 1)

( )
2
cov
2
SAA Q PA Q SAA PA Q
f | | | | o + A + (Part 2)

2 2
PA Q PA PA Q
f | | o + A (Part 3)

2
e
o e + (Part 4)
Generally speaking, we can see that part 1 accomplishes the strategic asset
allocation task. Depending on the lambda used to determine policy, the optimal SAA
portfolio (the portfolio having market risk level
SAA
| ) would be on the capital market line
(CML), to the right or to the left of Portfolio Q. This is the form of mean-variance utility
that most of us are accustomed to seeing.
But there is more, as this form is capable of simultaneously evaluating active
decisions, making this a true total return utility function.
Part two is a covariance term relating exceptional market forecast utility and SAA
utility. If one studies the first order conditions of this utility function for
SAA
| , one can
see that this is a zero term where several conditions are satisfied: there must be no
exceptional market forecast, all return/risk combinations must lie on the security market
line, and the lambdas for all parts of this utility function must be equal. But since we
want to optimize even when those difficult conditions are not met, well retain the term
rather than dropping it (as suggested in Grinold and Kahn [2000], chapter 4; they could
drop it only because they were assuming the benchmark to have already been set and the
lambda to be equal to the SAA lambda, presumptions that we will seldom be able to
repeat in practice. However, in circumstances where the SAA policy were in fact already
in place, and if we believed that the lambda for this covariance term is the SAA lambda,
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then again we could show that Part 2 becomes in that special and limited context
irrelevant.)
Part 3 is driven entirely by the exceptional market forecast, a TAA or active
beta form of active management. A little later when we move to multi-factor models
well use this input variable to support various beta timing activities not just in a single
beta context, but also across multiple betas, which organizes disciplines such as tactical
asset allocation, market timing, country rotation, and style rotation. Where in any period
there is a non-zero exceptional market return, the optimization will cause there to be a
non-zero portfolio active beta in that period.
Part 4, dealing with residual utility, has two parts. The first simply deals with the
mathematics of asset class mixes that are off of the CML, creating residuals as a result.
Well deal with the need to account for these residuals in later sections. This is
uninteresting in the sense that these residuals are uninformed by insights, but yet they
must be accounted for if one desires a complete utility solution. These residuals are a
natural result that happens when there are limited number of managers availableno
optimal combination of the managers is likely to perfectly represent the ideal aggregate
beta, but will have some degree of misfit risk.
The second, more interesting, part is driven by expected alphas sourced in active
management of the residual holdings within the overall portfolio or any of its sub-
portfolios (asset classes or styles). This part represents the utility function for manager
selection, or if we want to develop it as such, for security selection. Well focus on its
role in manager selection, but any economist that is comfortable with the rest of the
mathematics of this chapter (the vector-matrix forms) could comfortably adapt it to allow
for security selection within one or more of the investors asset classes.
Note that we have a potential to have as many as five lambdas, one for the basic
SAA policy decision, one for the covariance relationship between SAA and beta timing,
one for beta timing decisions, one for active manager decisions, and one for uninformed
residuals. These dont have to be set differently, and some will argue with some
persuasiveness that they shouldnt be, but we are providing the flexibility that they can
be.
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So this utility function, so far, accomplishes all of our total return optimization
goals other than the inclusion of the liability: It develops our SAA policy. It allows for
tactical positioning. And it allows for manager structure decisions regarding the search
for alpha through active management.
4. The interaction of equilibrium and exceptional market forecasts
If we look at the first order conditions of equation (7), we see that there appears to
be an effect on the strategic asset allocation beta in the presence of exceptional
benchmark forecasts:

2
2
cov
2
2
Q SAA SAA Q
SAA
Q PA Q
U
f
o
| o
o|
| o
=
+A
(8)
and so the solution is:

2
cov *
2 2
2
2 2
Q Q PA Q
SAA
SAA Q SAA Q
f | o
|
o o
A
= + . (9)
The left hand term in the solution is quite ordinary and expected. The right hand
term is the one of interest here. Im still trying to work out the implications of its
presence.
One can posit circumstances under which this term might be a zero term, and in
fact there is some intuition that this writer hasnt yet proven to himself that it might
always be a zero term, unconditionally. But until and unless this is proven, we will have
to assume an interaction. (not proven as of 10/1/2006)
I think it may mean that the SAA policy wouldnt be same if calculated without
exceptional benchmark forecasts as it would be if calculated when there were such
forecasts. If so, we have to decide how to handle it:
1. Do a first pass optimization without any exceptional market forecast
inputs, to determine the static SAA beta policy. This preserves our notion
of the policy as a static benchmark. Then, in the second pass, using this
benchmark, we would separately determine the portfolio active beta
resulting from the addition of exceptional forecasts. This is probably the
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preferred alternative if we want the SAA result to feel similar to how it has
felt in past practice.
2. Or we just do a single-pass optimization, acepting a new and non-static
notion of the policy portfolio, a portfolio having some interaction with the
exceptional market forecasts. This feels like the impact on the SAA beta
is partially active in that it is affected by the exceptional forecasts. This
isnt an appealing result, and my understanding of it is not yet complete,
but it may be exactly correct.
We will have to understand this better before finalizing this paper or locking
down the code for the optimizer.
B. A PARSED SURPLUS TOTAL RETURN UTI LI TY FUNCTI ON
1. A model of surplus total return
Lets now make the model fully generalized, by including the liability. Weve
been using subscript A to designate the asset portfolio; now well add subscript L to
designate the liabilities. The return of the surplus has been stated as follows, expressed in
scalar form:
6


0
0
S A L
A
R R R
L
= (10)
Note: If rewriting this I would probably divide through by assets rather than by
liabilities, getting the alternative form of surplus return; possibly I would divide through
by surplus, using the native form and suffering the zero divide problem; minor, really.
Restating this in a form acknowledging that we can decompose both asset and liability
returns into their beta and alpha components; i.e., by populating it with our asset and
liability return models as hinted at by the notes in brackets below the equations:

( ) ( )
0
0
A L
S F A Q A F L Q L
R R
A
R R f R f
L
| o | o = + + + + (11)

6
Waring, M. Barton. Liability Relative Investing II: Alpha, Beta, and etc. Journal of Portfolio
Management, Fall 2004.
Page 12; 3/3/2013

0 0 0
0 0 0
Residual surplus return Beta-related surplus return
1
S F A L Q A L
A A A
R R f
L L L
| | o o
| | | |
= + +
| |
\ . \ .
(12)
This is useful, but we can further parse the beta terms, in the same way we did in
equation (4), above. We simply substitute that parsed form for the summary notation of
the return of the assets and the return of the liabilities. (Note that the portfolio active beta
for the liability is definitionally always zero as the liabilitys beta doesnt change
depending on the exceptional market forecast.) So the parsed return form for the liability
only includes part 1 and part 4, leaving parts 2 and 3 as zero terms. Restating equation
(11) in that four-part parsed form developed earlier, we have:

( ) ( )
( ) ( )
0
0
0 0
A
L
F SAA Q SAA Q PA Q PA Q A
R
F L Q L Q L
R
A
R f f
L
R f
| | | | o
| | o
= + + A + + A +
+ + A + + +
(13)
Combining like terms and setting surplus return into its parts:

0
0
1
S F
A
R R
L
| |
=
|
\ .
Risk-free rate (14)

0
0
SAA L Q
A
L
| |
| |
+
|
\ .
Part 1

0 0
0 0
SAA L Q PA Q
A A
f
L L
| | |
| |
+ A +
|
\ .
Part 2

0
0
PA Q
A
f
L
| + A Part 3

0
0
A L
A
L
o o
| |
+
|
\ .
Part 4
2. Surplus total risk
Next, lets develop surplus risk, based on the risks found in the return equation,
equation (12):

2
2 2 2 0
0
S A L Q S
A
L
o | | o e
| |
= +
|
\ .
(15)
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This is expressed in terms of the optimal asset portfolio beta,
A
| . But presuming
that this beta may include a portfolio active beta, lets separate that portion out from the
strategic beta. Remembering that portfolio active beta can only be on the asset side, not
the liability side:

2
2 2 2 0 0
0 0
S SAA L PA Q S
A A
L L
o | | | o e
| | | |
= + +
| |
|
\ . \ .
(16)
This setup is now equivalent to that we used to arrive at equation (6). Following
through in parallel form, we multiply out the squared term (and dealing separately with
the residual risk term
2
S
e in expanded format), we get a usable and intuitive parsing of
surplus risk in scalar form:

2
2 2 0
0
S SAA L Q
A
L
o | | o
| |
=
|
\ .
Part 1 (17)

2 0 0
0 0
2
PA SAA L Q
A A
L L
| | | o
| |
+
|
\ .
Part 2

2
2 2 0
2
0
PA Q
A
L
| o + Part 3

2
2 2 0 0
, 2
0 0
2
A A L L
A A
L L
e e e + + Part 4
By inspection, one can see that the minimum variance portfolio for surplus (with
respect to beta) will be where the parenthetical strategic surplus beta term
0
0
SAA L
A
L
| |
| |

|
\ .
equals zero, i.e., where
* 0
0
SAA L
L
A
| |
| |
=
|
\ .
. This itself is an important result,
as it suggests that an underfunded plan must invest aggressively simply in order to keep
up with the liability, if controlling surplus volatility is part of the objective function. At
this point, the portfolio would be solely a hedging portfolio, with no companion risky
asset portfolio.
3. Surplus Utility
Now we can set up the total return/total risk form of surplus utility, again in these
same four parts:
Page 14; 3/3/2013

0
0
1
F S
A
R
L
Max U
| |
=
|
\ .
(18)

2
2 0 0
0 0
SAA L Q SAA SAA L Q
A A
L L
| | | | o
| | | |
+
| |
\ . \ .
Part 1

2 0 0 0 0
cov
0 0 0 0
2
SAA L Q PA Q PA SAA L Q
A A A A
f
L L L L
| | | | | | o
| | | |
+ A +
| |
\ . \ .
Part 2

2
2 2 0 0
2
0 0
PA Q PA PA Q
A A
f
L L
| | o + A Part 3

2
2 2 0 0 0
,
0 0 0
2
A L A A L L
A A A
L L L
e
o o e e e +
| |
| | | |
| +
| |
|
\ . \ .
\ .
Part 4
This is a valuable and general form of utility function (even though we have yet to
deal with residuals sourced in constraints on the underlying optimization problem). Lets
proceed to implement these utility functions in optimizable, vector-matrix form.
C. VECTOR-MATRI X VERSI ONS: MULTI PLE ASSET CLASSES
The development so far has been expressed in a single beta form. To be truly
useful in actual practice we need a multi-factor model, spanning the useful asset classes,
sub-asset classes, and styles that we are likely to be using.
The market-related component of any asset allocation policy, any manager, any
asset class, and any liability can be described in the form of some list, or more formally
some vector of factor weights. All of these vectors are in reality vectors of factor betas
across asset classes and styles, and can be thought of not only in that regression sense but
as a sort of vector of mini-CAPM betas in a very real, market-related risk sense of the
term, as each style or factor weight is in fact a representative of some fully-diversified
component of market related risk.
7
Moreover, these multiple factors can be readily

7
There are other factors that might be usable for asset allocation work besides asset classes and
styles, and that might be used one day for next generation asset allocation and strategy decisions. For
example, one can imagine a time in the future when we might use BARRAs factors, or some newer factor
set appropriate to the task of global strategic asset allocation and much more granular than todays asset
class factors.
Page 15; 3/3/2013
combined into a single factor representing the actual CAPM beta, ideally a world market
portfolio beta.
The notation we will develop will have as many consistencies as is possible with
the scalar algebra notation just used. In general, we have followed the standard
convention that scalars are italic, and not bolded, and now well follow the additional
convention that vectors are in lower case bold non-italic letters and that matrices are in
upper case non-italic, bold letters. Beta vectors will be row vectors, all others will be
column vectors. Transposes will be indicated with a bold superscripted T. There will be
various subscripts, hopefully intuitively connected to the scalar algebra subscripts, to
differentiate types of variables.
The beta vectors that we use for the assets,
q
(the weights or betas of the asset
classes in Portfolio Q),
A
(the current policy asset allocation weights, inclusive of both
SAA and PA effects),
SAA
(the strategic component of asset allocation weights),
PA
(the
portfolio active portion of the asset allocation weights), and for the liability,
L
, are
(1 x q) row vectors of asset class factor betas across the q Portfolio Q asset class and style
factors.
1. Portfolio Active Beta in Multi-Asset Class Form
A bit of refreshing on the concept of portfolio active beta may be in order in
preparation for developing the concept in vector-matrix form. It is driven from a zero
position, if at all, by a special type of active return forecast. In the first section we
referred to single factor beta timing inputs, or exceptional market forecasts with respect
to the equilibrium return of Portfolio Q itself, but now were going to address exceptional
market forecasts on each component beta, the element of Portfolio Q. After parsing the
scalar version of the return function equation (2), above, we separated out from the total
return forecast
Q
f , the consensus expected return
Q
, and the exceptional market
forecast,
Q
f A , defining the relationship between them as
Q Q Q
f f = + A . In vector form to
capture the components of Q, we can write this return forecast
q
f for the (q x 1) asset
class and style return column vector as the sum of the consensus expected return vector
q
r and a vector of exceptional market forecasts
q
f :
Page 16; 3/3/2013

q q q
f = r +f . (19)
Well need additional notation,
q
V being the (q x q) variance-covariance matrix
for the asset classes or factors, and
n
V being the (n x n) variance-covariance matrix of
the n managers alphas.
8
We summarize the managers residual returns as alphas in a
single (n x 1) vector a across those n managers.
D. VECTOR-MATRI X FORM: ASSET-ONLY
1. Return model
With this notation, we can write directly in vector-matrix form, and thus make
usable, the four-part parsed return of equation (4). Well take advantage of the fact that
we can add the managers beta vectors together, getting a weighted average combined
beta vector, by multiplying the managers holding percentage vector (also the
optimization change variable)
n
h by the (n x q) matrix of the managers individual beta
vectors
n,q
B (the (n x q) matrix of the n managers q beta exposures; i.e., their normal
portfolios) , getting =
T
A n n,q
h B . (In this case, the forward-looking estimates of the beta
vectors of the n individual managers are taken as givens, estimated before the
optimization process.) Thus the holdings of the managers can act as the output vector for
the optimization by controlling manager weights one indirectly also controls the asset
allocation policy, within the confines of the betas available to the portfolio through the
candidate managers.
Beyond that point, Ill skip the algebraic progression of the parsing process, as
this represents a very straightforward mimicry of the parsing process used to obtain
equation (4), written in a form that assembles the returns from the individual manager
building blocks of this portfolio, an improved level of construction detail relative to
more typical asset class building block approaches. Here is the complete version of the

8
The latter is often thought of as a diagonal matrix, but need not be and strictly speaking, could
not be. Think of the extreme case: if there were only two managers in the world, and between them they
held all the securities, their alphas would have to be perfectly negatively correlated. In the real world,
diversification tends to drive managers from this bias to negative correlations towards a zero average, and
in practice zero is a good null hypothesis for manager correlations where there is no special contradictory
information.
Page 17; 3/3/2013
vector-matrix return model the labels below the vector-matrix terms translate each into
its scalar algebra equivalents:
Part 1
Part 2
Q Q Q
SAA A SAA SAA
PA
A F
f
R R

| | | |
|
A
| |
|
|
|
= + + +
|
|
|
|
\ .
T T T T T
SAA q q n n,q q q SAA q q SAA q q
q q q q q q T T T T
q q q q q q q q q q q q
V h B V V V
r - r f
V V V V
Part 4
Part 3
Q
A SAA
PA
f
o
| |
|
A
| |
|
|
|
+ +
|
|
|
|
\ .
T T T
n n,q q q SAA q q T
q q n n T T
q q q q q q
h B V V
- f h a
V V
(20)
a. Beta-related residuals
Well, I used the word complete. That was a bit of an overstatement. Equation
(20) is almost complete, but not fully.
Because we are going to use this in an actual optimization in a later step, we want
to make sure that we are properly representing beta-related residual returns, the alphas
from asset class misfit as opposed to the alphas from the active managers. This is a real
world issue that we didnt concern ourselves about when developing the scalar algebra
version earlier; we glossed over it. These alphas are uninformed by insights, simply being
a result of some deviations from market perfection. If we are in a happy world where
are beta expected returns lie neatly on the security market line, these alphas are all zeros,
but they will then be non-zero in practice for many consultants and advisors who ignore
such niceties. And the risk associated with these alphas will be positive in either event.
Heres the deal: Weve shown the pure alpha from the managers, but we havent
shown any residuals from the possibility (indeed the likelihood) that the beta vectors of
our asset mix and of our liability mix might be interior to, or off, the CML. This isnt
an unusual or exceptional issue, but a usual occurrence under common asset allocation
Page 18; 3/3/2013
situations, most obviously related to the practical constraints on beta imposed by the
limited beta factors usually available in the manager mix.
There might be other reasons for this on the asset side of the problem, perhaps for
as obvious a reason as a lack of available borrowing or lending capabilities at the risk-
free rate. This creates the usual curved efficient frontier just tangent to, but in whole or in
part below, the CML; this difference from the CML associated with residuals. Commonly
used constraints all cause a variation on this same problem in the presence of
constraints, the frontier is going to be interior to the CML at most or all points.
The liability beta vector is almost certainly not efficient, and thus it is also interior
to the CML. If the liabilities are exactly hedged, we eliminate it from the possibility of
contributing to a residual, but that isnt always going to be the case. The bottom lines is
that we need to differentiate and account for the difference between these actual factor
beta vectors and their CML counterparts, and that requires us to deal with the somewhat
messy math of the residuals.
A direct way to start thinking about these beta-related residuals (inspired by
Appendix to Chapter 4 of G&K) is to solve for them, for example by manipulation of
equation (2) for asset-related residuals, getting:

( )
A F A Q
A A Q
R R f
r f
o |
o |
=
=
(21)
This simple manipulation confirms my assertion that there is a beta element to the
residuals, they arent solely the manager alphas as we are accustomed to expressing them.
To the extent that the beta vectors are interior to the CML, there will be a beta-related
residual component of returns, and also of risks.
b. Capital market line beta vectors and factor beta vectors
To write this in matrix form, well need to have the tools to differentiate between
the factor beta vector, loosely equivalent to an asset class holdings vector and which may
include residuals, and the pure or CML beta vector, which has no residuals as it is
composed of beta values that place it somewhere on the CML. This latter vector is the
classic two-fund portfolio, part Portfolio Q,
q
, the world market portfolio, and part the
Page 19; 3/3/2013
riskless asset. In this section well set up these tools, including the CAPM single factor
beta which controls the leverage of
q
in this two-fund format.
The CAPM beta is the ratio of a covariance of a portfolio with the market, to the
variance of the market. For example, if the factor beta vector for the SAA policy
9
is
SAA
,
and if for the asset classes as invested through managers it is the sum of those managers
asset class exposures:
=
T
A n n,q
h B (22)
then the scalar asset and SAA betas would be formed by dividing the covariance (with q)
of our factor beta vectors, by the variance of q:

A
| = =
T T T
A q q n n,q q q
T T
q q q q q q
V h B V
V V
(23)

SAA
| =
T
SAA q q
T
q q q
V
V
(24)
Lets use these scalar betas to find the residual terms in vector-matrix form.
Expressing equation (21) in this form:

( )
o = +
T T
n n,q q q T T
n n,q q n n q q T
q q q
h B V
h B f h a f
V

o
| |
= +
|
|
\ .
T T
n n,q q q T T
n n n n,q q q T
q q q
h B V
h a h B f
V
(25)
But we can simplify this with the scalar beta abbreviations so that we have an
easier equation to read, and it makes it easier to note that were just comparing the actual
factor beta vector of the assets to the CML beta vector that represents those same assets:

( )
A
o | = +
T
n n A q q
h a f , (26)
or, if the beta-related residual vector (the portion in the parenthesis) is indicated as a beta
vector with subscript R, then we can abbreviate this even further, to:
o = +
T
n n R q
h a f . (27)

9
If there are any constraints, the SAA policy will not be on the CML but will be on some interior
efficient frontier.
Page 20; 3/3/2013
The first term of equation (26), summing the managers alphas, is already familiar
weve been using it to represent the managers alphas already (Waring, et al [2000]). It
isnt a new component of the residual for our optimization.
The second term isnt really new, either. It is the misfit return of the same paper,
weve simply generalized it as a total portfolio measure. Perhaps it better renamed from
misfit return to beta-related residual return.
c. Total return equation, with beta-related residuals
The addition of this residual component allows us to state a generalized, usable
total portfolio return term, to truly complete equation (20). Expressed fully including
the new material in Part 4, it is:

A f
R R = (28)
+
T
SAA q q
q q T
q q q
V
r
V
Part 1

Q Q
SAA PA
f
| |
A
| |
+ +
|
|
\ .
T T T T
n n,q q q SAA q q SAA q q
q q q q T T T
q q q q q q q q q
h B V V V
- r f
V V V
Part 2

PA
|
| |
+
|
|
\ .
T T T
n n,q q q SAA q q
q q T T
q q q q q q
h B V V
- f
V V
Part 3

| |
+ +
|
|
\ .
R
T T
n n,q q q T T
n n n n,q q q T
q q q

h B V
h a h B f
V
Part 4
Or equivalently, we can state this quite compactly, using more abbreviated
notation:

( ) ( )
Part 1 Part 2 Part 3
Part 4

A f SAA A SAA SAA A SAA
R R | | | | | | = + + + +
+ +
q q q q q q q q
T
n n R q
r - r f - f
h a f
(29)
Page 21; 3/3/2013
2. Risk model:
The scalar algebra version of the risk model in equation (6), above, can also be
expressed in vector-matrix form, again across the same n managers and q asset classes or
styles (or other market factors).
Well start with equation (5) and follow a similar progression to that we used for
parsing the scalar algebra version. To keep it simple, well use the scalar values of beta
developed in equation (23), et seq:

2 2 2 2
A A Q
o | o e = + (5)

2
A
| =
T T
q q q n n n
V +h V h
Separating the beta of the assets into its strategic and portfolio active components:
( ) ( )
2
2
A SAA A SAA
o | | | = + +
T T
q q q n n n
V h V h
( ) ( )
2
2 2
Part 4
Part 1 Part 2 Part 3
2
A SAA SAA A SAA A SAA
o | | | | | | = + + +
T T T T
q q q q q q q q q n n n
V V V h V h (30)
Well, again, almost. In a world with no beta misfit residuals, we would be done.
But alas, it still isnt such a world. We need the beta misfit residuals to parallel the
additional term we added to the return term, in equation (28). Well do this by solving
equation (5) for residual risk, and rewriting it in vector-matrix form:

2 2 2 2
A A Q
o | o e = + (5)

2 2 2 2
A A Q
e o | o =
If we write
2
A
o directly, it will be in terms of the vector of asset factor betas, not
in terms of the scalar betas:

( )
2 2
2
2
A Q
A
A
| o
o
| = +
T T T
A q A n n n q q q
V h V h V

( )
2
A
| = +
T T T
n n n A q A q q q
h V h V V (31)
Were already familiar with the term on the left hand side of equation (31), the
residual risk introduced by the search for alpha engaged in by the managers. The new
term, in parentheses on the right, is the beta-related residual risk term. With this more
Page 22; 3/3/2013
complete residual risk term in hand, we can restate total portfolio risk, equation (30), in a
more complete and general form that will fit the real world:

2 2
A SAA
o | =
T
q q q
V Part 1 (32)
( ) 2
SAA A SAA
| | | +
T
q q q
V Part 2
( )
2
A SAA
| | +
T
q q q
V Part 3

( )
2
A
| + +
T T T
n n n A q A q q q
h V h V V Part 4
These return and risk equations admittedly look a bit hairy, particularly when
remembering that we have used abbreviated scalar forms for many beta terms, but this
parsing is valuable. And look at the bright side: this is what computers are for! Once
programmed, a long equation is as easy as a short equation but you better understand it
at least once!
3. Utility
Collecting return and risk terms developed above, we get the following fully
generalized version of the utility function (a reminder: were still in asset-only space).
This uses the abbreviated versions of the beta terms, but of course would have to
implemented with the full versions:
Max
p f
U R =
n
h
(33)

2
SAA SAA SAA
| | +
T
q q q q q
r V (Part 1)
( ) ( )
cov
2
A SAA SAA A SAA SAA
| | | | | | ( + +

T
q q q q q q q
- r f - V (Part 2)
( ) ( )
2
A SAA PA A SAA
| | | | +
T
q q q q q
- f V (Part 3)

( ) ( )
2
A A e
| |
(
+ + +

T T T T
A q q n n A q A q q q n n n
f h a V V h V h (Part 4)
The optimization change variable is simply
n
h , the manager weights, the basic
unit of trade for a sponsor portfolio, and the key to summing up both the asset beta and
the alpha terms. Because this term is hidden through our abbreviations, the operation of
this utility function is a bit obscured. But this is a key to using this as a total return
optimization function. Through the manager weights, which tie in the managers betas,
the optimizer allows for both active beta and alpha to be optimized relative to the SAA
Page 23; 3/3/2013
policy, and simultaneously for the SAA policy to be established. This is important, and
handy. What this means to the investor is that the output of the optimizer tells her what
managers to hold and in what weights, and this is controlling all the important underlying
variables, including strategic asset allocation policy in Part 1, tactical asset allocation
policy in Part 3, and manager optimization policy in Part 4. Thats a lot!
E. VECTOR-MATRI X FORM: SURPLUS UTI LI TY
1. The surplus residual terms
This time, well develop the residual terms before building the return and risk
models. Well solve for the total surplus residual return (the unsystematic residuals plus
the beta-related residuals) by manipulating equation (12), repeated here solely for
convenience:

0 0 0
0 0 0
1
S F A L Q A L
A A A
R R f
L L L
| | o o
| | | | | |
= + +
| | |
\ . \ . \ .
(12)
Rearranging to solve for the residual return with respect to beta, and with respect
to both the assets and the liability:

0 0 0
0 0 0
1
A L S F A L Q
A A A
R R f
L L L
o o | |
( | | | | | |
=
( | | |
\ . \ . \ .

Because the term
0
0
1
S F
A
R R
L
| |

|
\ .
is simply the excess return of the surplus,
S
r ,
this simplifies further. We subtract the portfolio surplus beta, and rearrange, to get a
complete expression of the entire residual:

0 0
0 0
total residual
A L S A L Q
A A
r f
L L
o o | |
| | | |
=
| |
\ . \ .


0 0 0
0 0 0
unsystematic residuals
S
L A L
r
A A A
L L L
o | |
(
(
| | | | | |
( = +
| | |
(
\ . \ . \ .
(

T
A L q n n q q
f h a f
Page 24; 3/3/2013

0 0 0
0 0 0
L A L
A A A
L L L
o | |
( | | | | | |
= +
( | | |
\ . \ . \ .
T
n n A L q q
h a f (34)
Notice that we have used the same type of compact notation that we developed
above to describe the CML beta of the liability,
L
| =
T
L q q
T
q q q
V
V
.
This can be further abbreviated, and although well lose the details we may see
the intuition more clearly:

0 0
0 0
A L L S
A A
L L
o o o |
| | | |
( = +
| |

\ . \ .
T
n n S q q
h a f (35)
This reads that the total surplus residual return, on the left hand side, equals the
sum of the residuals from manager alphas uncorrelated with the asset class factors, and
the beta-related residuals from the combined liability model and asset class vectors where
they are off of the CML.
While were dealing with the residuals, lets figure out a full definition of surplus
residual risk, expecting to find a risk term parallel to the surplus residual return, equation
(34):

2
2 2 2 0
0
S A L Q S
A
L
o | | o e =
| |
+
|
\ .
(15)
2
2 2 2 0
0
0
0
0
0
2
2
2 0 0
0 0
2
2 0 0
0 0
beta-related surplus residual r
S S A L Q
A L
A L
S
S
S
A
L
A
L
A
L
A A
L L
A A
L L
o
e o | | o
| |
| |
e
e
=

| |
|
\ .
| | | |
| |
= +
| |
|
\ .
\ . \ .
| | | |
| |
= +
| |
|
\ .
\ . \ .
T
T
A L q A L q q q
T
T
A L q A L q q q
V V
V V
isk

Page 25; 3/3/2013
0
0
2
2 2 0 0
,
0 0
Unsystematic surplus residual risk
2
0 0
0 0
beta-related surplus residual risk
2
A L
S A L L
A
L
A A
L L
A A
L L
| |
e e e

(
(
| |
( = +
|
(
\ .
(

| | | |
| |
+
| |
|
\ .
\ . \ .
T
n n n
T
T
A L q A L q q q
h V h
V V
(
(
(
(
(

(36)
We lose the detail, but this can be abbreviated and expressed as:

2
2 2 2 0 0
,
0 0
beta-related surplus residual risk
Unsystematic surplus residual risk
2
S A L L S
A A
L L
e e e |
| |
= + +
|
\ .
T T T
n n n S q S q q q
h V h V V (37)
Again, there is no point in using vector-matrix algebra to represent the liabilitys
alpha-related residual risks nor its covariance with the asset residual risks, so we will
continue to show these terms in scalar form.
While looking at the unsystematic portion of residual risk, there are some
observations that we can make: The third of these terms,
2
L
e is a constant, and could be
dropped. And one would expect the middle term, the correlation of the asset and liability
unsystematic residuals, to tend towards zero, so this risk term shouldnt be especially
important to the optimization process However, the total risk may more accurately be
represented if an estimate of these risks are made and included.
10

2. Surplus return
With this result, we can write our surplus return equation (14) in matrix form,
including the more complete surplus residual of equation (35):
0
0
1
S f
A
R R
L
| |
=
|
\ .
(38)

0
0
SAA L
A
L
| |
| |
+
|
\ .
q q
r Part 1

10
These liability residual terms can become very real and important, where as in some cash
balance plans the liability itself is credited with a rate that includes an explicit manager alpha with its
attendant residual risk, or where it includes company stock with all the residual risk of a single stock
portfolio.
Page 26; 3/3/2013
( )
0 0
0 0
SAA L A SAA
A A
L L
| | | |
| |
+ +
|
\ .
q q q q
f r Part 2
( )
0
0
A SAA
A
L
| | +
q q
f Part 3

0
0
L S
A
L
o |
| |
( + +
|

\ .
T
n n S q q
h a f Part 4
Note that the alpha, or residual return, for the liability,
L
o , i.e., the portion of the
liability return not related to market risk factors, is simply a scalar alpha, not one in
vector-matrix form. With todays data, its probably impossible to accurately estimate
this number but thats ok, as it is a constant and the largest error wont affect the
optimization result. While we wont be precise, we can probably back into a number that
is reasonable. One probably improves the clarity of the risk-return view by making a dull
axe estimate and including it simply so that it shows up in the output, but I would
understand that some analysts might exclude it and simply note that the resulting return
number is understated for lack of its inclusion, its true magnitude being unknown. The
same, of course, will be true on the risk side.
I should be clear this liability alpha is trivial to the optimization, but it may not
be trivial to the sponsor that actually experiences this very real element of return and risk.
There are risks in DB plans that cannot be hedged away in the markets under any
circumstances. These can be moderated by being less ambitious in increasing benefits,
by pricing benefits correctly, by using mortality tables with more improvement built in,
etc. But not all risk can be eliminated through the asset portfolio. This is the alpha of the
liability, or the residual risk of the liability. It is risk not related to the markets.
3. Surplus risk

2
2 0
0
S SAA L
A
L
o | |
| |
=
|
\ .
T
q q q
V Part 1 (39)
( )
0 0
0 0
2
A SAA SAA L
A A
L L
| | | |
| |
+
|
\ .
T
q q q
V Part 2
Page 27; 3/3/2013
( )
2
2
0
0
A SAA
A
L
| |
| |
+
|
\ .
T
q q q
V Part 3

2
2 2 0 0
,
0 0
2
A L L S
A A
L L
e e |
(
| |
( ( + + +
|

(
\ .

T T T
n n n S q S q q q
h V h V V Part 4
4. Surplus utility
Now we assemble the risk and return terms into a utility function:

0
0
Max 1
S f
A
U R
L
| |
=
|
\ .
(40)

2
0 0
0 0
SAA L SAA SAA L
A A
L L
| | | |
| | | |
+
| |
\ . \ .
T
q q q q q
r V (Part 1)

( )
( )
0 0
0 0
0 0
cov
0 0
2
SAA L A SAA
A SAA SAA L
A A
L L
A A
L L
| | | |
| | | |
( ( | |
+ +
( ( |
\ . (
(
| |
(

|
(
\ .
q q q q
T
q q q
f r
V
(Part 2)
( ) ( )
2
2
0 0
0 0
A SAA PA A SAA
A A
L L
| | | |
| |
+
|
\ .
T
q q q q q
f V (Part 3)

2
2 0 0 0
| ,
0 0 0
2
|
2

L A L L
S S
A A A
L L L
e o
e |
o e e
| |
( (
| | | |
( ( + +
| |
( (
\ . \ .

(
( ( ( +

T T
n n n n n
T T
S q q S q S q q q
h a h V h
f V V
(Part 4)
Ive abbreviated this through my notation a great deal, so that some of the
operations cant be seen. The most important one that cant be seen with this abbreviation
is the optimization change vector, the manager holdings vector
n
h . It is found inside of
every
A
| through the required term found in its numerator, =
T
A n n,q
h B . So apologies
there is much accounting to do in properly handling total returns, and even more so in a
surplus context.
Note that part four is really two parts the informed residuals and the beta-related
residuals.
Page 28; 3/3/2013
This is a very complete total return utility function, capable of informing a
number of the common strategy decisions that every plan sponsor and other serious
investor routinely faces:
- Basic strategic asset allocation across asset classes, on either or a liability-relative
or on an asset-only basis.
- Making the manager selection decision and the manager structure decision.
- Making tactical decisions to re-weight asset classes and styles based on
exceptional market forecasts (views).
- Beta-alpha separation decisions.
F. TACTI CAL BETS, BETA TI MI NG, AND THE LI KE
1. A Bit More on Beta Timing
There are two reasons why an optimization might result in a beta different than
the strategic asset allocation beta,
SAA
| , i.e., why it might have a non-zero
PA
| . Weve
just discussed the beta-related residuals.
The other of these reasons is the active management reason discussed earlier,
the forecasting of non-zero exceptional market forecasts. Recall, this results in an active
beta, the beta that is different than the beta of the SAA policy in single beta space, and
different from the CML SAA policy beta vector in multiple beta space, i.e.,
PA p SAA
| | | = , and the more generally useful
PA p SAA
= - . We discussed beta timing
briefly above, in section A.1.d, but now that we have built the vector-matrix version we
can make some additional observations.
This is beta timing, or market timing, or active beta, which in different
applications is known as tactical asset allocation, style rotation, country rotation, etc. A
sponsor or other investor could hold intentional mis-weights of the beta factors in the
total portfolio benchmark (such as styles, asset classes, or other factors) in an effort to
add alpha to the portfolio through active positioning of the asset classes. The exceptional
market forecast component of expected return,
Q
f A or in vector form,
q
f , is the input
that would drive any such intentional beta mis-weights.
Page 29; 3/3/2013
This of course, is as active as active gets, by any definition. Each time the
optimization is run, the forecast exceptional market return might well be different, so the
resulting active beta position will also be different during that period. If these forecasts
are skillful, value will be added over a time series of such forecasts. That value will be
experienced in realization as a regression alpha over and above the policy beta return.
In todays practice, this particular active management discipline is growing to be
unusual, often disparaged even, though in the hands of the skillful it really is an
appropriate investment discipline. The search for alpha today is more often through hired
money managers expected to add alpha through their carefully selected residual holdings
of securities (and occasionally of styles and factors) relative to the managers underlying
benchmark.
Ive organized our work here with the goal of supporting the sponsors beta
timing activity, processing the sponsors exceptional market forecasts appropriately into
the current asset allocation policy. While many scoff, nonetheless sponsors often want
their portfolio to reflect a view that value will beat growth over the next period, or
bonds will beat stocks, or domestic equities will beat international equities, or whatever.
The exceptional returns vector allows a sponsor to readily incorporate such views.
This has the quite important side benefit of taking some of the forecasting angst
out of the basic SAA decision. Using consensus expected returns for the asset classes that
are the elements of Portfolio Q is pretty easy reverse optimization is quickly and readily
available and can usually be applied sensibly. Modifications to that set of forecasts can be
understood for what they are, exceptional forecasts, and processed in a manner and with a
risk aversion term appropriate to their active nature.
G. ADAPTI NG THE OPTI MI ZER TO DI FFERENT SOLUTI ON
NEEDS: A SI DE NOTE FOR I NTERNAL DESI GN USE
The biggest problem facing anyone implementing an optimizer with these talents
may not be the development of the mathematics, now set forth above. The biggest thing
may be the design of the user interface that allows a user to control such an optimizer in
actual use. Seldom will a strategist use all the talents of this optimizer in a single grand
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optimization, although that might happen. Can we identify the tasks that it might be used
for, in an effort to support the design of the user interface?
There are four major inclusion/exclusion questions that the strategist must answer
before setting up this very generalized optimizer to solve a particular problem:
1. Are we solving for the underlying SAA policy, or has it already been
determined so that we can take it as a given benchmark?
a. And if we are solving for the SAA policy, are we doing so on an
asset-only basis, or on a surplus basis relative to a liability?
2. Will there be exceptional market forecasts, for beta timing (portfolio
active beta)?
3. Will there be manager structure (alpha) decisions, or are we simply
optimizing for SAA and portfolio active beta (beta decisions) across the
asset classes?
Depending on which of these decisions are to be included in the optimization,
there are implications for the inputs that will be needed, the outputs that will be
interesting, and for which ones of the five terms of the surplus utility function will be
used. It is conceivable that one might do all of these tasks together in well-coordinated
total return optimization, or that we take some one or more of them one at a time, as we
have done for years in optimizing manager structure. There are many different
combinations, and this presents many design challenges for the user interface, for the
schedules of input parameters, and for the type of output graphs and data tables that will
be useful. Well only figure this out over time.
1. Question 1: Is the strategic asset allocation policy to be
determined, or not?
If, in answer to the first question, the policy asset allocation, or SAA policy, is to
be determined by the optimization, then
PA A SAA
= , i.e., the SAA beta vector is a
variable and will be determined in the process; it is the optimization change vector (either
directly, or through the manager betas and the manager holdings, see below). If, on the
other hand, the SAA policy has already been set, it is not going to be up for change, then
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it can be expressed as a fixed benchmark beta vector, and
PA A b
= . The vector is
frozen.
2. Question 1A: Is a liability to be considered?
If the SAA policy is to be determined, then it will be determined either with, or
without, the inclusion of a liability (the present value of the future consumption for which
the assets are being held). If the liability is to be considered, then the utility function in
equation (40) is OK, as is. If not, then the values for the vector
L
and the scalars
, A L
e ,
and
L
e are all set to zeroes, and the value for the A/L ratio
0 0
A L is set to 1, except
where it modifies the risk free rate term, where it is also set to zero. With this, equation
(40) is identical to the asset-only utility function, equation (33).
If the answer to the first question was that the SAA was not to be determined,
then the answer to question 2 is also determined, since liability considerations would only
seldom be valuable where the SAA policy were not at issue. The exception that disproves
the rule is for cash balance plans: in the rare occasion where the liability is set by
reference to a third-party managed active fund, there is an alpha that is hedgeable, since
the plan can actually invest in that fund if it chooses to do so. In that case, we want the
liability terms even if not doing SAA policy and just doing manager structure.
3. Question 3: Is beta timing included?
If the optimizer is going to be used to decide whether to over- or under-weight
some of the asset classes in the beta vectors, then it would be done by putting non-zero
entries in one or more of the elements of the exceptional market forecast vector,
Q
f .
This will have the effect of altering the
PA
vector to reflect those biases. This is an easy
one to handle: the vector is by default a zero vector.
If the
Q
f vector is made to have any non-zero elements, then we may want to
display output data for the
PA
vector, and the risk and return impacts of this portfolio
active holding, perhaps separately for Parts 1 and 2 of the utility function.
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4. Question 4: Are managers being allocated, is this in whole or in
part a manager structure optimization process?
If managers are included in the optimization, we often refer to the active
return/active risk part as a manager structure optimization process (MSO). In this case,
the optimization change vector is
n
h , as it is determinative of
A
| through the handy
mechanism
A
| =
T
n n,q q
T
q q q
h B V
V
, which sums the managers raw beta vectors and calculates the
vector of CML betas that the manager holding vector thus implies.
Without managers being included in the optimization, we are simply determining
the asset allocation solution and not the simultaneous manager structure solution.
A
is
the optimization change vector.
So depending on whether the problem involves managers, the optimization
change vector changes its level of aggregation. A simple
A
when they are not included,
and the function =
T
A n n,q
h B translates the manager holdings vector into the total assets
beta vector when they are.
H. MI SCELANEOUS
1. Manager structure optimization:
If managers are included, even if the exceptional market forecast is a zero vector,
then in addition to the Part 4 treatment of their alphas and true active risks, the beta-
related residuals from Part 4 and the (sometimes zero) risk from Part 2 will be needed.
If we take out the liability terms (which might be very valuable to leave in for a
cash balance plan that has alphas in its crediting rates, for example), and if we combine
the beta-related residual risk from Part 4 with the portfolio active risk from part 3
(requiring us to set the lambda equal to each other), then this becomes a very
straightforward manager structure optimization utility function.
I . ALPHA-BETA SEPARATI ON
We are in the habit of presuming that alpha always has to come with beta in a pre-
packaged form. But the reality is that real alpha is definitionally uncorrelated to beta, and
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that observation frees the mind to consider unleashing alpha and beta from each other.
The new class of market-neutral long-short funds are good evidence of this reality
being pure alpha (plus the risk free rate) they can readily be ported onto any readily
available source of beta, from index funds to futures contracts, etc. The long-standing
practice of taking alpha from a fixed income portfolio by shorting Lehman Aggregate
and going long S&P 500 is another example.
But true alpha (regression alpha), being independent of beta, need not be ported
from one asset class to another. In the ideal world, one would build a portfolio of the best
alpha sources one could identify, regardless of their beta exposures or lack thereof. And
when done, one would fix the betas so as to make them look like the intended SAA
policy. We call this portable beta, and we see it as the fully generalized version of
portable alpha, full separation of alpha and beta.
There are costs and other frictions on this ideal process, so in reality it is not two
steps, but must be done as one, with costs on beta transfer and availability of beta
transfers being taken into account.
To do this with this optimizer, we only need to set up a system of constraints that
allows this to happen. We might (or might not it is potentially a strategists decision
variable) start with a budget constraint on the dollars of alpha exposure. And usually,
alphas sources are long-only with respect to the investor, because it is unfortunately
difficult to short a manager (although the alpha source itself may be short, long, or
mixed). These two constraints operate on the holdings of the managers. What about
betas?
The beta constraints would be separately stated from the alpha constraints. It has
been the practice to have both a budget constraint and a long-only constraint on the total
beta holdings of all asset classes and an implied constraint on the combined beta-alpha
exposure of each manager. Of course, to return the CML, cash must be available for use
in leveraging Portfolio Q, the reference portfolio, which implies that one must be able to
short cash. In practice, most strategists dont allow cash to be shorted, as one cant in the
real world borrow at the risk free rate. But this isnt enough. An example will illustrate
why.
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Thus unconstrained with respect to manager sources of alpha, we want the
optimizer to put the weight of the portfolio into the best combination of the best
managers without regard whatsoever to the beta of those alpha sources. One can imagine
the entire portfolio being invested in one small cap growth tech sector specialist if that
is where ones assumptions indicated that the best alpha was to be obtained. Of course,
then we would have to short most of that managers beta in order to go long the other
asset class betas to get back to the optimal beta portfolio.
The point is, we have to allow individual positions in beta that are short; it is only
the net beta positions, across short and long individual positions, that must be compliant
with the budget and long only constraints. So if we allow particular managers to go short,
most easily managers that are really just beta (indexes, futures, etc.), so long as the net of
all asset classes meets the budget and long-only constraint, the optimizer can short beta
where it needs to in order to favor one alpha source over another.
Costs for beta shorting and longing need to be estimated in the form of rates of
return, and incorporated into the short beta opportunity set.
The approach to actually conducting such an optimization is deceptively simple
merely include any available short beta sources (managers, futures, swaps, trusts,
whatever) as additional managers in the optimization, with their cost estimates. If the
costs of shorting and holding these short beta sources is included as a negative alpha
(take care to get the signs right its a short position, so the negative alpha will end up
being positive), then the optimizer will do the best it can within the constraints of costs
and availability to maximize utility across alpha and beta separately.
J . CONCLUSI ON
The idea of conducting a total return, total risk portfolio optimization across all
important variables is an appealing one. To date, those that have said they are doing this
have done so without really parsing the utility functions correctly. While the math is
tedious to work out, once set up it is no big deal; the computer takes care of it.
There is still an open question in my mind about whether we can do a one-step
total return optimization and get sensible results, or whether we need to first determine
the SAA benchmark (with the liability, if desired) and then move on to the other
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decisions. I suspect that we have something yet to learn about the interactions of strategic
and tactical inputs.
We also have a lot to learn about interface design and output design.
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To do list:
Capture the two fund (three fund) theorem page from my Q-Group presentation to
simplify some of the concepts here; citing Waring, M. Barton and Duane Whitney. 2009.
An AssetLiability Version of the Capital Asset Pricing Model with a Multi-Period
Two-Fund Theorem. Journal of Portfolio Management, Vol. 35 No. 4, Summer 2009,
http://www.iijournals.com/doi/pdfplus/10.3905/JPM.2009.35.4.111 .