The Econometrics of Asset Allocation

Carlo Favero Massimo Guidolin

February 2012

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 1 / 20

Making Optimal Asset Allocation Operational
Consider a standard (static) portfolio allocation problems in which an
agents as to choose a vector of weights w that determine the
composition of its portfolio in terms of different financial assets. Given
a degree of risk aversion a standard description of this allocation
problem is the following

max0 w 0.5 w0 w
w
r (, )

The solution of this problems determines portfolios weight in terms of

the preferences of the investor, the mean and the variance covariance
matrix of the joint distribution of returns.

1 1
w=

In order to make the approach operational knowledge of needs to be
paired with estimates of and
Favero - Guidolin () The Econometrics of Asset Allocation February 2012 2 / 20
The view from the 70s

Estimate and by using historical moments

CAPM is a good measure of risk and thus a good explanation of
why some stocks earn higher average returns than others
Excess Returns are close to unpredictable: any predictability is a
statistical artifact or cannot be exploited after transaction costs
Volatility is constant

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 3 / 20

The econometric specification

Consider the following linear regression model for a vector of returns

Y observed over a sample of size T:

Y = X + u
The simplest possible probability model for the time series of returns
implies the following specification for Y, X
2 3 2 3
y1 1
6 y2 7 6 1 7
Y=6 7 6 7
4 ... 5 , X = 4 ... 5
yT 1
The OLS estimate of in this case illustrates the econometric model for
returns behind the traditional approach to portfolio allocation.

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 4 / 20

Black-Litterman

The traditional simplest approach to portfolio allocation can lead to

dramatic swings in the optimal portfolio weights for small changes in
investment views as given by the estimates of and .
A possible solution to this problem is offered by Black-Litterman, in
their approach portfolio weighs are obtained by combining optimally
market allocation and the investors views expressed as departures
from this allocation.

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 5 / 20

Black-Litterman

Given the knowledge of the market capitalization and therefore of the

market weights wmkt and some estimates of the variance-covariance
matrix of returns, we can use the optimal portfolio allocation condition
to derive the expected returns consistent with the market
capitalization:

mkt = wmkt + erf

The portoflio allocator holds some views on a subset of size q of the k
returns included in the market portfolio:

Pr s Nq (V, )
where r is the vector of k returns, and P is a selection matrix (qxp)
that selects the subset of returns on which there are views.

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 6 / 20

Black-Litterman

This views have to be baanced against the distribution of returns

implied in the market capitalization:

r s Np (mkt , )
A value of for the expected returns BL is then generated by
combining optimally the distribution of returns implied in the market
capitalization and the views of the portfolio allocator. This is obtained
by solving an optimization problem:

BL = arg min ( mkt )0 () 1

( mkt ) + (P V )0 1
(P V)

1
1 1
BL = () + P0 1 P () mkt + P0 1
V

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 7 / 20

Black-Litterman

Note that BL could be equivalently written as:

BL = mkt + K (V Pmkt )
1
K = () P0 PP0 +

Given BL optimal portfolio weights are obtained by the usual formula:

1 BL erf
wBL =
e0 1 BL erf

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 8 / 20

The view from this course

Returns are determined by a permanent "information" component

and by a temporary "noise" component.
The noise component dominates the data at high-frequency, while
the information component emerges when high-frequency
observations are aggregated over time to construct long-horizon
returns.

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 9 / 20

The main features of the data

high frequency returns are not predictable but there is

predictability of returns at low frequencies. In general,
predictability of returns increases with the horizon. The best
estimate for the mean of (excess) returns at high frequency is zero,
but a slowly evolving time-varying mean of returns at
long-horizons should be modelled.
the presence of the noise component in returns is reflected in the
fact that volatility is not constant over time but there is persistence
in volatility.
The (annualized) volatility of returns decreases with the horizon
Non-normality is an important feature of the distribution of
returns at high frequencies but as the horizon at which returns are
defined increases nonnormality tends to disappear.
There are structural breaks in the distribution of returns, and they
are visible in all moments (1st, 2nd, 3rd and 4th).
Favero - Guidolin () The Econometrics of Asset Allocation February 2012 10 / 20
Returns at different frequencies

US Stock Market Returns: 1-M

0.5

-0.5
19461950195419581960196419681972197619801984198819921996200020042008
US Stock Market Returns: 1-Y
1

-1
19461950195419581960196419681972197619801984198819921996200020042008
US Stock Market Returns: 10-Y
2

-2
19461950195419581960196419681972197619801984198819921996200020042008

Monthly returns are not normally distributed. Non-normality

disappears from annual data
Favero - Guidolin () The Econometrics of Asset Allocation February 2012 11 / 20
The Volatility of Returns at different frequencies

US Stock Market Returns: 1-M

1

0.5

0
19461950195419581960196419681972197619801984198819921996200020042008
US Stock Market Returns: 1-Y
0.4

0.2

0
19461950195419581960196419681972197619801984198819921996200020042008
US Stock Market Returns: 10-Y
0.4

0.2

0
19461950195419581960196419681972197619801984198819921996200020042008

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 12 / 20

Returns and Fundamentals

-2.0 .20

-2.4 .16

-2.8 .12

-3.2 .08

-3.6 .04

-4.0 .00

-4.4 -.04

-4.8 -.08
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

US d-p (right scale)

10-Year annualized real US Stock Market Returns (right scale)

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 13 / 20

The Dynamic Dividend Growth Model
Define the one-period holding return in the stock market as follows:
Pt+1 + Dt+1
Hts+1 = 1
Pt
Pt
dividing both sides by 1 + Hts+1 and multiplying both sides by Dt we
have:
Pt 1 Dt+1 Pt+1
= s
1+
Dt 1 + Ht+1 Dt Dt+1
taking logs and with lowercase letters denoting logs of uppercase
letters we have:
pt dt = rst+1 + dt+1 + ln 1 + ept+1 dt+1

Taking a first order Taylor expansion of the log term around the mean
_____
price-dividend p d we have:
_____
_____
ep d _____
ln 1 + ept+1 dt+1
= ln 1 + ep d
+ _____ pt + 1 dt + 1 p d
1 + ep d

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 14 / 20

 P
pt dt = rst+1 + dt+1 + ln 1 + +
D
P/D ______
+ pt + 1 dt + 1 p d
1 + P/D
= rst+1 + dt+1 + k + (pt+1 dt+1 )
_____
ep d
= _____
1 + ep d

So total stock market returns can be written as follows:

rst+1 = (pt+1 dt+1 ) + dt+1 (pt dt )

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 15 / 20

To illustrate the role of fundamentals and noise in determining returns
consider the following simple model in which we augment the
linearized definition of returns with a specification of the process for
dividend growth and for the dividend price ratio:

rst+1 = 0 + (pt+1 dt+1 ) + dt+1 ( pt dt )

dt+1 = ad + 1 1t+1
(pt+1 dt+1 ) = adp + (pt dt ) + 2t+1 2t+1
2
22t+1 = + 22t + (pt dt ) adp ( pt 1 dt 1)

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 16 / 20

High Frequency Returns in the DDG

The one-step ahead prediction of this model for for stock market
returns can be written as:

rst+1 = adp + ad + ( 1 ) ( pt dt ) + vt
vt = 1 1t+1 + 2t+1 2t+1

One-period ahead returns are dominated by the noise components

that determines a time-varying volatility and very little predictability
of future returns given current fundamentals.

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 17 / 20

Iterating forward for m periods, we obtain simple model for the
determination of long-run stock market returns:

m m
j 1
rst+j = r0 + (dt pt ) + j 1
dt+j + m (pt+m+1 dt+
j=1 j=1
m m
( pt + m + 1 dt+m+1 ) = m (pt dt ) + j adp + j 2t+1 j 2t+1 j
j=0 j=0

The model states clearly that, in absence of

bubbles lim m (pt+m+1 dt+m+1 ) = 0 , expected long-run stock
m ! !
m
market returns Et j 1 rst+j depend on the current
j=1
dividend-yield and!on future expected dividend growth
m
Et j 1 dt+j . As a consequence the importance of noise to
j=1
determine short-run returns is substituted by the role of fundamentals
at long-horizon.
Favero - Guidolin () The Econometrics of Asset Allocation February 2012 18 / 20
The Properties of the DDG model

The model implies the possibility that long-run returns are

predictable. So forecasting models for the stock market return
should perform better the longer the forecasting horizon.
The forecasting performance for stock market returns depends
crucially on the forecasting performance for dividend growth.
Note that in the case in which the dividend yield predicts
expected dividend growth perfectly the proposition that returns
are not predictable holds in the data. However, the empirical
evidence available tells us that the dividend yield does not predict
dividend growth (Cochrane 2006).

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 19 / 20

The Properties of the DDG model

If other variables than the dividend yield are predictors of

dividend growth, then the combination of these variables with the
dividend yield delivers the best predicting model for the stock
market (Lettau and Ludvigson 2005).
Inflation illusion and the stock market (Cohn and Modigliani
1979, Campbell and Vuoltenahoo 2004)
The validity of the linearization on which the model is based
requires that the dividend yield fluctuates around a constant
mean (around which the model is effectively linearized) (Lettau
and Van Nieuwemburgh(2008), Boudouk et al.(2007)).

Favero - Guidolin () The Econometrics of Asset Allocation February 2012 20 / 20