Morningstar Magazine - June/July 2014 - (Page 62)

Strategies Evaluating New Methodologies in Asset and Risk Allocation Risk parity doesn't cut it. Markowitz 2.0 and liability-relative optimization do. Portfolio Construction 66 Back to Markowitz 70 Meet the Johnson Family 74 Making the Oil Patch More Efficient Sifting Through PIMCO's Problems A S S E T A L LO C AT I O N Thomas M. Idzorek Quant U Investment Research 78 Best Ideas 82 86 Weathering the Market's Storms The Benefits of Buybacks The traditional Markowitz mean-variance optimization paradigm has been popular and served the industry well, but it is time to embrace improved versions of the framework to take into account the current investing environment. At Morningstar, we believe liability-relative optimization and incorporating non-normal distribution assumptions into the optimization process, which we call "Markowitz 2.0," substantially improves mean-variance optimization (MVO) while keeping the core of the process in place. Portfolios may be optimized by asset class or risk factor; neither is inherently superior. An alternative framework, risk parity, has been pitched as an MVO alternative, but our research shows it fails to outperform. including expected asset-class or risk-factor returns, expected variation in returns, and an expected correlation matrix of all asset-class pairs. These three inputs are fed into an optimizer, traditionally based on Harry Markowitz's MVO framework, resulting in an efficient frontier. But practitioners are questioning Markowitz's MVO paradigm. Surveying the literature, there are several criticisms to the Markowitz paradigm: 1 When used with typical capital market assump- tions, it does not result in diversified asset allocations but rather concentrated exposures to a few asset classes. Also, depending upon the inputs, traditional MVO portfolios have unstable asset class weights over time. Both of these well-documented problems stem from the difficulty of forecasting expected returns and the sensitivity of the MVO to small relative changes in returns. 2 It relies on the first two moments of the In addition to working on superior asset-allocation (or factor-based) optimization techniques that incorporate non-normal return characteristics as represented by Markowitz 2.0, we are working to develop a fund-of-funds portfolio-construction optimization process that also incorporates non-normal distribution assumptions. Because the departure from the normal distribution can be far more significant for strategies than it is for asset classes, incorporating higher moments (skewness and kurtosis) into the fund-of-funds optimization procedure would seem to be far more important. Modern Investment Management The modern investment management process, whether based on risk factors or asset classes, ultimately requires capital market assumptions, 62 Morningstar June/July 2014 return distribution-namely, returns (the first moment) and variance and covariances (the second moment). The tech crash and global financial crisis in the 2000s highlight the fact that bad events occur in the market more often than is explained by the normal (bell-shaped) distribution. In reality, returns are not normally distributed for most asset classes, especially various alternative investments. 3 It considers the interrelationships in an asset-only context, ignoring frameworks that embrace a liability-driven investment perspective. LDI is important because almost all portfolios exist to pay for streams of future liabilities, so surplus optimization or liability-relative optimization is a more appropriate framework than an asset-only optimization.

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2014

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Morningstar Magazine - June/July 2014